Brexit hedging leaves Ficc books unbalanced

Bank market-makers are struggling to recycle some interest rate and inflation client flows targeting the UK's referendum on membership of the European Union, say traders, meaning they have to warehouse positions that could lead to losses if the vote today (June 23) results in a violent market move.

The referendum has two possible outcomes – either the UK remains in the EU or leaves. An interest rate options trader at one major dealer says his desk is trying to keep its exposure flat through the event, but most client demand has been to build long volatility positions, and sellers of volatility in the hedge fund world – often the other side of the trade for a market-maker – have been hard to find.

"Who ultimately are the end-users that are going to take risk? Say sterling volatility balloons; who is going to sell to me? Historically, you'd say hedge funds would sell. But the sector's performance has clearly not been great and individual trader mandates at these funds are different now. There's no real appetite to be the guy who sold one-month 10-year sterling and lost a fortune," he says.

Only a couple of large dealers have been willing to sell volatility through the broker markets, he says, meaning some banks will have to warehouse short volatility positions. The trader says his desk has managed to offset some exposure by pushing multi-legged options trades such as butterflies and condors to other clients.

To some extent we have to warehouse those risks – that is part and parcel of what we do
Inflation derivatives trader at a large dealer

While banks can't sit on the same amount of risk they could three years ago, the trader says they can still accept some of the volatility and pick up the risk premium. "Ironically, some of the banks seem to have a larger risk appetite than some of the funds," he says.

An inflation derivatives trader at another large dealer says his firm also aims to be flat through the vote, but has had to take and hold some positions because it also has a commitment to provide liquidity to clients into the event.

"To some extent we have to warehouse those risks – that is part and parcel of what we do. From our point of view, we hope that by warehousing the risk – which may make money or lose money – means that over time you're providing that service and having a profitable business on the back of having given clients what they need. Post this event, that's what we hope to do," he says.

Downside risks

In the foreign exchange options market, premiums on downside sterling/US dollar forex options have spiked in recent weeks, indicating banks may be facing similar constraints. According to data from electronic foreign exchange options broker Digital Vega, implied volatility rates for one-week sterling/US dollar put options at a 1.40 strike are now quoted 30% higher than the equivalent upside 1.52 calls, making hedges against an expected downward move in the rate on a Leave vote expensive. Implied volatility on overnight options referencing the pair also jumped to record levels this morning. Sterling/US dollar spot was at 1.48 on June 23.

It is unclear whether this is due to difficulties covering existing risk positions or indicates a general reluctance by banks to sell puts.

Mark Suter, co-founder of Digital Vega, believes the premiums that market-makers are quoting in forex options shows there is considerable risk to the downside should there be a Brexit vote.

Mark Suter, Digital Vega

"Unsurprisingly, the market makers really don't want to sell them and, if anything, they'd much rather buy them where they can. That much larger upfront premium cost for the downside would suggest there is still some unhedged risk below 1.40. The market as a whole is probably still net exposed to the downside as many people have been buying sterling puts over the past several weeks as insurance. If it comes to it and the vote was to leave, there would be a big reaction to the downside. The major positions range anywhere between 1.30 to 1.40 puts, so they would be paying up for those if there were to be a Brexit vote," he says.

That analysis is shared by Robert Savage, chief executive at currency fund CC Track Solutions in New York, who says the banks have potentially left risk open to a Leave vote. "The movement seen this week is a quarter of the volume of what should be done. There are people that are structurally short into this event with an option, and so only a fraction of what needs to be bought or sold in sterling to cover a short or gamma trade has been done," he says.

Foreign exchange

The forex options market has been an obvious choice for market participants looking to hedge the outcome of the referendum. As a result, traders have seen high implied volatility for downside sterling/US dollar hedges, with a large spike occurring when some opinion polls showed the Leave campaign had gained a significant lead over the Remain camp earlier in June. Nevertheless, there are funds still willing to pay the premium.

"We had one account that paid 40% [implied volatility spread] for 1.30 puts on a two-week maturity, receiving a price back of 20% on the bid and 60% offered," says Digital Vega's Suter. "Some of the more active accounts were selling short-dated sterling strangles or straddles, and picking up the premium because volatility was so high. A few days later we saw the same type of activity in euro/US dollar," he adds.

Not all firms are as bullish – many that have exposure to sterling have been busy dialing down risk. Some have cut sterling positions by as much as 50%, or exited the currency altogether.

Felix Adam, ACT Capital Partner

"We don't have any sterling positions on right now," says Felix Adam, chief executive at ACT Currency Partner in Zurich. "We are not that heavily involved in sterling anyway, but right now we don't see it as a strategy to run."

Liability-driven investment (LDI) and currency managers have also looked to roll their forward contracts early to avoid some of the sharp moves in sterling pairs that would inevitably increase the cost for their customers. 

"For our passive hedging clients that have sterling exposure the idea has been to avoid rolling open forward contracts in periods of heightened volatility. If you're rolling a long sterling hedge in a high-volatility period and picking a local low point for sterling, then you can crystallise a bigger negative cashflow for the client at settlement than would otherwise be the case. Also, there are wider spreads embedded in trades during a higher-volatility environment," says James Wood-Collins, chief executive at Record Currency Management in Windsor.

Inflation expectations

Speculative hedge funds piled into the short-dated inflation market earlier in the year, as the expectation is that falls in sterling following a vote for Leave would push up inflation around the one-year point. Those funds have since taken profit on these trades, says the inflation trader at a major dealer.

LDI funds have been active throughout, though. One derivatives trader at an LDI manager says his firm has been trading until last week, mostly looking to reduce asset-liability mismatches between swaps benchmarks and bond portfolios across the curve.

The LDI trader is concerned about the effect a Leave vote may have on the gilt repo market. Regulations such as the leverage ratio and net stable funding ratio have already put pressure on the repo market, and the LDI trader fears a Brexit vote could push up internal risk weightings, cutting banks' capacity even further.

"Obviously, these things don't just happen and a switch is flicked, but further down the road if there's a downturn and it leads to a downgrade by the credit rating agencies, you may see something filtered through," he says.

Another inflation trader at the same large dealer agrees, adding the timing is also bad as it is nearly the end of the financial quarter, which is when banks look to trim their balance sheet for reporting purposes. "That could cause some of the micro relative-value relationships to trade in wider ranges than they would otherwise. We've seen some slight signs of those ranges increasing over the past week or so ... [where] some of the adjacent bonds through the gilt curve are trading a bit wider than they have been," he says.

Interest rate derivatives

Unlike forex and equities, the rates market's reaction beyond the ultra-short-dated products is difficult to determine. Strategists disagree on what a Leave vote would mean for the five-year/five-year gilt market, for instance. Some suggest it could lead to mass dumping of the instrument, while others say prices could rise on the back of a possible rate cut from the Bank of England.

The interest rate options trader says that although he has not seen a lot of risk riding on the referendum vote, he has run various scenario analyses to capture any gap risks that may arise. The desk isn't planning to be structurally long volatility, as a win for the Remain camp could cause a drop in volatility.

If we have the exit, the [iTraxx] Crossover will soar 400 basis points; if we remain it will tighten 300bp. So it's difficult to take a view on that
Alexandre Caminade, Allianz Global Investors

"The challenge for us is to keep the dynamic right from a modelling perspective, making sure any rotation in the volatility smile or any change in volatility as a function of rates moving is correctly captured in the greek scenarios and in the delta and vega," he says.

Like many, he expects liquidity to be scarce on June 24 for shorter-dated products, but believes it will return relatively quickly.

"Clearly, one-month 10-year [swaptions] won't be as liquid as most. But by the time you get out to one-year 10-year, I imagine by Friday afternoon or Monday morning we'll be back to normal," he says.

Reluctance to take strong positions in credit

In credit, the binary nature of the outcome – and pre-existing liquidity issues in cash markets  – have dampened any strong position-taking, according to buy-side firms and credit analysts. Investors that have been expressing a view tended to use indexes on credit default swaps (CDSs), which have been more liquid than the cash underlying.

CDS indexes such as the iTraxx Europe and Crossover widened out last week on the back of stronger polls in favour of a Leave vote, but then tightened again this week (see figure). The names most affected are those denominated in sterling, as well as senior financials both in and out of the UK, according to analysts.

Also at play has been the European Central Bank's bond-buying programme. That has been a boost for euro-area investment-grade names in the CDS indexes, say analysts, helping to cancel out some of the widening of spreads resulting from worries about a Leave vote.

Nevertheless, fund managers say the uncertainty of the vote has kept them from wanting to take any kind of firm position, even in more liquid indexes.

"We use iTraxx Crossover, but it is extremely volatile as well. In such situations, it is difficult to take an outright view because it's a bit binary. If we have the exit, the Crossover will soar 400 basis points; if we remain it will tighten 300bp. So it's difficult to take a view on that," says Alexandre Caminade, chief investment officer responsible for corporate credit in Europe at Allianz Global Investors in Paris.

Meanwhile, fears of the longer-term impact of a Leave vote on the economy are pushing up volatility in the credit swaptions market.

"When we think about options markets – you see this in currency, and certainly in credit – the implied volatility in options for expiry dates after June 23 reflects the uncertainty. Implied volatility has been at multi-year highs in any security closely associated with the EU referendum. In credit, [you have] the iTraxx main index. It's only 20% UK credit but it's the hedging vehicle of choice for most European investors, so we've seen those moves in implied volatility since mid-April. That will come down starting the morning of June 24," says a credit analyst at one UK bank.