11 December 2016

BIS: The changing shape of interest rate derivatives markets

Overall, turnover in both OTC and exchange-traded markets has expanded moderately since 2013. The average daily turnover of US dollar-denominated instruments has nearly doubled, driven by contracts with short maturities. Turnover of euro-denominated instruments has halved. The authors argue that monetary policy has been an important factor behind these changes. Despite a tightening of US monetary policy, activity in long-maturity US dollar contracts has remained subdued, which they attribute to reduced hedging demand from government-sponsored enterprises. Regulatory reforms have continued to influence market structure. To date, OTC markets have not lost market share to exchanges. In fact, regulatory changes are making OTC markets more similar to exchanges

The G20 OTC derivatives market reform agenda has reshaped the structure of these markets in a number of ways in recent years. Even though the speed of implementation of the reforms has varied across jurisdictions, the impact on global OTC markets is already evident. Central clearing of derivatives, aimed at reducing counterparty risks, has gained ground. Electronic trading has also become more prevalent. Since the mandatory execution requirements for swap trades came into effect in October 2013 as part of the Dodd-Frank Act, swap execution facilities (SEFs) have served to move a large share of OTC swap trading to electronic platforms.

Another key element of the G20 reform agenda has been the introduction of initial and variation margins for non-centrally cleared contracts. This has recently come into effect in the United States, Japan and Canada, and will be implemented in Europe and Asia in 2017. Such margining requirements could raise the costs of OTC trading and thereby encourage a shift in trading activity to exchanges.

OTC markets have adapted to regulatory changes by a wider adoption of portfolio compression. Such compression reduces capital charges and trading costs by shrinking notional amounts outstanding, while leaving net exposures unchanged. The increasing use of clearing houses has facilitated trade compression, as they allow for an efficient identification of offsetting exposures.

Amid low and stable interest rates across the globe, trading in OTC and exchange-traded interest rate derivatives markets has grown moderately. The structure of those markets, however, has changed shape, owing to a shift in the currency composition of contracts and to regulatory reforms.

The authors argue that monetary policy has been an important driver of the shift in the currency composition of activity from the euro to the US dollar. In the euro-denominated market segment, the expected persistence of stable and negative interest rates has reduced demand for swaps, while the rise in the turnover of short-term swaps in the United States is consistent with expectations of increasing short-term rates. They also suggest that the reduced demand for swaps by the GSEs in the United States has been a key factor behind the subdued activity observed in long-term swaps.

Several reforms on the G20 agenda have had an impact on the structure of OTC interest rate derivatives markets. More than 70% of notional values are now centrally cleared in all major currency segments, reducing counterparty credit risk. Electronic trading platforms, including swap execution facilities, have made inroads, improving market liquidity and transparency. OTC markets have adapted to regulatory changes by increasing their recourse to services, such as portfolio compression, that lower capital charges by reducing notional amounts, while keeping net exposures unchanged. The full impact of the recent introduction of margining requirements for non-centrally cleared contracts on OTC markets may lead to further structural changes.

Full paper

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