US INFLATION DERIVATIVES SPONSOREDSPONSORED ROUNDTABLE FORUM

Risk: To what extent is the market for US inflation contingent on the asset market? To what extent does that have an impact and what other sources are out there when you look at it compared with Europe? Alvaro Mucida, JP Morgan: Asset swaps are still the major source of supply of inflation derivatives. One relatively new development in the market is that a broader base of clients is getting involved on the sell side, paying inflation. That includes real money, hedge funds and even insurance companies and pension funds, which historically had been exclusively receivers. The low real-yield environment also helps by bringing in people interested in paying real yields, which works effectively as supply of inflation derivatives. Then there are the traditional textbook sources of inflation derivatives such as infrastructure and utilities, but the Street hasn’t Encouraging growth in the been very successful in sourcing from them so far. There are a number of initiatives that are trying to get more infrastructure projects going in the US, like the creation of an infrastructure Evan Guppy development bank. That could be very positive for the future of US inflation inflation derivatives, but it is still further down the road. Risk: Is there still some interest in deflation hedges? Prabhat Arora: A number of equity hedge funds and portfolio Prabhat Arora, Bank of America Merrill Lynch: We have seen real- managers have shown an interest in deflation protection this year. There continues to be uncertainty about the direction of US inflation, particularly given the money players pay inflation, especially when forward inflation gets The bulk of their portfolio gets hurt significantly if there is a realised latest attempts by the Federal Reserve to stimulate growth, known as Operation Twist. This to certain levels that are perceived to be too high. That’s something deflation scenario, so buying deflation floors is a good tail-risk new and it has also been a source of inflation supply for the Street protection strategy. Compared to some of the other options that uncertainty is encouraging a broader range of investors and hedgers to enter the US inflation in swap format. are available for tail-risk protection, deflation floors are still relatively derivatives market, according to senior inflation experts in a panel discussion sponsored by cheap because there is a decent supply of these through issuance Risk: Is anyone interested in inflation protection now? We’re still of Tips and subsequent asset swapping of these Tips. BGC Partners in New York recently in quite a low inflation environment. Evan Guppy: Headline consumer price index (CPI) is 3.9% in the US. Risk: What do you think of the way liquidity has developed in That still tends to grab people’s attention. For overseas investors – the market over the past year? Are dealers able to get large the overseas central banks, European banks, UK- or Asian-based transactions done? insurance companies or asset managers – one of the things they Nikolay Stoyanov, Barclays Capital: It’s probably back to pre-crisis are concerned about when investing in US markets is the strength levels of 2006 and 2007. There are two ways we can judge that. One of the currency. One easy way to mitigate risks against currency is by how much a large transaction will move the market, and it’s not depreciation is to buy inflation protection via the cash market, that much. Two, you have broker quotes basically – quoted by us, derivatives or options. In the past 18 months, we have seen people essentially – that are within a couple of basis points that nobody is who hadn’t looked at inflation before suddenly have inflation on hitting or lifting, which means that everybody is fairly certain where their radars. actual levels are. There is also another aspect to this. During the crisis, Risk: Let’s start with the question of how volumes in US the spread between Tips breakevens and inflation swaps widened inflation swaps have held up over the past year. What have The Panel Risk: Do you see a similar trend in client activity at Citi? dramatically. The primary reason was balance-sheet concerns. This volumes been like? Bank of America Merrill Lynch, Prabhat Arora, Vice-president, Andrew Henson, Citi: We’ve seen a few equity accounts come in. has largely decreased as a concern. If we look at Tips on asset swaps D’Arcy Miell, BGC Partners: Over this past year, we have seen Inflation Trading We hadn’t seen equity participants in the inflation options space versus their nominal counterparts, that spread is back to what it was considerable growth in the market – across swaps, asset swaps Barclays Capital, Nikolay Stoyanov, Director, Inflation Derivatives Trading before. A lot of them are hedging equity positions with long floors. at the pre-crisis level. There is still demand for asset swaps because and options, with volumes up 70–75% compared to last year. BNP Paribas, David Pereira, Vice-president, US Inflation Trading That, along with positioning for protection, is something new to the The majority of that growth is in options, with an increase in Citi, Andrew Henson, Inflation and Cash Tips Trader market and is really making the inflation options space much more the volume traded of around 200%. Elsewhere volumes are up Credit Suisse, Robert Tzucker, Inflation Derivatives Trader and Director liquid. We no longer have everybody wanting to sell floors – we around 50%. Deutsche Bank, Allan Levin, Head of Inflation Trading, North America actually have buyers of floors on the other side. There is also that HSBC, Evan Guppy, Director, Inflation Derivatives Trading much more uncertainty in the eurozone. Given that risk, we’ve seen Allan Levin, Deutsche Bank: The growth in volumes reflects JP Morgan, Alvaro Mucida, Executive Director, Head of US Inflation Derivatives euro accounts doing cross-currency trades where they look at our an increase in the number of participants in the market. A good inflation, realised inflation versus implied , and it looks fairly BGC Partners, D’Arcy Miell, Global Head of Inflation Products number of our trades have been with clients who had not traded cheap on inflation long-term versus euro volatility. inflation prior to 2011. risk embedded in their portfolios and taking advantage of some Robert Tzucker, Credit Suisse: Even if you believe that inflation David Pereira, BNP Paribas: The growth in the derivatives market market distortions. might be quite low for a little while, the range of possibilities and is also the resultant of the significant increase of activity we outcomes of inflation are quite wide. With central banks printing witnessed this past year in the cash market (Treasury Inflation- Evan Guppy, HSBC: What we have seen this year, probably across money to try to get out of their problems, there is tail risk to the Protected Securities – Tips). A lot of players have been looking most markets, is that investors are trading more from the point of upside. If we get into the Japan scenario, there is tail risk on the at and taking more interest in inflation and real rates in general, view of fear rather than greed. As a result, there are more people downside. There is a variety of views and that’s something that with the past 18 months’ volatility and the absolute level of who are looking at inflation because of quantitative easing and helps the inflation volatility market grow. At the same time, it helps real rates in particular. As a result, we got a natural increase in high headline rates of inflation and thinking this is something they inflation products because investors see inflation products as a bit inflation derivatives, with more accounts managing the inflationNOT need to be concerned about.FOR REPRODUCTIONlike insurance. Nikolay Stoyanov US INFLATION DERIVATIVES SPONSOREDSPONSORED ROUNDTABLE FORUM

people are still chasing yield, so that keeps the market well supplied inflation protection as well. The second theme is with respect to have been quite active in the long end of the UK asset swaps with synthetic inflation payers. The new development is inflation forward trading. At the beginning of the year, volatile movements market. They have started to look at Tips and say, well, these options. The market was non-existent a few years back. Now, there is in gasoline and oil had a significant impact on spot-starting headline levels relative to nominals and relative to where the a fairly good agreement over pricing. It is interesting because, prices. It was recognised that forward trading was an UK asset swaps are trading are actually quite cheap. So we see in a less developed market, you would expect a large divergence effective way to trade the inflation markets without having to be more and more people getting involved in the US market and, in way-out-of-the-money strikes and, while they have the greatest concerned about short-term movements in commodities or even increasingly, it seems to be these guys in the UK looking for value divergence in terms of dealer pricing, there is still what I consider to seasonality. So it freed participants to focus on long-term inflation outside of their own market and looking for Tips on asset swaps as be a relatively tight agreement. prospects without worrying about short-term dislocations – which a way of picking up extra yield. made many participants much more comfortable in trading D’Arcy Miell: The interbank market has become far more liquid inflation derivatives. Nikolay Stoyanov: There have also been opportunities over the over the last year. More market-makers are providing liquidity on past couple of weeks for people who are willing to hold their a daily basis, and spreads are tighter. As Nikolay pointed out, we Risk: You mentioned volatility in oil. A big theme in the market positions a little longer. These arise due to the third round of have markets quoted that are 1–2 basis points (bp) wide. They will this year seemed to be uncertainty. How has that affected the quantitative easing. The Treasury programme will also involve be there all day long – they may move with the market but they inflation market? the buying and selling of Tips, which would obviously affect the are still there. People are becoming more confident about where Robert Tzucker: Uncertainty is great for a lot of markets but it’s bonds. But that operation, in reality, has little to do with inflation things are, which I think is a good thing. The liquidity that was only good in as much as people are still willing to trade during that expectations. So, once the Treasury announced it would be selling missing from the market on a day-to-day basis a couple of years Prabhat Arora uncertainty. In inflation, people were trying to find protection. The short-end Tips, those Tips cheapened significantly on asset swaps. ago is now here. more uncertainty there is, the more they desire protection, the Some of that cheapening has since reversed, but I still think there stable and balanced. The inflation market also tends more business we do, the more liquidity we have. There are a lot is room to richen the levels of these relatively short-term maturities Evan Guppy: The interbank market is being a bit more sensible to have dislocations or opportunities to earn significant returns of people looking at the energy markets who like to trade it versus asset swaps. than it was in 2008. It is also down to the way in which the clients from time to time. Real-money clients are well positioned to inflation products. They look at oil futures versus the front end of have been educated about how the market works. So I think there take advantage of these dislocations and add alpha to their the inflation market, or options on energy and options on inflation, is a little more understanding that, if you want to do a big clip of portfolios, so it’s a win-win situation for both dealers and clients. and compare the two markets. If the larger spot volatility is driven Tips or a big clip of inflation swaps, the way you execute that isn’t We have seen real-money involvement in a variety of trades this by something like that, it will bring people to look at the relative the same as it would be if you executed Treasuries. Maybe in 2007 year. Increasingly they are taking views via inflation swaps on value between markets. and 2008 investors would have thought: ‘well, I’ve got a big trade different parts of the curve, long or short, instead of just doing to do, I’ll do it exactly the same way I do Treasuries – I’ll ask five it via Tips. Also, forward-starting swaps have been popular Alvaro Mucida: I agree that uncertainty about the real economy, people for a price and deal with the best one’. While liquidity in this year– for example 5-year/5-year or 10-year/10-year swaps employment and inflation itself is positive for the market. The inflation is a lot better than it was last year and the year before, it – as these enable real-money accounts to express views on type of uncertainty that maybe is not so positive is when the is still a different and smaller market. The experience that clients forward inflation easily. Another trade that has been popular is market is particularly concerned about potentially disruptive have had in the past few years has educated them that the way buying or selling CPI swaps versus Tips breakevens. Real-money events, which discourage people from trading, as Bob pointed they need to execute is to be more sensible and considered – accounts are also taking views on inflation volatility via at-the- out. So, earlier in the year, we had the debt-ceiling debate in the whether that is working with one or two big, trusted dealers when money, year-on-year options. So it has been pretty broad-based US and now we are experiencing the European crisis; these types they’ve got a large trade to do and being more patient about involvement from real money. of situations inevitably bring back some memories from 2008 doing large size. and can reduce liquidity. Still, even under these circumstances, David Pereira: The spectrum of players on the inflation derivatives volumes have held relatively well this year, which demonstrates Risk: One thing we alluded to about liquidity is the presence market has been growing, with real-money players taking that this market is maturing. of real money and real players. Can you talk about how their advantage of opportunities in the derivatives inflation market, Alvaro Mucida presence is growing? both on asset swaps as zero-coupon swaps and on options. The Risk: What do you think of the current level of US inflation swaps Prabhat Arora: Real money has been quite active this year and arrival of these accounts in the inflation market is a strong signal and asset swaps? this is a very positive development. Real-money players typically that liquidity is there for sizeable transactions and will now also Prabhat Arora: It comes down to one’s view on the US economy Risk: Do you have any thoughts on the impact of quantitative tend have a longer-term investment view and also the capacity attract more players such as proprietary desks and hedge funds, as and the situation in Europe, but there are some compelling trades easing and the Fed’s intervention in the market? to hold risk longer, which has helped to make our market more potential central banks. We have recently received such requests. out there. The front part of the swap curve is relatively cheap, Alvaro Mucida: Nikolay already pointed out that the Fed selling and you need to have a pretty pessimistic view of Europe and the front-end Tips cheapened them a lot, although this has already Allan Levin: There are some fairly large real-money accounts commodity prices for the levels to be justified. As soon as we have reversed quite a bit. Operation Twist and the previous rounds of that have historically focused more on Tips. These accounts have some kind of resolution of these issues, we should see a snap-back quantative easing also created interesting opportunities in the long broadened their mandates to allow trading in inflation derivatives higher in the front part of the curve. Asset swaps are also cheap, end of the market, particularly around the Fed operation dates as well. Accordingly, they are now trading inflation derivatives as especially in the long end. We’ve already seen that correct in the and we’ve seen more participants playing in the long end of the fluidly as they traded Tips. Trading volumes have also improved past week. But, even at these levels, longer-dated asset swaps still curve. Obviously, the market tends to price things as information due to product development, for example, new mutual funds that make sense for buy-and-hold-type accounts. becomes available and it doesn’t wait until the Fed acts. I explicitly include in their mandates the ability to trade inflation personally think that Operation Twist is priced in for the most part. I swaps. Not only are established real-money accounts trading Andrew Henson: There is still room to go on the longer-dated also think that the additional liquidity that the Fed operations have more actively in inflation derivatives, but also newer players have asset swaps as a Libor pick-up, purely based on the fact that we created enticed more participants to take views on the curve of entered the market with the intention of actively trading inflation are in such a low-yield environment and we’re seeing real-money both inflation swaps and Tips real yields and the market as a whole derivatives as part of their mandate. accounts selling in the nominal space just to pick up benefited in that respect. Furthermore, there have been two clear themes that have another 5bp or 10bp. That spread between 30-year Tips on asset encouraged derivatives trading. First, overlay usage – many asset swaps versus 30-year nominal asset swaps will continue to tighten Robert Tzucker: Operation Twist is not in itself inflationary. Printing managers invest in corporate bonds or other assets in order to as we see more yield enhancement trades. money in itself is not inflationary. You have to have a fiscal response earn the corresponding risk premiums from these asset classes. as well. What you get is a situation where premiums are higher By overlaying inflation derivatives, they are able to continue to Evan Guppy: One of the things we’ve seen recently is interest for being long inflation because, if you push this money cranking Allan Levin NOTearn credit spreads or other FOR sources of alpha while obtaining REPRODUCTION from UK pension schemes, which over the past three or four years from the three-year sector out to the 30-year sector, it gives the US INFLATION DERIVATIVES SPONSORED FORUM

government 27 more years to take that money and hand it out and So really, we’ve seen more risk-on/risk-off type trades in the form D’Arcy Miell: We continue to invest in the technology for Indicative what it used to be, but hopefully this is a start. This is basically spend it through some programme. Anything they can do to get of buying high-strike caps and low-strike floors. So we’ve definitely option pricing as we see the growth potential of the market. where the global demand for the low-strike floors and the supply that money out into circulation could be inflationary but, by itself, I seen the risk-on/risk-off trade from our client base, purely because We believe having a more accurate pricing system for indicative of the high-strike caps shows up. Right now, in order to provide don’t think the money printing does it. However, I do think it should it is cheap. There is a high correlation right now and high betas purposes will help us broker more effectively – that said, we are a better pick-up for investors, these inflation-linked notes are heighten people’s awareness and increase risk premiums and being exhibited in the Tips market and, I think if you are going helped very much by the liquidity being provided by market- typically associated with caps, so the CPI plus a spread coupon therefore increase uncertainty and probably tail hedging strategies. to take a view on the inflationary path, you probably should be makers on a daily basis. will be capped. These sorts of out-of-the-money caps give a hedging a tail-risk event caused by a risk-on/risk-off trade at the good pick-up for the investor who thinks inflation may go up, Alvaro Mucida: The other consequence of the second round of moment. We’ve seen a kind of a shift in overall investment strategy Andrew Henson: On Allan’s point about relative value in the but not quite so much. I’m probably a little more pessimistic on quantitative easing was inflating asset prices in general, including to hedging against a risk-on/risk-off type trade. options market, as we get a firmer volatility surface on the wings, the development of exotics, purely because, prior to the crisis, commodities and stocks, which of course indirectly had an effect we see more relative-value options accounts comparing implied there were various esoteric products that relied on inter-asset on our market as well. volatilities across different products and taking relative-value correlations, and they were priced with what turned out to positioning on that basis alone, instead of just purely directional be much too small margins of tolerance. The crisis essentially Prabhat Arora: It will be very interesting to see how the market options trades or hedging strategies. Accounts are coming in and introduced a very different behaviour to all those correlations handles the first couple of sales in the front part of the curve, selling 0% floors with purely a view that the probability on -1, -2 relative to any past calibrations or any past behaviour. So I think, i.e. sales of $1 billion to $1.5 billion of front-end Tips. In a normal versus nominal or euro skew is too high, which is a newer strategy to that extent, right now in more exotic pricing products you will market, at current levels, it wouldn’t be a problem as, duration-wise, in the inflation volatility market. I believe there is much activity at have higher margins embedded that will be required from the it’s not a huge size. But, if we continue to get negative headlines the wings. That is the natural business and it is like insurance. There trading desks themselves because they know what can happen from Europe, it could be tricky for the market to take down the is really no need to buy at-the-money options. now, and also by risk management at the banks. There is much supply, especially because people still have the memory of late tighter control on what type of products you’ll be able to come up 2008, when front-end Tips performed really poorly. Macro factors Prabhat Arora: There are some very interesting opportunities with. So these higher margins, which in this case would rightfully would be important to see how this twist pans out. in the options market. Zero-coupon floors offer a way to hedge be embedded, are probably going to be a little bit of a hiccup in against a tail deflation scenario. These floors have richened up in the development of that market. Robert Tzucker: For a lot of real-money participants, the short- premium over the last two to three months but, even at current end Tips have to be very cheap for them to want to get involved levels, especially longer-dated zero-coupon floors offer good because it takes a lot of them to move the needle on their returns value. As far as year-on-year options go, negative strike floors and, therefore, it becomes pretty balance-sheet intensive. That’s are very expensive on a normal volatility basis and, for accounts one of the reasons that, if we get this news out of Europe, it can Andrew Henson that have a view that inflation is going to be high, it makes snowball. You could see these things depressed below fair value sense to sell these floors either outright or against buying some for quite some time and quite a bit below fair value before we see Risk: And participants have been involved in that? protection in the form of nominal volatility. Another trade that buyers come in. Andrew Henson: It has been a very different client base over the still makes sense is selling year-on-year floors to buy year-on-year past few months. We’ve seen equity hedge funds coming in and caps. There is supply of year-on-year caps through structured David Pereira: The Fed operation, particularly on the long end buying low-strike floors on the -2%, -3%, even -1%. We’ve seen note issuance, so they trade a bit cheaper than the floors, and of the curve, has already been priced, and the impact on the accounts hedging doing covered-call positioning – so, buying clients can get into trades with pretty good optics and risk profile breakeven curve has been to flatten it even more than the nominal 30-year breakevens or 30-year swaps and selling a high-strike cap that are essentially costless. We’ve also seen some view-taking on market, given the size of the Tips market in comparison. The to fund the downside. I think, when you start to get more and at-the-money straddles in inflation, which is something new in impact on the derivatives curve has been similar, opening up more risk-on/risk-off reversals, you see more hedging strategies. the market. opportunities with low inflation forward swaps for long-term-view We’ve also seen more accounts coming in as we start to see the investors and opportunistic players. risk-on/risk-off trade normalise and a risk-on rally. We’ve seen more Risk: Before the crisis, we saw some hedge accounts coming in to look at 2012 asset swaps as a normalisation funds in the market. Has there been a shift in terms of the type Allan Levin: There has been mention of a fear of a 2008-type trade. We think that is fairly cheap. of people involved in inflation options? Robert Tzucker dislocation in front-end Tips and Tips in general. This type of crisis Prabhat Arora: Equity portfolio managers and hedge funds is less likely now than it was then for two reasons. First, now that Risk: One of the big stories last year was the high-profile have been involved this year. Other real-money accounts, after we know that this scenario can happen, many of us have taken inflation options trade. Do you see that interest in inflation looking at the Pimco trade from last year, have also shown interest Risk: Let’s turn to that issue of the banking sector. There is a lot measures to protect against it. Accordingly, dealers’ and other options sustained? in monetising some of the Tips floors they own. It is a tough of new regulation coming in, in particular Basel III will bring with participants’ books are much cleaner. Second, there are many more Allan Levin: For sure. At the start of the discussion, it was environment for pension funds and real-money managers because it enhanced bank capital requirements. How will this affect the value-oriented accounts that are waiting for opportunities to arise mentioned that volumes are up 200% in the interbank market. We of low yields and the inflation options market is an opportunity inflation derivatives space? in the inflation markets. Should prices drop too low, many of these see the same in terms of client volumes. Perhaps the high-profile to earn extra returns, as there are still some glaring dislocations in Robert Tzucker: This is an extremely important issue. Credit Suisse players will pounce on the opportunities; whereas, a few years ago, trades gave comfort to other investors to get involved. There is these compared to other asset classes. is adopting this on January 1, 2012, so we are already dealing they realised that the opportunities were there but were not yet much stronger interest across all options – both caps and floors, with these capital requirement issues. What this regulation does set up to take advantage of them. different strikes, different maturities, from both fast money and real Risk: Have we seen any other developments on the more is it makes every swap you have count as a risk-weighted asset, money. In every way, the market seems to be growing very rapidly. exotic side? and you’ve got to hold capital against it, so it is not so much a Risk: One of the phrases being used a lot is “risk-on/risk-off Some aspects have evolved; many of the trades last year were Allan Levin: There has been stronger issuance of inflation-linked balance-sheet issue, but it turns your swaps into something that trades”. To what extent is that idea relevant in US inflation, and directional – either someone just buying or just selling an option notes, this year – approaching $1 billion in the US, especially you have to be very careful of in terms of how much you have on. what impact does that have in the market? and taking a view on the direction of inflation or volatility. We now from dealers that have a higher cost of internal funding. Most In effect, what it does is reduce the bank’s leverage and makes Andrew Henson: It relates to the earlier question of uncertainty see many more relative value trades; so clients taking a view on issuance has been fairly lightly structured, with the occasional it much more difficult to be profitable. So you need to find a and, whenever I hear risk-on/risk-off, I always think bid/offer. The one strike versus a different strike and buying a cap spread or a put more exotic offering. way to reduce the risk-weighted asset weighting of some of the risk-on/risk-off trade is a little bit better for the dealer community spread. Or taking a view that certain options are expensive longer-dated inflation. But this is not just an inflation problem, in the derivatives space, aside from the fact that it does increase relative to other maturity options, so we’ll see participants sell Nikolay Stoyanov: Inflation-linked note issuance saw its boom in it is also a nominal swap problem. Reducing the impact that the illiquidity premium that the clients face. But, from a dealer long-dated options and buy short-dated options, or vice versa. 2004 and 2005, and then it died out and, throughout the crisis, some of these trades have is going to be a challenge. It is likely community, I think it increases two-way flow because you have Liquidity across the whole volatility surface has improved and more was virtually non-existent. It is good to see that there is now to have to make people charge more money for longer-dated more uncertainty in the inflation path for the next couple of years.NOT sophisticated strategies areFOR being employed. REPRODUCTIONsome resurgence in it. One billion dollars is still a far cry from asset swaps and zero-coupon swaps – things that last a long time US INFLATION DERIVATIVES SPONSORED FORUM

Risk: Do you worry about real-money clients perhaps being put number of international players to enter the US inflation market off by the possibility of having to post when centrally to both diversify and take advantage of relative value compared clearing through exposures? to their own markets. Third, we are going to see an increasing David Pereira: This is a generic problem for all derivatives, and level of sophistication. Now that we have a deep vanilla market, not specific to inflation derivatives, except one could argue that participants will become much more comfortable trading more cash flow profiles on inflation derivatives (in particular long- complex relative-value strategies as well as inflation options, and dated zero-coupon swaps) could lead to large margin calls over the growth and liquidity in the inflation options market itself has the life of a trade. With the cost of cash and collateral being made possible the creation of more exotic offerings, so I expect to a real concern for all, such a constraint could definitely be a see an increasing amount of innovation in the market. barrier, if not a deal breaker, for some operations. It is definitely a concern for the market-making side of the activity. On the Evan Guppy: I’m fairly bullish. I think more participants will other side, clearing inflation derivatives would minimise the continue to get involved, but that is kind of contingent on inflation systemic risk that any counterparty default could raise, and would remaining a key story. If we move into a Japan-style liquidity trap, also have the advantage for new players, currently limited by where we are in a constant deflationary world, then inflation their mandate/regulations/credit risk to come into the inflation products aren’t going to be all that interesting. So, as long as we derivatives market. have that uncertainty about the macro-economic environment, David Pereira As mentioned by Evan, in comparison to European and UK D’Arcy Miell where people are scared about the possibility of deflation and inflation markets, the US inflation market is still lacking the major other people are scared about the possibility of high inflation, we and natural players that infrastructure and utilities companies holding large Tips portfolios sold such options to enhance their are going to continue to see high growth. that are going to be with you. This legislation is meant to reduce represent, and new regulations would definitely trigger their arrival. return. Note that we remain in a very low-yield environment (both counterparty risk, and so holding this capital against these trades real and nominal curves coupled with relatively high volatility), so Alvaro Mucida: I agree with everyone’s optimism about the is a way to minimise the impact in case we did have some sort of Risk: How will the US inflation market develop over the next such an environment would also be favourable to the inflation prospects for the market next year. I think the growth in inflation 2008 crisis and you have banks and customers disappearing. It is year and will we see any further development? derivatives market in general. options that we have experienced in the past couple of years is going to be a massive challenge. There are already things being Nikolay Stoyanov: I don’t think it will change that much. In the very interesting in that it happened without much natural supply done like mutual termination clauses, between banks at least, participant base, there will be an increase in the number, the D’Arcy Miell: There is going to be continued growth in the options or demand for certain types of options. So, even though there on long-dated inflation trades. However, that is not always done liquidity is probably going to remain pretty good. What I would like space. I’ve had enquiries from some European banks that are on aren’t many people who are structurally short or long -2% or -3% with customers, and also it is not clear whether the regulators to see – but I have little hope of this happening – is trading in sub- the verge of entering the US inflation space. I think they may be floors or very high-strike caps, we still have had enough depth in are going to count that. If you have a 30-year swap with a mutual components of the CPI inflation. Right now, we only have headline slightly put off by what is happening in Europe at the moment the market for clients to get involved, taking views and providing termination clause after five years, are they going to count that as inflation, and the reason we always stick with this is because the but, hopefully, when that uncertainty is removed, we’ll see those liquidity. The fact that we have got to this level is very encouraging a five year? It is not clear a mutual termination clause is going to underlying Tips issuance, which in large part provides our hedges participants entering the market. There are about three or four for the future and I hope we’ll be able to expand our product clear that regulation hurdle. It may be necessary to come up with one way or another, only refers to headline inflation. But, over the banks that are at that juncture. So I do see the possibility for offering soon. For example, inflation would be a very other creative ways to reduce the impact on the risk-weighted years, we have occasionally been asked about core inflation alone, growth in the number of bank participants in the broker market, exciting development that could happen in the near future. So far asset measure. medical care inflation or education inflation, and those are trades it bodes very well for the future. The options business has seen in our discussion we’ve been talking about caps and floors, but an that, currently, one would not even begin to price properly, let spectacular growth this year, and I think there is more to come. inflation would be a different animal that could take us to Evan Guppy: As an inflation swap market participant, the alone hedge. So, if we see something along those lines, then the the next level and it could provide new opportunities for hedgers thing I am most worried about in terms of its impact on the inflation derivatives market is going to have a sure edge over the Robert Tzucker: Tips options are definitely something that are and speculators alike. development of the market is how it affects bringing new people Tips market. being looked at by a lot more people now. In the investment world into the market, particularly infrastructure companies and utility Another aspect of the inflation derivatives market that I believe there are very few leaders and there are a lot of followers. Some of Prabhat Arora: One thing for certain is that 2012 will again be a companies, where they feel like they should be a seller of inflation is going to develop more is the options. Inflation options are what the leaders have started to get involved in this market, particularly pretty volatile year. There are elections coming up in the US, and through swaps but are not in a position to do collateralised trades. the derivatives market can offer that the cash market cannot. On the real money. Once these guys come in, it is not that long before Europe continues to have a lot of risks, so there is every reason The biggest impact from Basel III is trades where we don’t have the vanilla products, if you want to buy protection against inflation, we start getting more and more of the followers joining the to expect that we will have a lot of uncertainty about macro- a collateral agreement in place with a counterparty – it becomes there is always the trade-off of whether to use the breakevens market. That’s where our growth lies. economic data and policy direction. Due to this, we will continue pretty much penal to do trades with those types of counterparty or the swap. Tips are more liquid instruments, so they are often to have clients with very divergent views on inflation going in the inflation space. In so far as we want to have a market where preferred if you have the balance sheet. But, for options, there is no Andrew Henson: I am fairly bullish on Tips on asset swaps, and that forward, and that bodes well for the inflation options market. There there is genuine two-way interest involved, I think Basel III in equivalent barring the zero-deflation floor embedded in the Tips. will be the overall theme for 2012, primarily based on the increased are other challenges coming down the road as well, like increased its current form – and how the market is currently – might well So that segment of the market, I believe, is going to perform better issuance from the Fed. If you just look at year-over-year supply, it regulation, which hopefully also present some opportunities for scupper any hope of getting more natural supply coming into the on a relative basis. is increasing at a fairly healthy rate, which should help to increase dealers and clients. market. Regulation isn’t entirely a brake on growth in the inflation interest in Tips on asset swaps, and possibly bring down the spread market though, as the move towards exchange-traded derivatives David Pereira: I remain bullish for the prospects of the US inflation between nominals, just based on pure supply dynamics. One thing BGC wishes to thank all participants for their valuable contributions to and centralised clearing is, to some extent, good for investors, in derivatives market. We are in a recovery phase and there is still we haven’t talked about is possible inflation targeting for 2012. We this forum and we invite any feedback and anyone interested to discuss so far as one of the things that would have scared people about growth until we reach past levels of volumes traded. Also, an are definitely noticing increased language over inflation bounding these issues now and in the future. 2008 was that they could have had a liability hedging strategy increasing number of players are looking at inflation and real or staunch language on the parameters of what they see as a in place with Lehman Brothers and all of a sudden this whole risks embedded in their books, on top of their risk, healthy inflation rate. It will be interesting to see how the inflation hedging strategy has disappeared. You might think I’ve got 30- and, given that products and competitive pricing are available to volatility market reacts if that comes to fruition. year liabilities and I’ve done a 30-year swap hedge but, all of a answer these hedge requirements, it will naturally further increase D’Arcy Miell sudden, they are in a scenario where they need to go out and do volumes on the derivative space. Allan Levin: There are a number of key themes. First, I think more Global Head of Inflation Products T. +1 646 346 7409 those swaps again. Taking away that concern about counterparty Before going into more exotic options, there is still a lot of growth and more US clients will enter the market. A larger and more liquid E. [email protected] exposure should be a good thing. It will cost investors and it will in the vanilla options market, in particular with floors embedded in market combined with an uncertain macro-economic environment cost banks in terms of higher levels of initial margin and higher Tips. More and more, they will be extracted and traded separately and ongoing market dislocations is making the inflation market www.bgcpartners.com levels of collateral posting, but they are paying for something that as investors try to monetise them. There have been also lots of that much harder to ignore. Second, the world is continuing to they value. NOTrequests over the past year FOR about Tips options, with investors REPRODUCTION be much more globally integrated, and I expect an increasing