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Euro derivatives in the Nordic markets

Nordea Markets examines the recent flow of Nordic activity into the euro derivatives market as balance sheet hedging accelerates

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The euro derivatives market has recently been influenced by large Nordic flows, hedging interest rate commitments and extending portfolio duration. Interest in this hedging opportunity has largely bypassed the local swap and volatility market, as the Nordic swap market has so far been unable to service such needs. However, current activity flows signal that new market participants can fulfil new needs. But this does not cause alarm, rather, we feel thrilled and maybe even a little proud that the Nordic financial market can participate in developing the euro swap market in terms of sophistication and liquidity.

New derivatives flows from Nordic institutional investors
Derivatives are now used to actively manage balance-sheet problems on liabilities and assets – a complex activity that demands high liquidity and reasonably low trading costs. This is illustrated in the euro swap market, as the bid/offer spread on the euro swap curve has decreased to between 1 to 2 basis points (bp). Furthermore, a deep and liquid market now exists out to 30-year maturities.

The introduction of the euro brought together all European derivatives interests in one market, which as a result is now comparable in size to the US dollar derivatives market.

The euro swap curve is now increasingly regarded as the benchmark curve for all European interest rate trading, since it is the only credit-neutral and hence unbiased euro curve. Even euro swap futures have been introduced, adding further liquidity to the market especially to the benefit of the market makers.

The Swedish krona, Danish krone and Norwegian krone swap market cannot compete with this development, even though spreads and liquidity are impressive considering the underlying bond markets. However, the euro swap curve, in particular, lends liquidity to the Danish krone swap market and subsequently the Swedish krona swap market where we see interest rates converging towards euro rates. This allows Nordea to create local derivatives solutions, where short-term hedging is done in the euro market and ensures better pricing and a better derivatives product development, in the Danish krone and Swedish krona derivatives market.However, some solutions have to be sought outside the local Nordic derivatives market. Not because Nordea is unable to present a local solution, but because large market liquidity is imperative to certain transactions.

Recently, Nordic asset managers have, in great numbers, used the euro swap and swaption volatility curve to hedge interest rate obligations. In this context, portfolios with Danish callable mortgage bonds presented a special case with duration decreasing rapidly as interest rates fell. The activity undertaken to cope with the problem is popularly known as convexity hedging, previously seen in the US dollar swap market. It involves the buying of structured interest rate options in order to secure yield and add duration extension to the asset side while rates fall. It cannot be established through the Danish krone swap and swaption market, as supply would be completely inadequate to fulfil the demand and need for market liquidity. Even though the euro swap market generally lends hedging liquidity to the Danish krone swap market, market participants would be unable to bear the build up of spread risk.

Admittedly, this reveals the shortcomings of the Danish krone swap market when faced with a flow counted in billions of euros. However, even the euro swap and interest rate market had difficulties in coping with these new Nordic flows as they poured into the market. Nordea’s understanding of the balance-sheet problems and Nordic regulatory constrains, enabled us to find a solution. However, the liquidity needed could only be found in the euro swap market. Clients required certainty that the hedging undertaken could be traded swiftly in a market with many committed participants.

Euro swaption volatility was squeezed making it soar rapidly, as interest rate hedging in the euro swap market accelerated making long-dated swap spreads tighten (see figure 1). The squeeze effect hurts trading spreads and liquidity in the market. A continued interest at a lower volume is much more preferable. Recent market developments have driven interest rates down again, but the situation seems more under control this time around. The derivatives hedging already established, while not solving all the problems asset managers face, certainly helps regulate the balance sheet.

The euro swap and swaptions market is under much less pressure this time. Nordea expects these Nordic flows to continue as derivatives have obtained a crucial role as a natural balance sheet instrument.

Accelerating Nordic swap interests
Nordea sees Nordic flows leading even further, as a more general conceptual asset management idea is being introduced. Asset managers are increasingly managing the bond portfolio as a credit portfolio, demanding a return in accordance with credit quality and liquidity. However, controlling duration does not comply with this, creating a new role for swaps in duration management. Swaps can efficiently fine-tune the portfolio duration, adding a degree of freedom to the credit and liquidity optimisation. Even 10- to 30-year maturities can be targeted on the euro swap curve, at trading costs no higher than for government bonds and strips, but with higher liquidity.

The euro curve has become very liquid and efficient, trading against all bond markets in the euro zone. Local bond markets are often priced and hedged at a spread to the euro swap curve. This results in ultimate support for the euro curve, which Nordic curves can never match. We choose to exploit the benefits of this to the advantage of our clients, rather than see it as a threat to the Nordic swap market.

The Nordic swap market after introduction of the euro
Previously, trades connected to new issuance by corporates, sovereigns and quasi-sovereigns dominated the Nordic swap market. But as active portfolio management entered the scene, Nordic-based entities demanded higher liquidity and lower trading costs locally. Nordea has been dedicated to this task and believe that we have succeeded in maintaining liquidity and increasing sophistication to the extent that can be expected in view of Nordic market size (see figure 2).

The Nordic swap market has roughly maintained its total size during recent years. However, our Nordic clients have intensified the activity, and growth has largely been brought into the euro swap curve. As many Nordic corporates now use the euro in their accounting and risk management, their interests in euro derivatives will likely increase.The Nordic flow seen in the euro derivatives market is a success largely due to derivatives themselves as they have begun to play a new role in portfolios. Derivatives are now included in portfolios in order to secure the yield, hence changing the speculative image they had previously. Interest, therefore, is not lost in the Nordic market but new interests are surfacing in the euro swap market (see figure 3).

Prospects for the Nordic swap market
Nordea is committed to the Nordic market supporting swap curves in all the local currencies. Moreover, structured swaps and derivatives are engineered to fit the needs of local currencies. Structured issues fitting the risk profile of local investors have great potential, as they allow for specific risks that fit the balance sheet and offer incremental yield. Here, especially in the Danish krone callable mortgage market, this has been a challenge as the bonds are highly complex and so is the need for asset swaps handling this complexity. An attractive asset swap market, often presents substantial Cibor plus margins, based on Aaa-rated mortgage bonds.

However, though the Nordic currencies are similar to name, the nature of the interest rate curves and market movements are very different. The Norwegian krone swap curve is very domestically driven, with influence equally coming from the US dollar and the euro markets. The Swedish krona swap curve is facing a euro convergence process, making the short-end volatile but maintaining the longer maturities in a tight spread to euro rates. Finally the Danish krone swap curve is soon to face its secondary euro convergence, but effectively the Danish krone currency and interest rates have for long only been a shadow of euro movements.

The Norwegian krone swap market is not likely to converge with the euro swap market in the near future. The local economy is strongly influenced by the US dollar, oil prices and the freight market and hence the Norwegian financial market, for the most part, leads its own life. The sophistication of Norwegian krone swap users has increased tremendously over the past few years. Nordea has a large and local Nordic presence and can offer tailor-made solutions for the smallest of clients. This kind of market interactivity is essential to the success of the Norwegian krone swap market.

Local trading and client support is also our precise strength in Sweden, Denmark and Finland. Currently, euro convergence is open for temporary opportunities to be exploited and risks to be hedged, which will greatly influence both the Danish krone and Swedish krona derivatives market. The process of leading clients towards new derivatives products has just started in the Nordic countries The Nordic flow into the euro derivatives market is therefore expected to grow in the coming years. However, an understanding of local constraints and requirements is ever-more important as demand for tailor-made products grows. Furthermore, small clients make extensive use of derivatives, demanding more from the local presence if the primary flow is to be identified and solutions tailor-made.

Contact
Peder Linnebjerg,
Markets division
Tel: +45 3333 6024
e-mail: peder.linnebjerg@nordea.com

Website: www.nordea.com/e-markets

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