Slowdown of the global OTC derivatives market in the second half of 2000
16 May 2001
The interest rate segmentexpanded by only 1% in the second half of 2000, to $64.7 trillion. While the stock of FRAs declined by 5% and that of options rose by 1%, the swap market grew by 2%, to $48.8 trillion. Two other developments also stand out in the area of interest rate instruments. First, contracts with a maturity of up to one year decreased by 7%, while longer-term instruments continued to expand at a healthy pace (about 5%). Second, euro-denominated contracts fell by 7%, while those denominated in US dollars maintained their rapid growth and those in yen grew at a steady pace.5
In the specific case of the interest rate swap market, the deceleration in growth was in sharp contrast to the very rapid pace of business seen since the end of 1998. That slowdown resulted essentially from a 5% contraction of euro-denominated swaps. The decline in euro-denominated business was spread across the three types of counterparties, but the most significant drop occurred in the inter-dealer group. Various factors may have accounted for this development. These include financial sector consolidation, reduced issuance of certain types of "domestic" securities (such as Pfandbriefe, which are often hedged with swaps) and belated efforts by banks to clean up their pre-euro legacy currency portfolios. The passage to the euro has allowed market participants to apply netting rules across contracts originally established in legacy currencies. By contrast, the stock of dollar-denominated swaps continued to grow at a sustained rate (10%). Net repayments of US government debt have affected the liqui dity of the US government bond market and the effectiveness of traditional hedging vehicles, such as cash market securities or government bond futures, encouraging market participants to switch to more effective hedging instruments, such as interest rate swaps.
Currency instruments also slow down
In the area of currency instruments, the value of contracts outstanding increased by 1%, to $15.7 trillion, following a fairly strong increase in the previous reporting period. While the stock of outright forward and forex swap contracts fell by 4% and that of currency options declined by 2%, currency swaps expanded by 23%. Instruments involving the US dollar and the euro expanded slightly but this was partly offset by declines in contracts involving the yen. This seems to be consistent with the pattern of implied volatility observed in the second half of 2000, whereby the volatility of the dollar/yen pair dropped sharply, while that of the dollar/euro remained high.
The lower value of outstandings in outright forwards, forex swaps and options may have reflected longer-term influences in the underlying spot market. Although new data on turnover and outstandings in the foreign exchange and derivatives markets will not be published by the BIS before the fourth quarter of 2001, anecdotal evidence suggests that interbank trading of currencies has declined in recent years owing to various factors, including consolidation in the financial sector, the move to electronic broking and the paring-down of leveraged positions in the aftermath of the Asian and Russian financial crises.
The cross-currency swap market represented the main exception to the downward trend observed in foreign exchange instruments. That segment has expanded steadily since the BIS began collecting data on the OTC market. Business is likely to have been fuelled by the large volume of syndicated loans and securities issues, particularly those arranged for telecommunications firms. In contrast, the introduction by the US Financial Accounting Standards Board (FASB) of new rules on derivatives and hedge accounting for all publicly traded US companies with a fiscal year ending on 15 June 2000 does not seem to have had a contractionary effect on the cross-currency swap market.6 In fact, the paring-down of positions by some companies in anticipation of the new rules might well have been offset by new business resulting from the replacement of complex hedges with simpler structures.
By contrast, equity-linked contracts expand more strongly
Activity in the equity-linked sector grew strongly, to $1.9 trillion, with all of the expansion taking place in the equity option segment. The second half of 2000 was a period of renewed uncertainty in global equity markets, with strong downward price pressures, particularly in technology stocks, leading to an upsurge in volatility. Business was most buoyant in options on European equities, such that this segment now accounts for nearly 60% of the stock of equity-linked instruments. Although it may be early to draw firm conclusions about longer-term trends, the increase in European option business in the second half of 2000 may also have been related to deeper underlying factors. One possible explanation may have been the greater popularity in Europe of equity-related investment products, such as stock investment funds, retail-targeted equity index products, convertible bonds and equity warrants.
Commodity instruments see robust growth
Commodity derivatives markets also expanded rapidly, to $0.7 trillion. The stock of gold contracts, the largest single group in that market segment, contracted substantially (by 16%) as the gold market returned to calm following sharp swings in the previous year. By contrast, the stock of "other" commodity contracts expanded at a record pace (by 38%). Although reporting central banks do not provide the BIS with a finer breakdown of commodity contracts, the upsurge in oil prices between the beginning of 1999 and the end of 2000, when they experienced an abrupt fall, could have accounted for such active business in commodity contracts.
Gross market values rise sharply
Estimated gross market values experienced the most pronounced increase since the BIS began collecting data on the OTC market, rising by 24%, to $3.2 trillion. Such an expansion was somewhat unusual since the notional amount of outstanding contracts barely increased over the review period. As a result, the ratio of gross market values to notional amounts outstanding rose to 3.3% at end-December 2000 from 2.7% at end-June 2000, reversing a downward trend observed since the second half of 1998. The largest absolute increase was recorded in foreign exchange contracts (by $271 billion, spread across the major currency pairs), followed by interest rate contracts (by $196 billion). As a percentage of notional amounts, the gross market value of foreign exchange contracts jumped to 5.4% from 3.7%, while that of interest rate contracts rose to 2.2% from 1.9%. By contrast, the gross market value of equity contracts fell both in absolute terms and in relation to notional values. Allowing for netting, th e derivatives-related credit exposure of reporting institutions remained at about one third of gross market values ($1,080 billion).7
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 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 2000.
4 Credit derivatives, which according to market sources have recently grown rapidly, are not identified in this survey. Data on such instruments will be collected at the time of the next triennial survey of foreign exchange and derivatives market activity at end-June 2001.
6 FASB Statement No 133 requires companies to record derivatives on their balance sheets as assets or liabilities that will be measured at fair value. Companies have to record in the income statement or in other comprehensive income any changes in the value of such instruments designated as hedges that do not closely offset changes in the value of the underlying assets.
7 In this context, netting refers to an agreed offsetting of positions or obligations by market participants. Such a technique, which reduces the number of individual positions or obligations, is increasingly used to mitigate counterparty credit risk. Netting may take several forms which have varying degrees of legal enforceability in the event of default of one of the parties.
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