Credit taxation and regulation are potential hurdles
As for any newmarket, taxation and regulation are potential hurdles in the buildup period. How property derivatives are treated when a manager uses them as a hedge is one important regulation issue that may impact the evolvement of the market. The use of property indices to hedge a specific portfolio assumes that the portfolio composition matches the index composition. Given the heterogeneous nature of property, this is impossible to achieve and will therefore not lead to a perfect hedge. However, if the hedge is good enough, i.e. correlation between the portfolio and the index is high, sellers would not be prevented from entering the market. Whether and how actuaries can apply hedge accounting for property derivatives, i.e. offset their risk and return against the ones of the hedged property portfolio, is currently under discussion. To apply hedge accounting, regulators require hedging effectiveness to be demonstrated using statistical or other numerical tests.
If hedge accounting is not applicable, portfolio managers have little incentive to hedge their position. In that case, property derivatives may even increase actuarial profit fluctuations, although economically the fluctuationswould partially cancel each other out. While local jurisdictions vary from country to country, international regulatory authorities are setting guidelines for the use of property derivatives. For example, the US Financial Accounting Standards Board (FASB) is currently reviewing its requirements for the application of a property derivative as a hedge for real estate.

The lack of replicability inhibits banks from launching a derivative product and simply replicating it by buying the properties contained in the underlying index. The more heterogeneous the underlying market is, the more difficult it will be to establish a replicating portfolio. In order to have a portfolio with prices closely related to those of the derivatives, a large number of properties must be bought in a very short time. Physical replication is thus inefficient, timelagged and costly. In the absence of perfect replicating strategies, a hedging error exists. In order to reduce or eliminate this error, the bank needs to find a counterparty that is willing to take the opposite side of the deal. In other words, banks simply act as intermediaries, matching supply and demand. If the bank keeps a risk position, it will try to reduce the hedging error by engaging in various hedging strategies.