Inflation derivatives house of the year: HSBC

When LCH opened the doors of its inflation swap clearing service in April last year, HSBC saw an opportunity. Over the years, its inflation businesses had built up a big book of UK inflation swaps, which soak up large amounts of capital for counterparty exposure: backloading them into the clearing house seemed to promise a swift reduction in risk-weighted assets (RWAs).

But while backloading legacy books is relatively straightforward for the interest rate swap market, inflation books are more complex. Over the past few years, corporate payers of inflation linked to the UK retail prices index (RPI) have been harder to find, with the market instead relying on relative-value investors paying RPI through asset swaps on gilt linkers.

These asset swaps are offset in dealer portfolios by zero-coupon RPI receiver swaps and interest rate swaps. LCH does not clear the asset swap packages, so backloading only the inflation and interest rate swaps would leave banks with a hefty directional exposure and a large initial margin bill.

HSBC solved this by splitting the asset swaps into their constituent parts. In its classic form, the product sees an investor paying the inflation-linked interest from a linker bond plus the inflation accretion at maturity, while receiving a Libor-linked rate in return – an outcome that could also be achieved by executing a series of zero-coupon inflation swaps and interest rate swaps.

If all you're doing is adding to your LCH exposure one way, you're solving one problem – reducing bilateral exposure – and creating another, in the form of initial margin
Dariush Mirfendereski, HSBC

Both of these products can be backloaded into LCH, balancing out the directionality and hence the initial margin requirement at the clearing house. Clearing the interest rate swap leg can help flatten interest rate exposures at the clearing house as well. Using this technique, HSBC reduced its bilateral inflation exposures to bank and buy-side counterparties by around 25% in 2016, with some seeing reductions of 75%.

"If all you're doing is adding to your LCH exposure one way, you're solving one problem – reducing bilateral exposure – and creating another, in the form of initial margin," says Dariush Mirfendereski, global head of inflation trading at HSBC in London.

This kind of story says a lot about the modern inflation derivatives business. A market made up of episodic, long-dated, often-uncollateralised trades is one that gets penalised heavily by new regulations as well as still-evolving swaps pricing practices, so dealers have had to learn how to reduce their financial footprint, while continuing to meet client needs.

HSBC wins this year's award for finding new ways to meet both goals.

As another example of the efficiency drive, the bank launched a clean-up of its interdealer collateral agreements, or credit support annexes (CSAs). Between December 2015 and the end of 2016, the bank agreed with four different dealers – two US banks and two other UK banks – to change the CSAs covering their sterling inflation books so variation margin could only be posted in sterling cash.

Moving to single-currency, cash-only CSAs allows banks to reduce their leverage exposures and net stable funding requirements (NSFR), while also removing some of the valuation complexities that have plagued the non-cleared over-the-counter derivatives market in recent years. Given LCH also requires the same type of CSA, this makes it easier to backload existing swaps, and to clear new trades as standard – a practice that has become the de facto standard since the non-cleared margin regime came into force in the US, Canada and Japan in September.

Getting clients to do the same has been a harder sell. Most large inflation receivers – pension funds hedging their liabilities, for example – do not have excess cash to use for variation margin, and so would have to go to the repo market, which is already stretched.

HSBC's pricing takes into account a counterparty's CSA, so clients continuing to use CSAs that allow them to post cash and bonds – for example – will not receive as tight a price as those on a cash-only collateral agreement. This strict approach ruffles the feathers of some clients.

"They're quite punitive on cash-and-gilt-CSA charges. They're very fair and communicate this, but on the pricing side others are more competitive," says a derivatives trader at one European asset manager.

We've had some successes, and others are either agreeing to eventually move or committed to move in a defined period, which means we could do new business with them on that basis
Dariush Mirfendereski, HSBC

Mirfendereski defends the policy as a key plank of the bank's efforts to make the inflation business sustainable. HSBC has been educating clients about the different components of its CSA-based pricing, emphasising the earlier clients move to cash-only CSAs, the more swaps business they can do with the bank.

"We've had some successes, and others are either agreeing to eventually move or committed to move in a defined period, which means we could do new business with them on that basis. With some we have an agreement that any new business will be on a cash-only CSA basis, whereas addressing the legacy trades could take a bit more time and effort," says Mirfendereski.

After moving to a sterling cash-only CSA with one large UK pension fund, HSBC was able to trade a 30-year swap with a per-basis point exposure to inflation (IE01) of £500,000. With another pension fund client that agreed to the same CSA terms, the bank traded an RWA-additive £300,000 IE01 trade in 24 hours, on short notice.

A major effort was also taken this year to reduce HSBC's derivatives exposure to the HSBC Pension Fund, its independent defined-benefit scheme. Around 10 years ago, the fund entered a series of large inflation receiver swaps solely with HSBC, largely to limit information leakage to the market.

These swaps became significantly in-the-money to the fund over that period. In 2013, the bank therefore moved a portion of the fund's portfolio of inflation swaps into linkers, so it could profit from the in-the-money position and reallocate that cash into cheaper gilts.

The fund still had a large number of swaps on with HSBC, however, which had posted £300 million in cash collateral to the fund to cover mark-to-market movements in 2015 – down from £1.7 billion in 2013. The size of the exposure attracted attention internally.

"I would get a tap on the shoulder at least once a week from various parts of the management structure saying ‘When are you going to sort this out?' just because they're big numbers," says Nobby Clark, a managing director in the Europe, Middle East and Africa (Emea) client solutions group at HSBC in London.

The trustees of the fund were also concerned about having that much swaps exposure to one counterparty. So in 2016, HSBC set about diversifying the fund's swap counterparty risk.

HSBC had hedged most of its trades with the fund, creating a number of banks with the opposite position. HSBC sought to collapse these interdealer trades and novate the other dealer to face the fund – reducing gross notional exposures in the process. The bank ran an analysis of its various positions, looking for the trades that would give the biggest exposure reduction when novated.

"Having identified the banks with opposing positions, we ran various optimisations on how to select the right transactions we have with the scheme, to offset the position we have with the banks," says Clark.

"If we start with eight or so target counterparties, you've got a very path-dependent optimisation on each of those banks as to which swap you would prefer to assign to which bank, presupposing they're prepared to engage in that process. So this massive preparation work was done before we made the first call to any other banks," he adds.

The end result saw the fund spreading its swap counterparty risk across six banks, including HSBC – meaning the latter's exposure was significantly reduced.

Credit-linked note

Another way the bank freed up lines was via an innovative credit-linked note (CLN). While the risk transfer in a traditional CLN rests on a credit default swap contract, HSBC's version instead references the credit risk of its derivatives positions with a particular counterparty.

The CLN notional, which can be as large as $50 million, is in effect the maximum mark-to-market exposure the noteholder will be exposed to. If the counterparty hits an event of default in its International Swaps and Derivatives Association master agreement, the noteholder loses its principal and instead participates in the recovery of the close-out amount on the derivatives portfolio.

"This could come over several years in batches. Say the first recovery payment made by the administrator is three years after the default, then we will pay that appropriate proportion to the investor," says Damien Haffner, head of fixed-income liability structuring for Emea at HSBC in London.

These work particularly well for inflation swap portfolios: large, uncollateralised positions that attract significant RWAs. The bank can sell five-year CLNs to investors such as pension funds, which can provide credit protection on the mark-to-market of long-dated portfolios, cutting capital requirements in the process.

If the counterparty is a whole business securitisation – which many inflation swap-using utilities are – an added benefit is that the derivatives counterparty is super-senior in the capital structure, meaning the recovery will be higher than with a normal corporate.

"It's a way to get a highly rated instrument and be paid a decent return over Libor, and I'm sure on their side it was a good way of relieving capital. It was a win-win in terms of both sides being happy to do it," says a source at one company with pension liabilities that purchased one of the Isda-linked CLNs.

On the cash side, HSBC landed a role as duration manager for the reopening of the UK's 2065 linker – the country's first syndication after the Brexit vote, which was conducted against a backdrop of significant market volatility and uncertainty. With a DV01 of around £27 million, the £2.5 billion syndication was the third-largest ever in any bond market.

"The market was at a high point, with record low real yields prevailing, so to be awarded that role as duration manager was pretty prestigious. It was a challenging role as at those levels of real yields you'd expect a large portion of bonds coming back on switch that would have to be dealt with," says Paul Bye, global head of public sector syndicate at HSBC in London.