For the first time since the G20 committed to reform the OTC derivatives markets to improve transparency, mitigate systemic risk and protect against market abuse, the International Swaps and Derivatives Association (ISDA) has published a market analysis to determine the size of the market compared to pre-crisis era, how much progress has been made in central clearing and how much netting reduces credit exposures.
Under the European Market Infrastructure Regulation (EMIR), due to be implemented in 2013, OTC derivatives will have to be standardized where possible so they can be centrally cleared and traded on exchange-like platforms, requiring buy-side firms to commit margin against their swaps exposures to mitigate systemic risk.
ISDA aims to integrate market data to show the impact of clearing, netting, compression – the tearing up of matched trades or trades that do not contribute risk to a dealers portfolio – and collateral on notional amounts and risk exposures in the OTC markets. Its market analysis aims to draw on information sources including LCH.Clearnets SwapClear, TriOptima, the DTCC Trade Information Warehouse, Markit, ICE, CME and ISDA Research. It tends towards a more informed view of the key trends shaping the global OTC derivatives market.
Looking at notional amounts (which measures activity and not risk) in the OTC derivatives markets published by the Bank of International Settlements, the size of the market increased by about 11% over the past five years. On an adjusted basis, however, the market declined by 9%.
Two things account for the difference, says ISDA. Firstly, the analysis eliminates double-counting of cleared swaps. Clearing increases volumes (as one swap between counterparties is transformed into two swaps between each counterparty and the clearinghouse), even as it is designed to reduce risk. It is worth noting that the cleared volume of interest rate swaps (IRS) totaled 53.5% of IRS outstanding at year-end. That is the highest percentage yet and it is a 151% increase over year-end 2007. ISDAs analysis excludes FX transactions given that they are in many ways unlike OTC derivatives.
Accounting for the decline of the market on an adjusted basis, ISDA says, one of the key factors is compression. Great strides continue to be made in compression in IRS. Over the past decade or so, compression has reduced notionals outstanding by a little over $200 trillion, says ISDA, including some $120 trillion in interest rate derivatives and $80 trillion in credit default swaps. Compression is clearly one of the biggest factors driving changes in the volume of derivatives outstanding.
Accounting for the fact that notionals address activity and not risk, gross market value (GMV) reflects that risk by measuring the cost of replacing contracts. As the BIS reported, GMV increased for the period ending December 31, 2011 from mid-year 2011. Netting lowers credit exposure to 14.3% of GMV and 0.6% of notionals. Collateralizaton reduces credit exposures to an even lower level. In the OTC derivatives market, adjusted volumes of OTC derivatives declined by 10.3% from June 2011 to $440 trillion, a smaller amount than reported in all periods except the second half of 2010.
In light of the fact that the clearing of OTC derivatives transactions increases notional values by 100%, ISDA reduces notionals by 50% of cleared IRS, FRAs and CDS. The cleared IRS and FRA data come from SwapClear while the BIS now reports cleared CDS figures. The BIS semi-annual release is based upon a survey of large dealers conducted by 13 central banks. The ISDA paper indicates that the OTC derivatives market fell 8.4% from $706.9 trillion as of June 2011 to $647.8 trillion as of year-end 2011. Looking further back, the market has increased 10.6% from $585.9 trillion as of year-end 2007.
Adjusted figures tell a different story. Adjusted volumes of OTC derivatives declined by 10.3% to $440.1 trillion in the second half of 2011. The $440.1 trillion level appears to be more consistent with historical data than the spike that was reported in the first half of 2011. The OTC derivatives markets, as adjusted, are now smaller than the markets as reported in 2007 ($475.3 trillion).
In the OTC interest rate derivatives market, adjusted volumes for interest rate derivatives products ‒ which includes interest rate swaps (IRS), forward rate agreements (FRAs) and interest rate options ‒ fell 10.5% from June 2011 to $362 trillion but are modestly higher (7% or less) than volumes reported for all other periods. Adjusted volumes for IRS alone fell 10.3% from June 2011 to $262 trillion but are modestly higher than volumes reported in most other periods. Uncleared IRS volumes fell 15.1% from June 2011 to $122 trillion and are smaller than volumes reported for all other periods except 2010. IRS compression totaled $120 trillion on a net, cumulative basis as of year-end 2011. Compression of cleared IRS reduced the ratio of cleared IRS to total IRS from 60.2% to a still high 53.5%.
Adjusted volumes for the CDS market fell 12.5% from June 2011 to $25.9 trillion, the lowest level since year-end 2006. ISDA estimates the total amount of trades that cannot be electronically confirmed (Copper trades) is no more than $2.8 trillion as of year-end 2011. Only $530 billion of these are multi-name transactions. Approximately 10.6% of adjusted CDS have been cleared as of year-end 2011. CDS compression totaled $82 trillion on a net, cumulative basis as of year-end 2011.
ISDA indicates that clearing CDS poses considerable risk management issues, relating to liquidity and volatility of prices. ISDA says progress has been made but is well below what has occurred in the IRS market. In all, 10.6% of existing trades have been cleared. This includes 8.0% of single name reference entities and 14.5% of multiple name transactions.
In relation to credit exposure management, GMV, a BIS measure for the gross credit exposure in the OTC derivatives market, increased significantly to $27.3 trillion, the highest level since 2008. The increase was primarily due to lower interest rates globally. The benefits of netting reduced credit exposure by 85.7% globally and by 92.1% among US banks. Collateralization also reduces credit exposure. Based on the metrics in ISDAs Margin Survey (which is also the basis for past Market Analyses), the combined effectiveness of netting and collateral is 95.9%. Netting and collateral reduce credit exposures to 4.1% of the GMV and 0.2% of the notional amount. However, another method for determining the effectiveness of collateral produces a slightly lower effectiveness rate of 92.3%. ISDA will continue its work on collateral in an effort to reconcile two entirely independent survey results.
During the second half of 2011, GMV increased from $19.5 trillion to $27.3 trillion, a figure only exceeded in 2008. BIS data indicates that $6.8 trillion of the $7.8 trillion increase occurred in interest rates with the balance in FX ($219 billion), CDS ($241 billion) and in the unallocated estimate ($563 billion). Gross Credit Exposure was 14.3% of GMV because of netting agreements. This percentage has only been matched in 2008 but was not enough to offset the increase in GMV. As a result, Gross Credit Exposure increased from $3.0 trillion to $3.9 trillion.
Collateralization further reduces credit exposure, says ISDA. In its market analysis for the period ending June 30, 2011, ISDA, as in prior reports, relied on its latest margin survey. However, in the last report, ISDA used the percentage of trades covered by collateral agreements (70%) rather than the slightly higher figure of the percentage of credit exposure covered by collateral (73%).
The results of the 2012 Margin Survey show small improvements in collateral metrics, including a small improvement in percentage of trades covered by collateral agreements (to 71.4%).
After applying the 71% reduction to gross credit exposure, the remaining exposure was only 4.1% of Gross Market Value. The dollar amount ($1.1 trillion) was higher than June 30, 2011 ($0.9 trillion) but was comparable or less than remaining exposures in all the other periods presented in Table 4. In all, netting and collateral reduced Gross Market Value by 95.9%.
(JDC)