08 December 2014

BIS: Quarterly Review: Buoyant yet fragile?

Flip-flopping from "risk-on" to "risk-off" sentiment in financial markets suggests that fragility underlies the current buoyant mood.

Markets remain buoyant despite mid-October's spike in the volatility of most asset classes. This sharp retreat in risk appetite reflected growing uncertainty about the global economic outlook and monetary policy stance, as well as increased geopolitical tensions. As selling pressure increased, market liquidity temporarily dried up, amplifying market movements.

Markets rebounded quickly as economic concerns faded and some major central banks further eased monetary policy. In particular, the Bank of Japan and the ECB provided further stimulus, while the Federal Reserve ended its QE3 asset purchases. These opposing moves unsettled exchange rates, with the dollar appreciating against most other currencies.

Reprising the August sell-off and recovery in global financial markets, this rapid flip-flop from "risk-on" to "risk-off" sentiment (and back again) suggests that more than a quantum of fragility underlies the current elevated mood in financial markets.

International banking activity expanded for a second consecutive quarter between April and June, regaining some of the ground lost in 2012 and 2013. Thanks to the latest quarterly increase, the annual growth rate of cross-border claims rose to 1.2% in the year to end-June 2014, the first move into positive territory since late 2011.

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Markets Media: Clearinghouses gain ground

The share of CCPs was highest for multi-name credit derivatives at 34%. The BIS said contracts on CDS indices are more standardised, making them easier to clear than single-name contracts. The report said: “Central clearing remained an important theme in OTC derivatives markets during the first half of 2014. It is high on the global regulatory agenda for reforming OTC derivatives markets with a view to reducing systemic risks.” As more credit default swaps have become centrally cleared, there has been an increase in netting as participants seek to reduce counterparty exposure by offsetting contracts with negative market values against those with positive ones.

Net market values as a percentage of gross market values was 23% at the end of June 2014, up from 21% at the end of last year according to the report.  “The prevalence of netting is greatest for CDS contracts with other dealers and CCPs, where it reduced the ratio of net to gross market values to 15% and 16%, respectively, at end-June 2014,” added the BIS. “It is lowest for contracts with insurance companies (85%) and non-financial customers (75%).” The report said: “While trade compression continued to eliminate redundant contracts, the volume of compressions in the CDS segment has slowed since peaking in 2008-09. That said, trade compression made further inroads into other OTC market segments, particularly CCP-cleared interest rate swaps.”

The BIS report said that in the first half of this year notional amounts of interest rate derivatives contracts was $563 trillion, about $2 trillion less than at the end of 2013. Outstanding volumes of interest rate swaps fell by 8% to $421 trillion. “An important driver of the fall in notional values has been the elimination of redundant swap contracts via trade compression, which has expanded significantly in 2014,” added the BIS report. The report also found a continued shift in activity away from dealers towards other financial institutions. Contracts between dealers and other financial institutions was $463 trillion at the end of June 2014, or 82% of all contracts, up from about half at the end of 2008.

The BIS said: “A potential driver could be the increased use of derivatives by asset management firms and a general shift away from the traditional dealer-centric market structure. That said, the trend towards central clearing of OTC contracts also plays an important role, as it may overstate growth in notional amounts for other financial institutions.”

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