Healthy Growth of Sovereign Hedging Culture – Role of Policy and Regulatory Reforms

With strengthening forces of globalization, increasingly liberal movement of capital and commodities across sovereign borders and widespread adoption of financial markets, risks have not only become inevitable evils of market economy but also made transparent for policy makers to be aware of and accountable to as well. As the pressure on sovereign finances increased prior to and with the onset of the recent financial crisis due to volatile market conditions, the cult of sovereign risk hedging is becoming predominant among emerging sovereign and sovereign owned businesses to manage their costs and revenues in a more prudent manner besides the risk of capital costs. Taking a step further, even the private airlines of the oil producing Middle East have started hedging their oil costs contrary to common understanding that they remain hedged through consuming oil at production cost which remains fairly stable than the price of oil in markets. Countries from Mexico to Morocco and Sri Lanka have increasingly adopted to the concept of risk management using instruments which are customised or standardized derivatives from plain-vanilla to complex and exotic instruments. Such products also range from publicly traded exchanges Strengthening of institutional participation and their financial products design and research capabilities provided strength to the emerging cult of sovereigns attempting to manage their risk exposure with their help.


The financial markets arm of the banks stood as counterparties on OTC hedge products which were offered to sovereign states or state owned agencies. In some of the instances, the research and technical advisory were provided by the arm of the institution which gave them the product to hedge their exposure. Lack of strong corporate governance among both the hedge seller and buyer could make the hedge buying firm in a vulnerable form due to information and technical knowledge arbitrage that professional agencies may look to earn on. Besides, the treasuries of sovereign institutions do not manage positions proactively in the market and that these are OTC products benchmarked to prices collected and disseminated by private agencies, needs that the financial arm of these institutions should follow strong corporate governance norms and policy promoting transparent to protect buy-side sovereigns. However, the recent regulations such as Volcker Act would potentially restrict geographies from which these firms could offer such products to sovereigns limiting competition that would have otherwise provided better products and brought in increased transparency.

 Thanks to its active hedge program, Mexican government was able to wade through the oil market crash of 2009. Mexico is reported to have spent about USD 450 million during 2014 to lock in their oil price realization, exports of which are done through a state-owned Mexican oil company contributes to nearly a third of their annual budget. This hedging plan as executed in advance of at least 1 year by the state-appointed investment bankers helps them manage their expenses and insulate their national finances from commodity price fluctuations. Reports indicate that Mexico’s oil exports have been insulated from a fall in oil prices below USD 81/barrel during 2014 and the same was done at USD 86/barrel during 2013. While Mexico had moved from plain-vanilla futures (in its early attempts at hedging its energy exports) into put options and collar spreads (to reduce cost but at a risk to the costs of hedging), Moroccans are new species into this world of sovereign hedging who attempted to hedge their energy exposures using call options on diesel provided by a domestic bank which bought a backup hedge with a multinational bank. In the process, it could have led to higher cost of hedging due to longer chain of intermediation. Such cases indicate not only that the sovereigns would have to strengthen their risk assessment and management capacity but also have shorter and direct access to cost effective products, matching their risk profile and cost expectations. As all of these sovereign hedging happens in the OTC markets, the broader market participants have no clue of sovereign assessments of price conditions and hence have the potential to stray away from the OTC market leaving arbitraging opportunity for the hedge providing institutions to take advantage of. Though the current G-20 transparency and OTC market clearing aspirations and the emerging Dodd-Frank and MiFID II regulations are an effort in this regard but their slow but steady adoption given the complexity surrounding territorial claims, margining, reporting of the data, it needs that sovereigns hedging their exposure shall make it transparent their hedge positions immediately post the trades were executed and should also insist upon the hedge providers to clear the same through central clearing parties which would also be making it public their clearing data within a given standard time interval. Such an effort would not only plug the unique arbitrage opportunities available to hedge providers but also remove undue speculation about sovereign positions in the broad public traded markets. The incident of Ceylon Petroleum Corporation which incurred losses to the tune of $1 billion is a case in point where the prices went against the positions of the sovereign hedging party either due to wrong guidance/expectations about the oil price movement or due to negligence arising out of market opacity and/or wrongful understanding of the product used in hedging.

It needs that the sovereign corporations that hedge positions on behalf of a larger portion of the national demand should follow strict adherence to corporate governance norms, have well trained staff manning hedge desks, access to all sources of market data about the product they are hedging and follow transparent public accounting and reporting norms. Besides, it also requires that the board may have specialists who can adequately govern risk management practices and guide the staff in doing the same. As pressures on public finance are increasing and as the culture of financial markets is slowly getting imbibed into policy making across sovereigns, the cult of sovereign hedging is likely to grow. Recent hedging by few of the African nations and Airlines owned by sovereigns of the Middle East is a clear indication of this trend. But it is essential that the growth of this cult would have to be nurtured appropriately with right set of policy reforms and regulatory structure so that it serves that larger public cause than denting the public finance.

Sovereign Hedging of Risks – Time for Market and Institutional Reforms

As the pressures on fiscal budgets surge with sovereigns increasingly recognizing the risks of their exposure arising out of global market movements, it had led to increasing acceptance of hedging as the means to conserve precious capital to spend in more productive ways than using it to protect its balance sheet from the impact of inevitable price fluctuations. As successful sovereign hedging models have emerged from Mexico to Ghana, it is likely to have considerable ‘demonstrative power’ on others. Nations with strong public sector are more likely to adopt sovereign hedging as the mode of risk management than nations with competitive private sector. Same will be true with sovereigns whose resources are nationalized and revenue from nationalized resources are more likely to affect national balance sheets compared with revenue from other economic activities. At the outset, it may seem to be a simple function of concentration of market risks on sovereign balance sheets. But sovereign hedging is a function of several other factors right from identification and quantification of such risks to access to knowledge and ability to manage risks, besides the existence of right set of policies and institutions. To make this process a smooth, fair, balanced and transparent process, it needs much of global and local transformation in markets, market advisory services, institutional, regulatory and policy reforms. The fact that markets are getting transparent and goods and services are moving to markets not only makes risks transparent and quantifiable but also help markets develop products to manage these risks in an effective manner and to seamlessly slice risks among investors who are willing to mop them out.

 While trading in financial markets involve paper instruments, these instruments would have to benchmark on physical or spot market transactions or prices discovered in a fair and transparent manner plugging all arbitration opportunities that might arise. It requires that spot markets be efficient and transactions shall ideally be reported/monitored for benchmarking purposes. In a policy environment which is aspiring to move from polled prices to transacted prices for benchmarking, it would be far fetching to talk about reported/monitored spot market transactions. Also that doesn’t block underlying interests of transacting parties to benefit from any anomalies in prices that might exist, which needs a mandatory market identity requirement such as a LEI, reporting mandate with all necessary data points to a central market data repository that may make data public while masking the identities of transacting entities as is the case with modern electronic market platforms. On the other hand, as sovereigns take positions to hedge their huge exposure, neither the transparency nor the opacity works in favour of efficient and arbitrage free functioning of the financial markets. Hence, it should be made mandatory that sovereigns/sovereign corporations make public their hedging intentions well in advance and their positions be published with minimum possible delay to help market soak up the information in a slow and steady manner and plug any arbitrage opportunities that might arise.

 In addition, these strategies being made public will help financial pundits have a public scrutiny and help make governance of such activities stronger. It will help the sovereigns/corporations in two ways. One, the financial analysts community shall help fine-tune the sovereign hedging strategies with their knowledge and past hedge performance at their back. Secondly, it will help the government as the broader financial activism would help keep hedged positions to the market and manage them cost effectively. Overall, financial activism would help in evolution of healthy sovereign hedging strategies through a vigorous two-way feedback mechanism and advance strong governance in sovereign financial activities. In fact, lack of such activism could lead to extreme downsides aided as well by the absence of strong governance mechanism and practices such as lack of active management of hedged positions, hedge through complex financial instruments, and/or benchmarks polled or collected from opaque markets. While for the sovereign hedgers the focus shall be on cost savings, it would be advisable to implement those hedges after appropriately estimating the cost and benefits of hedge including costs associated with tail side risks which weighed heavily against Ceylon Petroleum Corporation in their supposed to be a hedging program during 2010 against crude oil price movements.

 Also, if not appropriately benchmarked against the underlying and duration, treasury of the public corporations have the potential to overshoot the treasury risk management objectives driven by the profit motive moving away from the original objective of risk management. At times, apart from opacity and lack of MTM practices, undue profit motives could also introduce sovereigns/corporations in to territories of unknown risk as well. While the profit motive could also be boosted by the advisories of institutions such as the trading arm of an investment bank, who may also be acting as counterparties to positions without highlighting risks in such a process. In terms of governance, it needs that sovereign hedgers follow a strict tripartite firewall between the product offering institution, financial markets advisory and in-house research team who may provide quantifiable benchmarks for various financial parameters associated with the hedge instrument to make efficient and impartial decisions while managing risks. It needs that the risk management interface shall be effectively motivated to focus on risks in risk management right from counterparty risks including constant monitoring of the quality of collaterals.

As the developed nations are moving towards mandatory clearing mode for their OTC markets, sovereign hedgers shall also mandate routing their trades through well capitalized clearing corporations. While it will remove counterparty risks from transactions, reporting will make the transactions partially transparent. OTC markets thrive due to the freedom it offers for customisation of financial products but institutions interfacing with the organized market places offering standardized products shall be encouraged to offer customized contracts using standard products available in organized public platforms such as exchanges. However, if one were to go by recent regulatory developments in developed markets, capable institutions such as investment arms of banks would be extinct from this space soon. Even if it were to land up in the hands of capable large brokerages, extinction of banks from such activity could lead to collateral scarcity restricting market’s ability to cater to sovereign needs. Unless there is a reversal with liberalization of trading activities of banks with strong regulation, collateral requirements, monitoring and compliance norms sovereign hedging activities could come under potential pressure. While the recent financial crisis highlighted the pitfalls of uncontrolled growth in OTC markets, it had also highlighted the need for hedging of major risks associated with sovereigns or sovereign corporations leading to the growing cult of sovereign hedging. However, further growth of hedging by sovereigns and sovereign corporations can only be ensured by measured financial market reforms leading to healthy growth of global financial markets and intermediary institutions interfacing with them until nations diversify their economic activities and privatize their public corporations.