Diseconomies of scale

It is often assumed that small schemes (those less than £500m) will always struggle, due to their limited resources, to compete performance wise with their bigger counterparts.

Recently published research by Goldman Sachs Asset Management has shown that the big difference in performance (given the fall in interest rates) is due to whether a scheme has LDI or not.

One of the other often cited reasons for this difference is that the governance structure of larger schemes means that they can be more nimble as they have the time and resources to make quick decisions. This may well be the case today but it should not be the case. In my view, small schemes have a competitive advantage in the nimbleness game – especially when we think about nimbleness in LDI space.

The reason for this lies in understanding the role counterparties play in derivatives markets. It is a common misconception that counterparty banks take the opposite view to those with who they trade. This is not true. Counterparty banks are essentially facilitators. They trade one thing with a pension scheme and then immediately hedge that exposure in the market elsewhere. Banks make their money from a spread between the client trade and the hedging trade.

Typically, therefore, if a bank can easily hedge a client trade then it will charge a lower spread (proportionally) than for a trade that is less “hedgeable”. As well as the complexity of the trade, one of the biggest determinants of how easy it is to hedge a trade is the size of the trade.

Think about the following simple example; a client wants to buy shares in a company. If it wants to buy 100 shares then it is probably easy for the bank to source. If the client wants to buy 5% of the company, then that is difficult for the bank to source and so the offer price will be adjusted to allow for that risk.

The same is true in derivatives. Smaller sizes of transactions are easier for the bank to hedge and so are proportionally cheaper.

So, if nimbleness is key (which I am not sure about), large schemes will likely have high costs of nimbleness. If small schemes can solve the governance problem, then they actually have a competitive advantage in being nimble as the trades will be cheaper.

The same is also true of a simple initial LDI implementation. The charges for implementing LDI for a small scheme are proportionally significantly smaller than for large schemes.

So, if you are a small scheme thinking that you don’t have economies of scale to implement derivative strategies, think again. In fact, it is highly likely that your size is an advantage.


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