Rapid expansion of OTC derivatives market in the second half of 2001
15 May 2002
Data released today by the BIS on positions in the global over-the-counter (OTC) derivatives market at the end of December 2001 point to a sizeable increase of activity in the second half of last year.1 The total estimated notional amount of outstanding OTC contracts stood at $111 trillion at end-December 2001, an 11% increase over end-June 2001.2 This compares with a 5% increase in the previous half-year period. Gross market values grew by 24% to $3.8 trillion.3
Growth driven by interest rate instruments
Growth was driven by interest rate instruments, the largest of the broad market risk categories, with outstanding contracts rising by 15%. Activity was equally buoyant in all three main groups of interest rate products, namely forward rate agreements (FRAs), interest rate swaps and interest rate options. By contrast, business in foreign exchange contracts, the second largest broad market risk category, declined by 1%. Activity in equity-linked contracts was also subdued, with a similar percentage decline in amounts outstanding.4
Buoyancy of dollar and euro interest rate swap markets
Business in interest rate products was brisk in the second half of 2001, with a 15% rise in outstanding contracts to $78 trillion. This buoyancy was evident in all market segments but the most significant increase in absolute terms took place in the interest rate swap market.
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With $59 trillion in outstanding contracts, interest rate swaps remain by far the largest single group of products in the OTC market.
The US dollar and euro swap markets grew particularly rapidly. Dollar-denominated swaps expanded by 19% to $19 trillion. That market segment has grown at a steady and robust pace in recent years on the back of a shift in hedging and trading practices.5
The rapid increase in dollar-denominated swap contracts in the latter half of last year suggests that trading in dollar-denominated derivatives has been sufficiently buoyant to offset the possible contractionary impact of market consolidation. Vigorous monetary easing by the United States, in the wake of a pronounced deceleration of US economic growth and the terrorist attacks of 11 September 2001, probably fuelled hedging and position-taking activity in dollar-denominated derivatives. Moreover, the range of participants active in US derivatives markets appears to have broadened in recent periods to include, for example, mortgage banks and investors in mortgage-backed securities (MBSs). As long-term interest rates declined sharply between June and early November, such market participants were reported to have turned in increasing numbers to the swap and swaption markets in order to hedge the prepayment risk of their holdings of MBSs.6
Euro-denominated contracts returned to rapid growth following a slowdown in the previous two half-years. Here again, interest rate swaps provided much of the impetus behind market expansion, with the stock of euro-denominated contracts rising by 18% to $21 trillion. The market for euro-denominated swaps has developed at an uneven pace in recent years, accounting for much of the variability in the expansion of the OTC market.
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The stock of euro-denominated swaps grew rapidly in the wake of the introduction of the single European currency, as such instruments became new benchmarks for European fixed income markets. However, this growth slowed considerably in 2000. Various factors may have accounted for this development, including belated efforts by banks to clean up their euro legacy currency portfolios.7 The slowdown may also have reflected the completion of a stock adjustment process to the new integrated euro zone market. The resumption of growth in the second half of 2001 could thus represent a return to more "normal" market activity.
By contrast, the market for yen-denominated interest rate swaps expanded at a much slower pace, with the stock of contracts rising by 4% to $10 trillion. The weakness of overall economic conditions in Japan probably led market participants to believe that Japanese interest rates would evolve in a narrow range in the foreseeable future.
OTC business remains less active than that on exchanges in 2001
In spite of the recovery observed in OTC markets in 2001, business in such markets remained somewhat subdued compared with that conducted on derivatives exchanges over the same period.8 The stock of OTC contracts expanded by 11% in the second half of 2001, while open positions in exchange-traded contracts grew by 21%. In the previous half-yearly period, the stock of OTC contracts had only increased by 5%, while that of exchange-traded contracts had risen by nearly 40%. If sustained, such a rapid rise in exchange-traded activity would represent a significant departure from previous patterns, since the growth of OTC business outpaced that on exchanges during the previous decade.
Sharp rise in gross market values
Estimated gross market values increased by 24% to $3.8 trillion, following a slight contraction in the first half of 2001.9 At the same time, the ratio of gross market values to notional amounts rose from 3.1% to 3.4%.
However, it should be noted that data on gross market values tend to overstate the actual credit exposures faced by counterparties because they do not take into account the availability of legally enforceable bilateral netting arrangements and other risk reduction measures. Allowing for netting significantly lowers the derivatives-related credit exposures of reporting institutions to $1.2 trillion in the most recent half-year (see the entry for gross credit exposure in the attached tables).
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2 The notional amount, which is generally used as a reference to calculate cash flows under individual contracts, provides a comparison of market size between related cash and derivatives markets. The numbers are adjusted for double-counting resulting from positions between reporting institutions.
3 The gross market value is defined as the sum of the positive market value of all reporters' contracts and the negative market value of their contracts with non-reporters (as a proxy for the positive market value of non-reporters' positions). It measures the replacement cost of all outstanding contracts had they been settled on 31 December 2001. The numbers are adjusted for double-counting resulting from positions between reporting institutions.