UK - Pension funds' use of derivatives is continuing to grow rapidly and the use of over-the-counter (OTC) transactions is expected to almost double by the end of 2007 compared with last year, suggests data from consultancy firm Watson Wyatt.

Findings of the firm's own swap transactions on behalf of pension fund clients reveal the number of OTC transaction performed this year has already exceeded last year's levels and demand is fuelling the growth of the inflation-linked market to a possible £35bn (€50bn) by the end of this year, albeit the exact amount is unknown because deals are conducted privately between banks and pension funds or insurers.

This is perhaps because evidence indicates use of swaps can decrease a pension fund's deficit risk.

According to Nick Horsfall, senior investment consultant at Watson Wyatt, a typical £500m swap executed between June 14 and September would have reduced the financial impact of interest rates fall by £40m.

"For those clients using high-quality, well-managed cash vehicles, to back their swaps, there have been only minor issues in generating LIBOR recently and generally insignificant compared to [sic] the level of overall risk reduction provided by these swap strategies," said Horsfall.

That said, parties elsewhere in the investment sector are warning the use of derivatives is being held back by current operational limitations to managing and processing derivatives.

Consultancy firm Morse conducted a survey of 50 investment managers, including hedge funds, which suggests providers are having to use multiple sources to value OTC derivatives portfolios.

"There is no one single source which all investment managers feel they can use to value their OTC derivatives portfolios," said Chris Sier, consultant at Morse.

"Building an operational model to manage derivatives is not easy because of the complexity of the task. As a result, almost 60% are forced to adopt a blended or ‘mosaic' model involving a combination of some, or all available methods."

Moreover, the study said 55% of firms had been unable to find a suitable outsourcing service to help with OTC derivatives trading and prime brokers were seen as too expensive.

Morse suggests there is a "huge opportunity" for any outsourcing firm who can be first to market with a "suitable, comprehensives, and cost-effective method for managing derivatives".