12.16.2019

OTC Derivatives Markets Undergo Structural Change

Over-the counter derivatives markets are coming to resemble exchanges more closely due to structural changes according to the Bank for International Settlements.

The BIS said this month in its latest Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets that the 143% growth in OTC derivatives to $6.5 (€5.8) trillion per day over the last three years was the highest since the surveys started in 1995.

BIS said in the report: “Structural changes including clearing, compression and automation made OTC markets more closely resemble exchanges.”

The regulator continued that the regulatory push towards central clearing and electronic trading, and the evolution of compression services, has led to a relative shift from exchanges to OTC markets as there has been a decline in counterparty risks, a reduction in transaction costs and increased speed of trading.

“These benefits appear to have outweighed the costs related to margining and collateral requirements for cleared and uncleared derivatives, implemented in most jurisdictions including the United States and the European Union,” added BIS.

Chris Barnes at Clarus Financial Technology said in the derivatives analytics provider’s blog that cleared interest rate derivatives volumes hit a monthly record of $70 trillion in June this year.

“Total volumes over the past 12 months were $686 trillion (average daily volume of $2.7 trillion, monthly average $57.2 trillion),” added Barnes. “As the BIS highlight, more of the market is now clearing than ever before.”

Barnes also noted that 58.3% of trading was on a swap execution facility and at the beginning of this and now only 58.5% trades on-SEF.

“Not much of a trend to report there,” he added. “For example, 72.6% of overnight index swaps is still trading off-SEF. This shows how much work is still left to be done in the potential electronification of rates markets.”

Compression

Compression allows counterparties to “tear-up” offsetting trades in their portfolios to reduce the notional outstanding and the number of line items in their portfolio while maintaining the same risk exposure. Use of compression services has increased following the introduction of stricter capital requirements, such as the Basel III leverage ratio, which has led to banks reducing their balance sheets and capital efficiency becoming increasingly important.

“Discussions with reporting dealers suggest that including compression trades can boost reported turnover by 40-60% for some dealers,” said BIS. “Compression trades may thus account for a good portion of the increased turnover, though there are no hard data to provide a precise figure.”

Volumes have been boosted by an increase in the frequency of compression cycles form 13 to 35 per month between the last two BIS triennial surveys. Runs by third-party vendors, including for multilateral compression, have increased from from five to 14 per month, while those for blended rate compression rose from eight to 21.

“Blended rate compression replaces multiple contracts with different fixed rates into a single contract with one blended rate,” added BIS. “This is particularly notable because this type of flexibility is a relative advantage of OTC markets over the automatic reduction of gross positions (via contract cancellation) possible on exchanges.”

Concentration

Concentration helps to deepen liquidity and facilitates portfolio compression, which in turn incentives even more trades to move to the core CCPs. LCH, the London Stock Exchange Group’s clearing house, is dominant in clearing interest rate derivatives according to BIS.

LCH said RepoClear last month successfully cleared its first variable rate repo trade indexed on €STR, the new Euro short-term reference rate launched by the European Central Bank in October. The trade cleared on 29 November with Credit Suisse among the first participants to clear the new rate at LCH.

Dipen Mistry, a director in the global liquidity group at Credit Suisse, said in an email: “The ability to clear repo trades index to €STR is another important step in the market’s transition to new references rates”

Fragmentation

BIS also analysed costs associated with clearing fragmentation when multiple central counterparties clear the same or similar derivatives contracts. The research analyse the cost difference for dollar swap contracts cleared at CME and LCH.

“We find that the average CCP basis for dollar swap contracts was around 2 basis points during our sample period,” said BIS. “This is economically significant as it translates into a daily opportunity cost of around $80 million for end users.”

The paper continued that CCP basis allows dealers to recoup increased collateral costs when clearing is fragmented.

“In those cases, dealers, who provide liquidity globally, cannot net their offsetting trades across CCPs,” said the research. “This increases their collateral costs.”

These costs are passed onto end users through the CCP basis. That is, dealers quote a higher price at a CCP where buyers prevail, and a lower price when sellers prevail.

BIS concluded: “Fragmenting clearing across multiple central counterparties is costly.”

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