In recent years, the volume of interest rate derivatives in the over-the-counter (OTC) market has surged. A combination of factors has contributed to the increase in OTC trading. There have also been some significant changes in the market structure of OTC trading, and regulatory changes have led to an increase in the use of central clearing, electronic trading platforms, etc., so that some of the same benefits as exchanges can be obtained in the OTC market, resulting in some transactions shifting from on-exchange to over-the-counter.
A significant change in the structure of the market
In recent years, the trading volume of interest rate derivatives in the over-the-counter market has surged. From April 2010 to April 2016, average over-the-counter daily trading volume rose steadily, from $2.1 trillion to $2.7 trillion, before jumping sharply to $6.5 trillion in April 2019, up 143 percent from 2016. Trading volumes within exchanges have also increased, but the proportion of increases has been relatively small, with a 53% increase from 2016 to 2019. OTC trading accounted for only 21% of interest rate derivatives trading in 2010 and 46% in 2019.
A combination of factors has contributed to the increase in OTC trading. First, the number and coverage of non-market-oriented transactions has expanded, especially back-to-back and compression transactions. Second, the popularity of electronic trading platforms has reduced transaction costs, which in turn has spurred the growth of transactions, especially those of investment funds and other asset managers. Finally, uncertainty over short-term interest rates in the United States has fueled hedging and speculative trading activity.
There have also been some significant changes in the market structure of OTC trading, among which regulatory changes have led to an increase in the use of central clearing, electronic trading platforms, etc., so that some of the same benefits as exchanges can be obtained in the OTC market, resulting in some transactions shifting from over-the-counter to over-the-counter.
BiS's three-year survey shows that between April 2016 and April 2019, the average daily turnover of the OTC derivatives market more than doubled to a growth rate of 143% to $6.5 trillion, the highest growth rate since the survey began in 1995. Between 2007 and 2016, the average growth rate between the two surveys was only 17%. The trading volume of exchange-traded interest rate derivatives also showed rapid growth between 2016 and 2019, but only increased by 53%, in fact, since 2010, the trading volume of interest rate derivatives has shifted from exchanges to over-the-counter markets.
By category, interest rate swaps remain the most traded instrument, with Overnight Index Swap (OIS) accounting for 64% of global turnover (up from 69% in 2016). Turnover in US dollars and euros increased by 141% and 148%, respectively, accounting for 50% and 24% of global OTC derivatives turnover, respectively.
The chart shows the volume of various types of interest rate derivatives (by OTC division, OTC market by trading instrument, OTC market by currency division)
The sharp increase in dollar and euro interest rate derivatives turnover was mainly driven by trade between the United States and the United Kingdom. In April 2019, the UK accounted for more than half of global OTC derivatives and 86% of euro-denominated turnover, with 39% and 73% respectively in 2016. The UK has also strengthened its role as the main offshore trading location for currency contracts in emerging markets. The U.S. remains the dominant region for over-the-counter interest rate derivatives trading in dollar terms, with trading volumes increasing from $1.1 trillion to $2 trillion, but the U.S. share of global turnover fell from 80 percent to 61 percent in both surveys.
The chart shows the volume of OTC derivatives by currency and region
Five factors in B drove up trading volumes
The increase in trading volume is driven by a combination of factors, such as more non-market-oriented trading (sometimes referred to as administrative trading), including back-to-back trading and portfolio compression trading, although market-oriented transactions are also increasing significantly.
Increase in related party transactions
Traders in some trading jurisdictions noted an increase in related-party transactions, especially back-to-back transactions, in the 2019 survey. A related party transaction is a transaction between a reported dealer and a subsidiary, or between a dealer and its parent company or other affiliated entity. A back-to-back transaction is a related party transaction, and the liabilities, obligations and rights of the second transaction with a market capitalization are exactly the same as those of the original transaction. They are usually conducted between affiliates of the same merging group to facilitate internal risk management or internal bookkeeping. Back-to-back trading should only be reported to the BIS triennial survey if the risk is transferred to the reporting dealer. Feedback from the survey suggests that many traders did not fully include these deals in the 2016 survey, but they reported them in 2019 (which is consistent with survey guidelines).
The increase in connected transactions accounted for about 30% of the increase in OTC trading volume, excluding related party transactions, the average daily turnover increased by 117% since the 2016 survey, which is a considerable growth rate and is roughly in line with the trends shown by other data sources, such as the ccp's statistical results.
Portfolio compression use expands
Portfolio compression trading is another important factor in the substantial increase in OTC trading volume. A compression trade replaces two or more offset positions with a new one representing a net position, while a net position keeps the exposure essentially unchanged.
This compression has grown steadily in recent years, and discussions with reported traders have shown that some traders can increase their total turnover by 40%-60% if they include compressed transactions. Therefore, compression transactions may account for a large part of the growing turnover, but there is no conclusive data that can provide an exact value.
There are two reasons why the volume of compression trades is large: one is that compression trades are not always fully effective when offsetting all possible positions, and the other is that compression trades can be applied to all unliquidated derivative positions, not just the latest ones. As a result, the resulting compression transaction may have a large notional value.
Regulatory and other drivers have led to increased portfolio compression of interest rate derivatives, with some regulations explicitly requiring institutions to regularly compress trading. Other legal rules, such as Basel III, impose some regulatory requirements based on total notional positions rather than net positions, so companies will have an incentive to reduce their total derivatives positions by compressing their portfolios. Central clearing provides liquidity for standardized out-of-product contracts, capable of bringing together many large players. These changes are driving more companies to participate in portfolio compression, thereby boosting transaction volume growth.
The increase in the frequency of compression transactions also increased the turnover between the two surveys. The compression service for interest rate derivatives already existed in 2008, but the compression cycle of OTC interest rate derivatives was short. The frequency of compression has risen sharply in recent years, increasing from 13 to 35 per month in the last two surveys, the compression offered by third-party traders (including multilateral compression) has increased from 5 times per month to 14 times per month, and the compression of mixed rates has increased from 8 times per month to 21 times. Mixed-rate compression replaces multiple contracts with different fixed-rate contracts with one contract with one mixed-rate contract. This is particularly noteworthy because this operation causes the OTC market to automatically reduce the total position relative to the floor exchange, and the volume of these trades also rises as the frequency of compression increases each month.
More compressed trades increase the transaction volume. In recent years, the turnover of OTC interest rate derivatives has greatly exceeded the outstanding nominal amount. In contrast, in on-the-exchange trading, during the same period, the proportion of derivatives turnover and outstanding notional principal traded on the exchange also fluctuated slightly, but it did not change much.
The changing interest rate environment
The uncertainty created by the evolution of policy rates and possible future changes will affect trading activity in the interest rate derivatives market, especially for short-term instruments. If the policy rate changes, the demand for hedging and speculative activities of short-term interest rates increases, and the volume tends to rise. If there is uncertainty about the expected change, speculators are more likely to trade on both sides of the interest rate derivatives. Similarly, stable and predictable interest rates mean lower turnover.
During the triennial survey from 2016 to 2019, the volume of short-term instruments grew strongly. OIS and Forward Rate Agreements (FAs) are shorter maturity instruments that account for 61% of the total turnover of all interest rate instruments in 2019. OIS turnover was disclosed separately for the first time in this survey, but data from CCPs showed that the increase in turnover of short-term instruments was particularly pronounced, driven in large part by dollar-denominated OIS and FAs.
In April 2019, changes in short-term interest rates and increased volatility in the U.S. drove an increase in short-term dollar derivatives trading volumes. Monetary policy in the United States began to gradually tighten in December 2015. In the years that followed, while expectations of further rate hikes could lead to uncertainty about short-term rates, the expected path for future rates was clear: gradually rising. But the outlook for monetary policy changed at the beginning of 2019, and April 2019 was a turning point as short-term interest rates began to fall and volatility of short-term interest rates began to rise significantly. This suggests that the interest rate environment is constantly changing and that uncertainty is growing.
In addition, in the eurozone, during April 2016 and April 2019, the continued loose monetary policy kept short-term interest rates at a low and stable level, with short-term interest rate fluctuations being small, and the volume of short-term euro contracts at that time was also relatively small.
New players and automated trading
Interest rate derivatives are becoming increasingly important for investment funds and other asset managers. Over the past 10 years, the assets under their management have increased significantly. Exchange-traded funds (ETFs) have grown particularly fast, with ETFs growing from 4% of assets under management in 2010 to 10% in the third quarter of 2019.
Some asset managers use derivatives to manage their risk or copy their portfolios. For example, ETFs can use derivatives to track specific targets. Funds that invest in fixed-income securities can use interest rate derivatives, and such funds are under increasing management, with an increasing share of ETFs.
Total derivatives positions in asset managers and leveraged funds are growing faster than traders. From April 2016 to April 2019, the 3-month euro-dollar contract volume of asset managers and leveraged funds on the Chicago Mercantile Exchange increased by 37%, while the turnover of traders increased by 18%. This trend suggests that if the fund's demand for interest rate derivatives increases significantly, then the fund's demand for OTC interest rate derivatives will also increase.
Many asset managers obtain CCP clearing services through managing banks, or as clients of CCP members. Some non-banks have also begun to liquidate their positions directly by becoming clearing members of CCP. As of the end of March 2016, 96 bank members and 5 non-bank members had cleared positions through LCH, and by the end of June 2019, the number of non-bank members jumped to 22 and 102 bank members.
Another factor driving asset managers and other new players to enter the derivatives market is the decline in transaction costs. Technological advances, including electronic, automated and algorithmic trading, have reduced the cost of trading over the counter and on the floor, and have also promoted new investment strategies, especially those using algorithmic trading.
Automated trading has grown across all derivatives markets in recent years. If a transaction can be generated without human intervention, the transaction is considered automated, and the use of automated transactions on exchanges is steadily increasing. Swap Execution Instruments (SEF) in the Us see automated trading also used more commonly in the OTC market. The turnover of interest rate derivatives generated through SEF increased from $391 billion in April 2016 to $710 billion in April 2019.
The importance of the OTC market is growing
While the factors discussed above help explain the growth in interest rate derivative turnover, they do not fully account for the significant shift from on-exchange to off-the-counter shift. This variation is widespread in a variety of major currency-denominated instruments, both short- and long-term.
The relative attractiveness of OTC markets can be attributed, at least in part, to the fact that OTC markets now generate many of the benefits of the OTC market. The two main pillars of the over-the-counter derivatives market reform promoted by the G20, central clearing and electronic trading platforms, have reduced counterparty risk and transaction costs and increased transaction speed. More efficient and rapid compression trading on OTC can minimize the notional amount of open interest, thereby reducing regulatory costs. These gains appear to outweigh the costs associated with the margin and collateral requirements for settled and unsettled derivatives implemented in most jurisdictions, including the United States and the European Union.
Exchanges have tried to attract trading activity back from the OTC market by offering new instruments such as swap futures. Eris, which specializes in futures trading, launched a deliverable swap futures in February 2013. Although trading shifted to cmE in December 2018, the volume of these contracts has picked up in recent months, but it is still less than 0.5% of the dollar OTC swap volume.
C products still have a lot of room for development
The trading volume in the interest rate derivatives market has increased significantly over the past 3 years, especially in the over-the-counter market. The increase in non-market-oriented trading, such as compression trading and back-to-back trading, boosted trading volumes in the OTC market. Rising uncertainty about the outlook for U.S. monetary policy has also boosted OTC trading by causing investors to switch to shorter-term monetary instruments. In addition, structural changes in participants have also increased the trading volume of the OTC market.
Regulatory push for central clearing and electronic trading, as well as the development of compression services, has led to the shift of some transactions from on-exchange to off-exchange. The OTC market is now also able to offer the attractive features of trading, as well as the ability to offer more products and contracts, as well as the ability to meet customization needs. These factors have led to a significantly faster turnover growth rate in the OTC market than the on-exchange turnover growth rate.
Looking ahead, more structural changes are likely to occur. Expectations of Brexit could affect the structure of the OTC market, with London already trading more OTC already underway. In addition, the shift in benchmark interest rates to the new overnight risk-free rate (RFR) heralds a significant change in the type of trading instrument and the relative importance of the OTC market relative to the exchange-traded market. As debt contracts begin to reference the new RFR, the range of derivatives will expand, such as the need to use a term benchmark other than overnight interest rates to determine the interest obligations of cash instruments such as bonds. As a result, it is likely that new instruments will be developed, such as OIS with RFR as a floating exchange rate or long-term RFR futures, which may once again change trading between OTC markets and exchanges. Whether these new contracts will gain significant market share or even replace existing ones is unclear, as multiple benchmarks may emerge to serve different purposes and meet different market needs. (This article is compiled from https://www.bis.org)
This article originated from the Futures Daily network