A recent report by the Bank of Italy looks at why the various banks of Italy use derivatives. Specifically, the central bank of that country wanted to know: is it a matter of hedging? Or is it a matter of keeping a proprietary book?

Hedge fund managers and other pursuers of alpha will be interested in this paper to the extent that they find themselves on the opposite side of transactions with banks. It is often important to understand why your counterparty is in the transaction.

The short answer: banks chiefly use derivatives for hedging.

The authors of the paper are: Luigi Infante; Stefano Piermattei; Raffaele Santioni; and Bianca Sorvillo. They use the B of I’s quarterly supervisory data to look at that country’s banks’ use of derivatives through the period 2003-2017. The supervisory data includes information on: (a) the types of derivatives used; (b) notional amounts and relative fair values; (c) classifications in the banking or trading book. The “banking book” consists of all assets being held to maturity, while the “trading book” consists of assets and liabilities for which a trading intention exists.

The Findings

Banks unsurprisingly use derivatives to hedge against possible moves in interest rates, and against counterparty default. At the end of 2017, interest rate derivatives accounted for a little less than 90% of the outstanding amounts of such instruments held by Italy’s banks. Within that family of derivatives, the interest rates swaps dominate.

The report also finds that banks holding more capital and with greater liquidity in their asset base rely less on derivatives than do those with smaller numbers in either respect. This indicates that capital and liquidity are substitutes for derivatives, which in turn answers the original question. Capital and liquidity are substitutes precisely for the hedging purpose of derivatives.

The report reviews some basics about the function and significance of banks: they are in the business of transforming short-term liabilities into long-term assets. When interest rates move, the mismatch in the time horizon between liabilities and assets becomes a matter of risk. This is precisely why banks need to hedge against interest rate moves.