The U.K. inflation swaps market may face a shortage of counterparties willing to pay inflation because corporates operating under International Accounting Standards are concerned the instruments will add volatility to their accounts. Alan James, inflation-linked strategist at Barclays Capital in London, noted, "This will reduce the growth of the swaps market."
In the U.K., corporates have entered inflation swaps to mirror revenue streams that are either correlated to inflation, in the case of retailers, or directly linked, in the case of utilities. Many of these issued bonds and separately entered inflation swaps because it offered a lower cost of funding than issuing an inflation linked bond. Under IAS 39, however, corporates looking to manage inflation risk by entering inflation swaps on conventional bonds will not qualify for hedge accounting. This rule change is likely to have the largest impact on the sterling inflation swaps market because it is the most developed.
U.K. grocer J Sainsbury uses inflation swaps, but Simon Gibson, assistant treasurer in London, said if this issue is still hanging over the market when it needs to enter another swap it would not execute the trade. Joe O'Neill, group treasurer at AMEC in London, said the corporate has looked at inflation swaps for both its pension fund and as a treasury instrument, but has not executed any trades because of the adverse accounting treatment.
Gibson said Sainsbury will look at alternative methods of hedging inflation, but he noted it would have to be approved by its audit company.
James said the U.K. inflation swaps market may only be temporarily unbalanced. "The demand side is really driving growth," he added, explaining non-listed entities could help inflation supply. One corporate sales official, however, said he had already seen a drop off in inflation swaps by corporates. "It's a thorny issue and it's not immediately obvious how we will get around this," he added.