top of page
  • Writer's pictureWilliam Webster

Guilty Secrets

I worked with a client who provided a vivid lesson on the importance of the iceberg of risk. This is the story.

The bank's treasury invested in a portfolio of long-dated gilts, using swaps to hedge against interest rate fluctuations. They were confident in their approach, after all, risk had been neutralised, and that’s what the reports showed.

After some time a trend caught their attention.

The value of their gilts was rising steadily while the swaps used for hedging remained relatively unchanged. Sensing an opportunity, they decided to liquidate their positions, resulting in substantial gains. Naturally, they expected commendation for their success.

However, when the news reached the Board, their reaction was not so complimentary. How had they made money when there was no exposure?

What transpired was a significant hole in their oversight; the lack of proper monitoring for credit spread risk. The potential for the Gilts to increase in value relative to the swaps had been completely overlooked. All was not as it seemed and it’s a timely reminder when we look at risk reporting that some things can be hidden despite our best endeavours.

Reporting Shortfalls

The crux of the issue was that the reporting mechanisms in place did not capture the hedging mismatch. The traders focused on the immediate profitability of the Gilt positions, calling it a windfall gain, without considering the broader implications of what had occurred. The institution was blindsided by a risk that should have been apparent.

Credit Spread Risks

Credit spread risks of this type abound, you immediately see the effect in a mark-to-market environment but not when you are in accruals. Here such exposures can remain hidden but can be painful.

To prevent such oversights, it is crucial to incorporate an analysis of credit spread risks within the business. One effective approach is to implement a simple credit delta measurement to assess the sensitivity of the portfolio to changes in spreads. This involves calculating the change in the value of both the assets and their hedges given a shift in the relationship. It’s far from perfect but shows you the magnitude of what you are facing and if you want to go further you can try some scenarios.

For example, consider a stress where credit spreads widen by 100 basis points. In this situation, the value of the gilts would decrease significantly, while the swaps would not provide sufficient protection, leading to substantial losses.

By running such scenarios, the bank can better understand the potential impact of adverse market conditions and take pre-emptive measures to mitigate risks if they are considered excessive. On a slightly different note, it’s not a dissimilar exposure to the one pension trustees experienced on their Liability Driven Investment exposures in September 2022.

Encouraging Openness

One of the critical aspects of the situation I encountered was that the business prided itself on its internal communication about risk. But, for whatever reason, the risk remained opaque even though the traders were likely aware of the exposures early on.

Whilst on this occasion we are talking about windfall gains the Board rightfully asked why such risks were not discussed earlier. This means probing deeper into the communication channels and ensuring that there are no barriers to transparency between the traders and senior management.

This leads us to the role of the second line which should actively engage in reviewing trading/hedging strategies and independently verifying the risk exposures. If you don’t have the firepower in this area slippages like the one I’ve discussed will likely happen.

In this case, it’s a combination of issues. The traders should have flagged things earlier, the second line should have twigged things, and the Board should have asked for a detailed analysis of the risk being put on before the event - after all, it was big.

Ultimately, the key takeaway is that these things do arise, you can reduce the chance of it happening to you, but you can’t eliminate all risks unless you shut everything down.






6 views0 comments

Recent Posts

See All


bottom of page