15 February 2019

ECB: Working paper: The anatomy of the euro area interest rate swap market

This paper uses a number of perspectives to investigate the anatomy of the euro area IRS market. In particular, authors explore notional measures as well as observed transaction prices. They move from the transaction level to the level of aggregate exposures. Their approach provides new evidence to regulators and policy makers regarding the structure and activity in the IRS market.

Especially along two dimensions:

• risk absorption and
• the impact of regulatory reforms such as the clearing obligation and the role of Basel III capital and liquidity ratios in influencing trade activity.

Overall, authors show that on one side, the structure of the market in terms of trading activity is not just concentrated on a few global dealers. They highlight the relevance of the role of other institutions (intermediaries) that provide a significant contribution to trading activity. As regards net exposures, they document that their measure of risk absorption is not just concentrated at the periphery of the network, but also at the core, and this differentiates the IRS market from other OTC derivatives markets like CDS.

Moreover, authors show that bank size is not the only variable able to explain differences in trading activity, but Basel III capital and liquidity ratios play a significant role in a market where counterparty credit risk now has been dramatically reduced due to the mandatory clearing obligation.

In terms of the Basel III capital and liquidity ratios, the leverage ratio has an important role in explaining trading activity. Authors find that firms having a larger capital over total exposure ratio have lower trading activity. This is due to a peculiarity of the small and medium banks whose leverage ratios often exceed those of larger banks. In contrast, for large banks, different leverage ratio levels influence their trading activity. They find that firms having a larger capital over total exposure ratio have lower trading activity.

Their analysis confirms the claims of some market observers: The leverage ratio imposed by Basel III may provide a constraint to the trading activity in the IRS market even if it has no direct material effect on the net over gross ratio. The other Basel III ratios such as risk-weighted capital requirement or liquidity ratios have no significant effect on explaining trading activities. Regarding net exposure, the only exception is the risk-weighted capital requirement. Here, a larger ratio is linked to a larger net exposure on the IRS market.

Finally, their analysis of price dispersion finds that it is still significant even if counterparty risk is nowadays less relevant due to mandatory central clearing. Dealers and intermediaries are obtaining similar better pricing when they initiate the trade with asymmetries between paying and receiving fixed interest rates. Authors also show that Basel III capital and liquidity ratios affect price dispersion.

They find that those firms with leverage ratio constraints do search more in order to get a better price if they are large banks. Risk-weighted capital requirements also matter in explaining price dispersion.

Working paper

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