Inflation derivatives house of the year: BNP Paribas

Risk Awards 2024: Bank gains market share by increasing risk limits in the year of European inflation

Left to right: James Ritchie, Yiyi Zou, Stephane Salas and Hugo Delaborde

Photo: Joy Ekpeti

Making the right calls on eurozone inflation and investment from senior management in the bank’s inflation business has propelled BNP Paribas through the ranks of its competitors.

The bank has jumped from fifth place by market share at the end of 2021 to first place in the second and third quarters of 2023. In sterling, it has leapfrogged from 11^th place at the end of 2021 to first place in the same timeframe. The data is measured in PV01, the sensitivity of value to a one basis point move in underlying inflation, by one of the major trading platforms.

It’s an improvement in market share but also in customer satisfaction.

“For us, BNP Paribas has gone from being quite a niche player to working towards becoming one of our top-tier counterparties,” says the head of trading at a large US asset manager.

An increase in flows has also allowed it to assist clients with more esoteric trades, such as the Eurex-LCH basis, UK consumer price index swaps and hedging sovereign issuance.

It’s a journey that’s been fuelled by economic uncertainty.

Inflation has been in the DNA of BNP Paribas for a long time

Stephane Salas, BNP Paribas

For more than a decade, Europe had struggled to generate inflation and economic growth. Instead, concerns focused on deflation risk and ‘Japanification’ of the eurozone economy. Low inflation, low growth and near-zero interest rates – like those experienced for decades in Japan – led to stagnation and to difficulties in revitalising the economy. Many firms opted to leave the inflation derivatives market.

Not BNP Paribas.

“Inflation has been in the DNA of BNP Paribas for a long time,” says Stephane Salas, head of European and UK inflation at BNP Paribas. “There has never, ever been any question of not being committed to or involved in the inflation product or inflation markets.”

It was in early 2020, after Covid hit, that Europe’s inflation market started to show renewed signs of life. The outbreak of the virus and subsequent national lockdowns exerted pressure on global supply chains, affecting consumer prices in food and services. Inflation was being pent up in the system, says Salas.

While other firms were focused on rapidly rising inflation in the UK and US – but before the pandemic had exerted much upward pressure on eurozone inflation – BNP Paribas was actively engaging with clients in the region.

The approach paid off and, in late 2021, helped the bank win Risk.net’s annual inflation derivatives award.

“I think what's been positive about the BNP Paribas experience for us is that it's been consistent, and the improvement has been happening over a number of years,” says the US asset management trading head.

Seeking to build on its successes, the bank’s senior management invested further in its European and UK inflation businesses. They allocated more balance sheet to the inflation desk and raised its risk limits, allowing it to warehouse more illiquid risk.

Then, in March 2022, Russia invaded Ukraine and forced Europe’s energy prices to new heights, and sent inflation into an upward trajectory.

In late October 2022, the benchmark for eurozone inflation – the Harmonised Index of Consumer Prices excluding tobacco (HICPxT) – hit record highs of 10.8%.

“Higher realised inflation, especially in Europe, awakened peoples’ concern about future inflation,” says Salas. “The inflation genie was out of the bottle.”

On the basis of Eurex

During this time, the basis between clearing houses Eurex and LCH has become a new source of trading revenue for the bank’s inflation business.

In October 2020, Eurex cleared its first buy-side, euro-denominated HICPxT swaps. Until then, only minimal interdealer trades had been done through the European clearing house. Traders said they expected a basis to emerge between euro inflation swaps on Eurex and its rival LCH, and for it to widen to as much as 4–5bp in longer-dated contracts.

But, in July 2023, these expectations were eclipsed when the 30-year inflation swap basis blew out to 11.5bp. This was caused by European pension funds back-loading directional paying of fixed inflation swaps onto Eurex – having decided, post-Brexit, to clear all their derivatives at the European clearing house.

Market participants started to fear the basis could become unbounded.

“Until people started seeing the sellers, I think it was a question [of] how far the basis could go,” says Salas.

Having the Eurex curve in your systems means that you very easily see your risk

Stephane Salas, BNP Paribas

Years earlier, BNP Paribas had adopted Eurex curves into its internal systems and had the basis incorporated in its valuations. The bank also had limits and reserves linked to the basis.

It therefore has insight into the value of the basis and can adjust its internal curves more effectively by active participation and providing quotes to clients – a bonus, given that BGC, the only interdealer broker offering a screen on the basis, receives limited flows.

Salas says the bank was active early on with clients, talking to them about Eurex-cleared trades.

“Having the Eurex curve in your systems means that you very easily see your risk, you can easily trade the basis between Eurex and LCH as it's moving,” says Salas. “It's not something that is very transparent and liquid because that basis doesn't trade much in the interdealer market.”

When the basis widened to 11.5bp, some European pension funds started to pay to unwind their trades, believing the basis had become too expensive. Unwinds would reduce liquidity add-ons as part of the initial margin requirements at both clearing houses. BNP was able to facilitate the unwinds.

Others, such as bank asset-liability management desks, started to come into the other side of the trade, willing to take the mark-to-market risk that the basis was going to retighten. They achieved this synthetically through derivatives referencing Eurex-cleared swaps versus LCH-cleared swaps. The move also became popular with clients buying inflation-linked bonds on asset swaps, looking to play a retightening of the basis.

As measured by DV01 – the sensitivity to a one-basis-point move in interest rates – the bank has now facilitated more than €1 million ($1.1 million) of trades on the basis.

Serving sovereigns

The growth in European inflation certainly grabbed the attention of sovereign issuers in 2023. Early in the year, Slovenia, as part of its strategic objectives, chose to venture into the inflation-linked bond market for the first time.

The sovereign issued a €100 million ($110 million) 11-year inflation-linked bond, and unwilling to hold the inflation risk hedged the bond back into nominal issuance through an inflation swap.

Slovenia had widely discussed its issuance objectives with its primary dealers, but BNP Paribas won the deal by providing the tightest pricing on the swap transaction. It was the sole bank on both the issuance and the hedge.

“Issuing inflation-linked bonds and swapping into fixed euro was extremely competitive,” says Marjan Divjak, director general of the Republic of Slovenia’s treasury directorate. “[BNP Paribas] were able to deliver the tightest price, so the execution was smooth.”

We were able to meet [Slovenia’s] targets in terms of issuance, whilst also offering attractive levels to the investor

Hugo Delaborde, BNP Paribas

It took six months from its first discussion with the sovereign to the deal’s execution in early September.

And the bank had no trouble matching the flows with an investor on the other side.

“We were able to meet [Slovenia’s] targets in terms of issuance, whilst also offering attractive levels to the investor,” says Hugo Delaborde, head of IRFX corporate structuring, Emea [Europe, Middle East and Africa], at BNP Paribas.

In other sovereign business, the bank was able to assist a second Eastern European state in synthetically unwinding an existing structured inflation-linked bond – the first time the client had used an inflation derivative.

The issuer had a long position in real yields via the bond and, at the start of the year, wanted to capitalise on the positive move in real yields by bringing the issuance back into nominal rates. The bank was able to do this synthetically through a swap to hedge the inflation coupon on the existing bond, swapping it for a nominal rate.

Home front

The French Treasury also got in on the action. From early 2021, French inflation rose in parallel with that in Europe more broadly and peaked just above 6% in February 2023. In early June, the Trésor issued a 15-year inflation-linked bond, maturing in March 2039, which BNP Paribas helped syndicate.

Also in France, asset-liability management desks within private bank clients, financial institutions and corporate clients have been actively hedging liabilities linked to the Livret A benchmark via swaps. The Livret A rate is the interest rate on the French state-regulated, tax-free savings account that has inflation linkages.

“As a large French bank, naturally we are well positioned to see Livret A hedges,” says Salas. “We have traded at a higher level of notional than in previous years.”

In fact, the bank was able to trade more than €1 billion ($1.1 billion) notional on maturities ranging from five-years to 12-years.

Serious wedge

The bank’s inflation desk has also been developing its presence in the UK market as part of its overarching sterling markets plan.

The bank’s growth in this area has been recognised by the UK’s debt management office, which granted BNP Paribas its first role as duration manager for its September syndication of a £5 billion ($6.3 billion) gilt, maturing in 2063.

The bank’s prowess in nominal rates has translated across to its presence in the sterling inflation market.

“The focus on sterling has allowed us to be more comfortable making more competitive spreads in terms of execution,” says James Ritchie, head of UK corporate rates and FX sales at BNP Paribas.

And it’s recognised by the bank’s clients.

“BNP Paribas were always very solid for us in European interest rate swaps. I think they've stepped up now and they're actually a relevant player in the UK as well in gilts, linkers, sterling interest rate and inflation swaps,” says the head of trading at the US asset manager. “That's been one of the big areas where we've seen improvement from them.”

The focus on sterling has allowed us to be more comfortable making more competitive spreads in terms of execution

James Ritchie, BNP Paribas

In March 2019, the UK’s Statistics Authority recommended the chancellor phase out the use of the retail price index (RPI) as the benchmark for inflation and move instead to the less volatile Consumer Prices Index, including owner occupiers' housing costs (CPIH) by 2023.

Large utilities regulators have also been pushing corporates to move their inflation measure from RPI to CPIH. Because of the limited CPIH market, corporates still proxy-hedge using the consumer price index (CPI), which has grown in recent years but remains relatively illiquid.

After the outbreak of war in Ukraine, the bases between RPI and CPIH blew out significantly. For regulated utilities with debt linked to RPI and revenues linked to CPIH this created a problem.

They needed to get rid of the basis and move as close to CPIH as possible – and since the second half of 2022, BNP has seen a steady increase in the volume of so-called basis wedge trades to bridge that gap. So far, the bank has done over £3 billion notional in CPI versus RPI wedges.

Given the illiquidity of the CPI market, BNP had to warehouse significant amounts of the positions by extending its risk limits and allocating extra balance sheet.

“We thought that that would be a differentiator for us to go out and say to clients: ‘We don’t need to go and find the other side; we’re happy just to take this risk on our books and we will manage the market risk over time’,” says Ritchie.