Derivatives houses, including Lehman Brothers and JPMorgan, are considering building liquid government bond indices, on which they could structure swaps. The move comes as money managers are asking for total return swaps referenced to each house's proprietary government bond indices and dealers are finding it hard to fill the orders.
The stumbling block to developing a liquid index is the largest users, which are pension funds, insurance companies and family offices, all want to receive the performance of the index but there are no natural payers.
Because of the one-sided market investment banks are looking at putting together more liquid instruments. One solution to increasing liquidity would be to merge the investment banks' proprietary indices. This doesn't, however, get around the problem of the market all being on one side. In the credit derivatives market if there was a large group of end-users on one side, dealers could hedge the position by delta-hedging the individual names in the single-name credit-default swap market. This is not so simple in the interest rate market because the underlying bonds trade at tighter spreads than the interest rate swaps and therefore the bank would be left with a negative carry between the position it had sold to its client and its hedge position.
Kaushik Amin, co-head of global interest rate products at Lehman Brothers in New York, said increasing demand for the product means a solution will be found. "The dealer community needs to think hard about how we facilitate these products for clients," he added. Dealers either need to find a source of investors willing to pay the index or come up with a derivative solution, such as that used in the case of the credit indices, said Amin.
Index trading in commodities and credit has taken off and there is an ever greater demand for interest rate products, said Amin. Diane Knowles, director in strategic solutions at Schroder Investment Management in London, agreed pension funds with liabilities linked to interest rates would be interested. Managers at State Street Global Advisors and Aberdeen Asset Management also expressed interest.
Some structuring officials, however, noted a lot of money managers are restricted in their use of derivatives. "This is undoubtedly a boom area, but it may take some time to get off the ground," cautioned one official.
