Inflation-linked dealers in the U.K. are struggling to meet demand from pension funds for inflation swaps with embedded options. Demand is escalating now because pension funds are facing regulatory pressure to match their inflation liabilities. But there are no natural swap payers, and that has firms thinking the high premiums may attract hedge funds into the market, as they've done in Europe and the U.S.
The arrival of hedge funds on the U.K. inflation scene would be a definite relief, said one trader, who noted his firm is selling options but has no effective way of hedging as there is no underlying market. "There's a limit to how long we can do this for," he explained. Hedge funds are starting to venture into the inflation market in Europe and the U.S. (DW, 5/13) and they are likely to follow suite in the U.K., noted Volker Wellman, European head of inflation trading at BNP Paribas in London. He cautioned however, "This is still a ways away."
U.K. pension funds' liabilities are linked to a capped and floored inflation rate, known as Limited Price Indexation, which gives way to natural inflation swaps with embedded option collars, generally long a 0% call and short a 5% put. Although some caps and floors have been traded at 2.5% and 3%, traders said supply is limited and restricted to client trades rather than inter-dealer business. In the past, corporates have issued LPI-linked bonds, but changes to accounting standards mean corporates are now reluctant because they cannot get hedge accounting for swaps on the bonds (DW, 1/21).
Traders would not comment on LPI spreads as the swaps do not trade frequently in the inter-dealer market, but agreed LPI is seen as rich because it is a one-way market dominated by receivers rather than payers. "Hedge funds should definitely be looking into this," said one trader.
Some dealers say the lack of an inter-dealer market is also holding back U.K. inflation options and making it harder for firms to hedge the options they do sell. Sean Notley, global co-head of rates trading at Morgan Stanley in London, said it is surprising an interbank market has not developed, given there is some supply and demand for these type of products. One inflation trading chief at a U.K. firm agreed it is possible to source LPI flows, declining comment on where it finds these. But he explained he's reluctant to enter the inter-dealer market. "We work very hard to get LPI cash flows--the last thing I want to do is give them to a competitor," he noted.
