UPDATED: A tale of inflation, solvency & regulatory jeopardy

We first published this article in November 2022 but given current market events, we’re republishing it this week with some updated opening paragraphs. 

There is a common perception in securities trading that getting the timing right when taking positions in the market is far more difficult than having the right idea to begin with. In hindsight, the below blog, written in November 2022, was a classic example of this. Regulatory concerns I raised five months ago in relation to rising interest rates, badly positioned market counterparties, bond market losses, capital adequacy, solvency issues and fears of contagion were well placed, but four months too early…

In a similar manner to government preparations for a flu pandemic in 2020, following the 2008-2011 financial crisis, regulators were well prepared for a series of credit events. Unfortunately, the pre-cursor to the current situation is not a credit event but an interest rate event, for which preparations are far less appropriate, regulators simply find themselves looking in the wrong direction. Regulators will be quantifying counterparty exposures, collateral concentrations, leverage, levels of collateralisation and evidence of any further systemic risks. The principal tools for identifying these risks include SFTR, MMSR, SMMD and the likes of PRA Liquidity Reporting. If this data is poor, regulators will be active in their response. For a conversation about your data quality, please contact us.

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21 November 2022

The deflation that followed rapid Chinese industrialisation has kept interest rates on a declining and ultimately stagnant path for decades since the 1990s.  In recent years, interest rate and government bond markets could have been politely described as being as dull as ditch water.

However, as with all things in the market, the trend is your friend, until it isn’t…

UK Treasury 2050, 0 5/8% Bond Price – theoretically one of the safest investments…

Source: London Stock Exchange

Supply chain and booming inflation

Supply chain issues stemming from Covid, compounded by the emergence of China as a new superpower with massive domestic consumption and to a lesser extent Brexit, saw the price of the long dated UK Gilt (above) dip from around 100 (or par) into the 80s in February 2021. This c.20% fall in value accelerated as war broke out in Ukraine in February 2022 resulting in a dramatic jump in global inflation, with central banks increasing official interest rates in an attempt to ensure that this inflation is transitory. The downward trajectory in UK bond prices troughed with the fallout from the misguided September UK mini-budget on 8 October 2022 when the price hit 36.40 – a fall of 64% in the 2050 Gilt price from its high to low.

Rates markets have become sexy again

Higher interest rates, volatility, differing views on inflation expectations all of a sudden bring bond markets, money markets and securities financing markets back into sharp focus. While this may be to the delight of rates traders, it will have been highly unwelcome by the pensions industry as the value of many of their key ‘low risk’ assets are needed to service pensioners of the future evaporated. The moves were so dramatic, some pension funds’ solvency was called into question, resulting in intervention by the Bank of England to support the Gilt market in October.

What does all this mean for regulatory reporting?

Central banks and regulators will be on heightened alert to identify large interest rate exposures, the effective transmission of official central bank interest rates, solvency issues, credit default risk and the potential for contagion. Trade and transaction reporting regimes are among their principle means of performing this supervisory oversight and analysis. This will encompass everything from MiFID, SFTR, EMIR, MMSR, SMMD, CFTC, FinfraG, SESTA and many more besides. When faced with something of a crisis or an emergency situation, there is a risk that regulators need to react quickly with punitive measures if their investigative work is thwarted by reporting data quality issues.

Enforcement has been notable in its absence for a number of years, just don’t be too surprised if this now goes the way of the bond market.         

• If your money markets reporting (under SFTR, MMSR & SMMD), your bond market transaction reporting (under MiFIR) and your interest rate derivatives reporting (under EMIR, CFTC, MAS & HKMA) is not in perfect order or you are unaware of how good (or bad) it is, please get in touch.