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Kanaga Raja

Derivatives market continues to rise

by Kanaga Raja

19 May 2014

The outstanding notional amount of over-the-counter (OTC) derivatives totalled $710 trillion at the end of 2013, an increase from $693 trillion at end-June 2013 and $633 trillion at end-2012, the Bank for International Settlements (BIS) has said.

Adjusted for exchange rate movements, notional amounts at end-2013 were about 1% higher than at end-June 2013 and 13% higher than at end-2012, it said.

In contrast to the rise in the notional amounts, the Basel-based BIS reported a decline in the gross market value of outstanding OTC derivatives - the cost of replacing all outstanding contracts at market prices prevailing on the reporting date - to $19 trillion at the end of 2013, from $20 trillion at end-June 2013 and $25 trillion at end-2012.

In its latest statistics on the OTC derivatives market, BIS said that the decline "was driven by interest rate derivatives and, in particular, by a narrowing between market interest rates on the reporting date and the rates prevailing at the inception of the contracts."

According to BIS, the gross market value represents the maximum loss that market participants would incur if all counterparties failed to meet their contractual payments and the contracts could be replaced at current market prices.

Gross credit exposures equalled $3.0 trillion at end-December 2013, down from $3.8 trillion at end-June 2013, representing 16.3% of gross market values at end-December 2013, which BIS said was a bit higher than the 2009-12 average of 15.1%.

With respect to the market for credit default swaps (CDS), BIS said that central clearing and netting made further inroads, in that contracts with central counterparties (CCPs) accounted for 26% of notional CDS outstanding at end-2013.

"Bilateral netting agreements reduced the net market value of outstanding CDS contracts, which provide a measure of exposure to counterparty credit risk, to 21% of their gross market value," it added.

On interest rate derivatives, whose segment accounts for the majority of OTC derivatives activity, BIS reported that for single currency interest rate derivatives at end-December 2013, the notional amount of outstanding contracts totalled $584 trillion, which represented 82% of the global OTC derivatives market.

"At $461 trillion, swaps account for by far the largest share of outstanding interest rate derivatives."

According to BIS, the recent trend in the global market of increasing notional amounts but declining market values was driven by developments in the interest rate segment.

"Even as notional amounts rose, the gross market value of interest rate derivatives declined to $14 trillion at end-2013, from $15 trillion at end-June 2013 and its most recent peak of $20 trillion at end-2011. Such declines were reported for interest rate derivatives denominated in most of the major currencies."

BIS noted that long-term bond yields and swap rates in these currencies rose in mid-2013 after announcements in May that the US Federal Reserve envisaged phasing out quantitative easing.

"The decline in the gross market value of interest rate derivatives over this period suggests that the bond market sell-off narrowed the gap between market interest rates on the reporting date and the rates prevailing at contract inception," it said.

Increases in the notional amount of interest rate derivatives were concentrated in the medium- and long-term segments, said BIS, pointing out that the notional amount of contracts with a remaining maturity of one to five years rose to $234 trillion at end-2013, from $180 trillion one year earlier, or to 40% of all maturities outstanding, from 37%.

The notional amount of contracts with a remaining maturity greater than five years rose to $152 trillion, from $119 trillion over the same period, or to 26% of all maturities, from 24%.

"The increased activity in the medium- and long-term segments may have reflected investors’ changing expectations about the persistence of low policy rates and large-scale asset purchases by central banks over the medium term," BIS explained.

It further said that the distribution of interest rate derivatives by counterparties points to a continued shift in activity towards financial institutions other than dealers, including central counterparties (CCPs).

The notional amount of interest rate contracts between derivatives dealers has been falling steadily since 2011, to $96 trillion at end-2013 compared with the (post-2008) peak of $159 trillion at end-June 2011.

Contracts between dealers and other financial institutions stood at $470 trillion at end-2013, or 80% of all contracts, up from $355 trillion, or 64%, at end-June 2011.

"The shift towards central clearing exaggerates the growth in notional amounts for other financial institutions because, when contracts are cleared through CCPs, one trade becomes two outstanding contracts," BIS underlined.

Turning to foreign exchange derivatives, which make up the second largest segment of the global OTC derivatives market, BIS reported that the notional amount of outstanding foreign exchange contracts at end-December 2013 totalled $71 trillion, which represented 10% of OTC derivatives activity.

"The latest data show little change in the instrument composition of foreign exchange derivatives. Forwards and foreign exchange swaps accounted for close to half of the notional amount outstanding. However, currency swaps - which typically have a longer maturity than other foreign exchange derivatives and thus are more sensitive to changes in market prices - accounted for the largest proportion of the gross market value."

In contrast to the interest rate derivatives market, BIS said that inter-dealer contracts in the foreign exchange derivatives market continued to account for nearly as much activity as contracts with other financial institutions.

"The notional amount of outstanding foreign exchange contracts between reporting dealers totalled $31 trillion at end-December 2013, and contracts with financial counterparties other than dealers about the same amount."

The inter-dealer share has averaged around 43% since 2011, up from less than 40% prior to 2011, said BIS, adding that inter-dealer activity is especially significant in the yen and US dollar markets, where it accounted for 52% and 47%, respectively, of notional amounts at end-December 2013.

Among instruments, inter-dealer activity accounts for a greater share of more complex contracts, such as currency swaps (54% of notional amounts) and options (49%).

With respect to credit default swaps (CDS), BIS noted that in 2007, credit derivatives had come close to surpassing foreign exchange derivatives as the second largest segment in the global OTC derivatives market, but notional amounts have since declined steadily.

"Notional amounts of CDS fell to $21 trillion at end-2013 from $29 trillion at end-2011 and a peak of $58 trillion at end-2007. The gross market value of CDS fell to $0.7 trillion at end-2013, from $1.6 trillion at end-2011. The net market value fell to $139 billion from $417 billion over the same period."

According to BIS, this net measure takes account of bilateral netting agreements covering CDS contracts but, unlike gross credit exposures, is not adjusted for cross-product netting.

BIS attributed the decline in overall CDS activity mainly to a contraction in inter-dealer activity.

It said that the notional amount for contracts between reporting dealers fell to $11 trillion at end-December 2013, from $14 trillion at end-2012, while notional amounts with banks and securities firms also fell, to less than $2 trillion, from $3 trillion over the same period.

"Trade compression continued to eliminate redundant contracts, although the volume of compressions has slowed from the peaks of 2008-09," it added.

Central clearing, which BIS said is a key element in global regulators’ agenda for reforming OTC derivatives markets to reduce systemic risks, made further inroads in the CDS market in 2013.

The shift towards central clearing had made significant progress in 2010-11, when the share of outstanding contracts cleared through CCPs had risen from less than 10% to 19%.

However, BIS noted, in 2012, progress stalled, with the share stagnating at 19%, and that in 2013, contracts with CCPs rose to account for 26% of all CDS contracts at year-end. The share of CCPs is highest for multi-name products, at 37%, and much lower for single-name products, at 17%, it said.

Contracts on CDS indices in the multi-name segment tend to be more standardised than those in the single-name segment, which thus makes the former more amenable to central clearing, BIS emphasised.

Owing in part to the shift towards central clearing, the CDS market has seen an increase in netting, which BIS said enables market participants to reduce their counterparty exposure by offsetting contracts with negative market values against contracts with positive market values.

"A comparison of net market values with gross market values indicates the prevalence of legally enforceable bilateral netting agreements. As a result of the increased use of such agreements, net market values as a percentage of gross market values fell to 21% at end-2013, from 24% at end-2012 and 26% at end-2011."

BIS said that the prevalence of netting is greatest for CDS contracts with CCPs and other dealers, where it reduced the ratio of net to gross market values to 9% and 15%, respectively, at end-2013, and that it is lowest for those with insurance companies (83%) and special purpose vehicles (57%).

BIS further reported that the distribution of underlying reference entities indicates that contracts referencing non-financial firms have declined at a somewhat more rapid pace than those referencing other sectors.

Outstanding CDS contracts referencing non-financial firms stood at $7 trillion at end-December 2013, representing 34% of all CDS, and that this is down from 37% at end-2012 and 40% at end-2011 (when this breakdown was first reported).

Contracts referencing financial firms stood at $6 trillion at end-2013, followed by securitised products and multiple sectors at $5 trillion, and sovereigns at less than $3 trillion.

By rating, contracts referencing investment grade entities equalled $13 trillion and those referencing lower-rated or un-rated entities $8 trillion.

"The distribution of outstanding CDS by location of the counterparty showed little change in 2013. The CDS market is very international; CDS with counterparties from the same country in which the dealer is headquartered accounted for only 19% of outstanding contracts at end-2013, or $4 trillion. Most of the foreign counterparties were from Europe, followed by the United States."

BIS further reported that the notional amount of OTC derivatives linked to equities or commodities totalled $9 trillion at end-December 2013, and the gross market value at $1 trillion.

"Activity in equity-linked contracts declined precipitously in 2008-09 but has since fluctuated around levels similar to the notional amount reported at end-December 2013, $6.6 trillion."

By contrast, said BIS, activity in commodity contracts continues to decline, in that dealers expanded their commodity derivatives business rapidly between 2004 and 2008 but subsequently scaled back their outstanding positions.

The notional amount of outstanding OTC commodity derivatives contracts declined to $2.2 trillion at end-2013, from $2.9 trillion at end-2009 and a peak of $8.5 trillion at end-2007, said BIS

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