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Regulator informal action

Does a regulator’s direction to ditch a hedge mean a Hedging Party is “unable to commercially reasonably maintain” its hedge?

As long as there is no regulatory-approved alternative means of hedging (you know, futures, for example), then the JC says yes. The aspiration to maintain good relations with a body having power to regulate your operations, let alone a plausible apprehension of sanction (be it a monetary penalty, adverse publicity or the regulator barring you from operating in its market or just taking a dim view of your outfit) — provided it is sincere — is a reasonable commercial consideration which would prevent you from maintaining that hedge.

The bogus “why should I pay your hedging costs? I have no control over them” argument

Sniffy buyside counsel — especially hardcore ISDA specialists who are new to PB and don’t yet really understand it, might try suggesting a dealer’s hedging costs are its problem. This argument is bogus. Synthetic PB is just cash brokerage done with derivatives — the dealer hedges delta-one and has no skin in the game as it is simply executing a client order. The client would wear such costs in a cash trade — the dealer is an agent, after all — and the format of the transaction doesn’t make a difference. Okay: a swap counterparty is not in any legal sense an agent — that is axiomatic — but the trade is riskless principal, which is agency from an economic perspective.

  • The dealer owes best execution. That means, (subject to contrary instructions) it has to interrogate all venues and get the best possible price.
  • Under best execution rules the client may instruct the dealer to exclude certain venues and dealers.
  • To comply with best execution, the dealer must configure its order router to accommodate the client’s preferences.
  • But excluding a venue impacts the quality of the available execution (whenever the excluded venue had the best price, you’d miss it).
  • By not excluding the venue, therefore, you benefit from the venue being present (as long as it doesn’t fail) every order you place.
  • Trades settle DVP so there is market risk in replacing the trade, not credit risk.
  • The market risk could be significant: failure of a venue will heavily impact liquidity and market volatility for a period.
  • Asking the dealer to underwrite a market loss when a venue or intermediate broker fails while getting the benefit its best pricing as long as it does not is asking for a free option on your own execution risk.

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See also

References