Many Shades of Vanilla: The Complexity of Hedging

Executive Summary
The fog has begun to lift and the writing can now be seen on the wall:  Central clearing of formerly bilateral trade structures will impose new costs – mainly margin-related opportunity costs – that will serve as the primary catalyst in the cascade of product selection towards less exotic and outright “vanillas”.  While this may sound – on the surface – like one of those rare circumstances when the landscape becomes less complex, the opposite is actually occurring and will continue to occur for the foreseeable future. 

Not only will many exotic trade structures remain on the books of market participants until they eventually expire or are terminated, but new products aimed at mimicking the economics and potential accounting advantages of an OTC derivative while simultaneously exhibiting the operational efficiency and regulatory certainty of a listed derivative will be added to the selection spectrum.  In short, the list of available hedging products is set to expand, not contract.  Those products from the old paradigm coupled with those in the new will further complicate hedging decisions; decisions that most market participants never had to make before.  It should go without saying, therefore, that a heightened need for solutions that capture a greater diversity of products with a broader list of attributes and costs, including – perhaps most importantly – analyzing the “hedge effectiveness” of each choice is quickly becoming a requirement.  If it wasn’t obvious by now, swap market participants who plan to stay engaged with their hedging practices need to upgrade their internal capabilities.

This TABB Group Focus Note Many Shades of Vanilla: The Complexity of Hedging
is based on significant prior work in listed and OTC derivatives markets, including the impact of clearing and new margin related costs on hedge product selection.  The study identifies shifts in decision-making capabilities to the buy side and the needs for new tools to handle those decisions.