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.