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.