The BIS released ”The OTC interest rate derivatives market in 2013” last week, authored by Jacob Gyntelberg and Christian Upper. There are some interesting things in the report on macro trends. The information is based on data from the Triennial Central Bank Survey.
The first thing that caught our eye was the observation that the market share of inter-dealer activity was shrinking.
“…A larger volume of contracts with financial institutions other than dealers coincided with declining inter-dealer activity, causing the share of inter-dealer trades to shrink to 35%, the lowest since the inception of the Survey. The volume of transactions with non-financial firms also declined…”
“…A relatively small number of major derivatives dealers have dominated the OTC derivatives market since its inception in the 1980s. These dealers continue to be important as counterparties for other market participants, but the share of inter-dealer trading is falling. In April 2013, transactions between dealers accounted for only 35% of turnover, down from 44% in 2010 and a peak of 66% in 2001. It is an open question whether this reflects a reduction in proprietary trading in response to regulatory changes, or increasing market concentration, or changes in how dealers offset the risk from their client positions…”
The dominance of the market by a few players is well known. But each of these large institutions is under the same regulatory pressure and navigate the same markets. Will those institutions react in the same way? Will regulatory and market forces push a convergence in business models (and hence institutional connectivity)? Time will tell.
Activity in derivatives overall – or at least the growth in activity — seems to be slowing down. But not all markets are trading in lock step. For example, FRA trading in Euro is increasingly active, almost doubling from the prior survey. But most seem to be well off the beak neck growth path experiences pre-crisis. What is behind this general downshifting? Beyond what we mentioned above (a reduction in prop trading, increasing market concentration, or changes in the ways dealers manage risk), the growth of the underlying bond markets, absolute level of rates and the shape of the curve play important roles.
“…The relatively low growth in swap turnover may reflect the relatively moderate increase in the volume of outstanding bonds between 2010 and 2013 compared with earlier periods. Our best estimate of the nominal amounts of all outstanding bonds went up by 4% to just under $100 trillion at the end of March 2013, compared to an increase of 28% between 2007 and 2010. The importance of the bond market’s size as a determinant for swap turnover is confirmed at the currency level, where we find a positive correlation between the growth of the volume of bonds outstanding and the increase in swap turnover…”
“…The more moderate growth in swaps may also have been driven by the yield curve flattening for major currencies between 2010 and 2013. This follows from evidence that swap market activity depends on the spread between long-term and short-term interest rates (Chernenko and Faulkender (2011). Banks, partly due to regulatory demands, use swaps to actively manage the maturity gap on their balance sheet. The flatter yield curve should reduce the incentive to enter swaps that receive long-term fixed rates and pay floating rates…”
“…non-financial corporations have increasingly turned to the bond market to raise long-term fixed rate funds (BIS (2013)), which reduces the need for swaps as a means of locking in long-term rates…”
It begs the question “what happens when rates rise and curves steepen”. In the U.S., where that seems more imminent than in Europe, it could mean more US dollar interest rate volatility that, in turn, will lead to more market activity. Will this prompt a reallocation of resources for the banks? London, as a trading center, dominates derivatives. “…Just under one half of the global total was traded via sales desks located in the United Kingdom and another 23% in the United States…”
Central clearing has the potential to push activity higher or lower, taking market liquidity along with it. “…lower counterparty risk owing to central clearing and higher collateralisation could spur turnover…” but “…higher transaction costs owing to tighter collateral requirements could reduce it…” Don’t we know it!