Everyone loves a good statistic to pin a story on. And, in the world of derivatives, the statistics everybody pays attention to are those published every six months by the Bank for International Settlements (BIS). Like IFR, Financial News and Law360, we had a good look through the latest figures. And there are a couple of useful changes that are worth flagging.
For one thing, the latest commentary gives much more prominent airtime to gross market exposures, rather than focusing primarily on notional outstanding. Looking at notional outstanding can help flag trends in market activity, but it can’t tell us anything about risk or possible losses. Gross market exposure, on the other hand, represents the cost of replacing all outstanding contracts at market prices, and was reported as $20.7 trillion at the end of 2015 – just 3.8% of total notional outstanding.
This is further reduced through netting, and is reflected in the BIS figures by the gross credit exposure measure. This reached $3.7 trillion at the end of June 2016, or 0.7% of total notional outstanding.
The other notable change is that the BIS split out the positions reporting dealers have with central counterparties (CCPs) for the first time – and this is the element most of the press coverage picked up on. The headline was that 75% of dealers’ outstanding interest rate derivatives positions are now cleared, according to the BIS’s calculations. That’s despite the fact that clearing mandates for interest rate products have not been fully rolled out in some jurisdictions. Seeing as interest rates represent the largest asset class – nearly 80% of total derivatives notional outstanding – this means a majority of the overall market is now being cleared.
But some reports also picked up on the fact that clearing in other asset classes is much lower – 37% for credit derivatives and less than 2% for equity and FX derivatives. There are good reasons for that. First, not all products are suitable for clearing – and, in fact, aren’t offered for clearing by CCPs.
The vast majority of FX products, for instance, tend to be much shorter dated than interest rate contracts. As such, the primary risk is settlement failure, rather than counterparty risk, and an industry mechanism (CLS) is already in place to tackle that. Non-deliverable forwards are just about the only FX derivatives product that is currently available at CCPs.
In the equity derivatives space, the majority of activity is in highly standardised exchange-traded futures and options contracts. But there is demand for over-the-counter instruments that are customised to meet the needs of individual users. The unique, highly bespoke nature of each contract means that many transactions are unsuitable for clearing, where the key criteria for CCPs is liquidity and daily price availability.
A similar issue exists for single-name credit default swaps (CDS). Clearing in the single-name space is limited, largely because many contracts tend to trade infrequently, meaning they don’t meet the liquidity criterion set for clearing – although a group of large buy-side firms pledged last year to clear what they can on a voluntary basis. Clearing in CDS indices, on the other hand, is much more prevalent. According to data submitted to US trade repositories and compiled by ISDA SwapInfo.org, 81.4% of average daily CDS index notional volume was cleared in the second quarter of 2016.
The other issue is that regulators and market participants focused first on the largest part of the derivatives market: interest rates. While interest rate derivatives comprise nearly 80% of overall gross market exposure, credit derivatives (1.7%), equity derivatives (2.5%) and FX derivatives (17%) and are much smaller, and so pose less of a systemic threat.
Linked to this is the fact that regulators never intended for all derivatives to be cleared. As Commodity Futures Trading Commission chairman Timothy Massad has said: “Sometimes, commercial risks cannot be hedged sufficiently through clearable swap contracts. Therefore market participants must craft more tailored contracts that cannot be cleared. In addition, certain products may lack sufficient liquidity to be centrally risk managed and cleared.”