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The BIS recently released the results of the triennial survey on the turnover of IRDs. According to these figures, daily average IRD turnover stands at around $2.3 trillion, up from $2 trillion in 2010 and around $1.7 trillion in 2007. Among the bilaterally traded derivatives, IRDs make up the lion’s share, representing around 77 per cent of all the OTC derivatives traded in nominal terms. Likewise, in the aftermath of the OTC derivatives market reforms, IRDs make up the lion’s share of central clearing counterparty (CCP) trades following a most remarkable shift from dealer trades. According to the ISDA statistics, 52 per cent of IRDs were centrally cleared in 2012 – up from 39.2 per cent in 2011. It is therefore relevant and timely to see whether central clearing has already had an impact on the liquidity of this market segment.
Daily turnover is a widely accepted proxy for liquidity and, hence, its development may provide some indication of the liquidity trends in this market segment. The numbers are huge in nominal terms and, at first glance, point to an increase in liquidity. Nevertheless, the relative indicators of turnover reveal a different trend. The growth rate in turnover volume over the 2010-2013 period stands at just 14 per cent, the lowest since the start of the triennial survey. The nominal increase is also subdued at only $289 billion in three years, the second lowest to date. All in all, the growth in turnover seems to be muted compared to previous years.
A number of reasons may have led to a slowdown in liquidity growth. The most immediate explanation would be the stagnation in economies globally over recent years. Indeed, there generally is a positive correlation between GDP growth and derivatives market growth. However, even at the peak of the crisis in 2010, the liquidity of IRDs increased 22 per cent in spite of the only 1 per cent increase in the notional amounts outstanding. This suggests that the slowdown in liquidity growth seems to exceed the levels that can be explained by real-economy-related factors alone.
A more relevant factor in this respect could be the impact of recent regulatory reforms. As already argued, a remarkable proportion of IRDs are now centrally cleared, and the very nature of central clearing may lead to a mechanical reduction in liquidity. Trade compression – a practice that is possible without the introduction of CCPs but becomes simpler and more comprehensive with them and which reduces the size and thus, by implication, the turnover in the market while leaving the net risk positions unchanged – could lead to a reduction in liquidity. Supporting this hypothesis, ISDA statistics estimate that trade compression has become widespread and reduced the notional amounts of IRDs by $44.6 trillion in 2012 and $32.3 trillion in 2011.
All in all, the new financial market infrastructure seems to have already had an impact on the liquidity of IRDs due to the compression of redundant derivative trades. Regulators and market participants should take these immediate changes into account for their IRDs positions and trades in the future.
For a more detailed analysis, see: Reforming OTC derivatives markets: Observable changes and open issues (Orcun Kaya)