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The Knock-on Effect of Regulations
By Matthew Streeter CFA | January 11, 2013

A recent article in Risk magazine did a great job of pointing out one of the cases where new regulations, with the flick of a pen, are causing widespread market change, many times with unintended consequences.  One of these recent proposals coming out of regions of Europe is the introduction of a new interest rate curve construction methodology to be used at pension funds that affects the longest end of the curve, beyond 20 year tenors. Stemming from this new proposal  is the necessity for pension funds to decide between hedging programs that are in their best economic interest, and hedging practices that favor regulations, as these are still seemingly at odds. It seems counter-intuitive but the regulations - meant to be a better reflection of real market conditions and the reduction of risk when defining discount curves that better reflect market behavior - provide an incentive for financial institutions to not engage in rate hedging, a fundamental aspect of ensuring a sufficiently funded pension scheme.

Whether this is embraced by other sovereigns, across Europe or globally, remains to be seen, but we are still seeing industry wide (not just pensions) where firms are demanding analytic capabilities with inherent flexibility, in the way discount curves are constructed but also in other ways such as a more robust hedging analysis tool. An example of this flexibility is with regard to hedging practices. Pension managers are now more often asking the question of what will their portfolio look like under a variety of market conditions, such as what is the cost of not hedging, being fully hedged, varying  hedging strategies, and what are the optimal hedging notional under each scenario. These are especially important considerations as market conditions change.  It is important to be able to take a stressed market scenario and test out how theoretical hedges will respond in stressed market conditions. These are all "what if" scenarios that have to be run before executing hedges and must be done on an ad-hoc basis. This has not been common practice historically but times have changed.  And as we look at different financial instruments that can be either central cleared or over the counter and each have different capital and margin requirements their relative costs these hedging dynamics will be more important than ever.

For the full article in Risk that I mentioned, it's available here.