Derivatives concentration

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See also credit default swaps, CDS clearing, CDS confirmation, CFTC, derivatives, ***House derivatives 2009***, muni swaps and regulatory harmonization.



Commercial bank, total derivatives and leverage -- *Source: OCC end of 2009 report March 19, 2010

ISDA on derivatives concentration

    • According to the ISDA Market Survey for Mid-Year 2010, the largest U.S.-based derivatives dealers account for 37 percent of the global total notional amount outstanding of derivatives reported by Survey respondents.
    • The largest fourteen derivatives dealers (G14) hold 82 percent of the total notional amount outstanding.
    • Broken out by products, the G14 group holds 82 percent of interest rate derivatives, 90 percent of credit default swaps, and 86 percent of equity derivatives.

IOSCO Chair on derivatives concentration

Hedging of positions has been a common way of managing risk for a very long time. They were developed to manage and lower risk, and crude versions of derivatives have been in use for centuries. Derivatives began being sold off-exchange in the early 1980s. Today, they account for vast sums of money – the Bank for International Settlements estimates the total outstanding notional amount at $684 trillion (as of June 2008).2

Derivatives certainly bring legitimate business benefits. The use of derivatives to hedge positions in business and to offset risk is well understood and an important business tool. The Basel Committee on Banking Supervision has pointed out that credit risk protection through collateral pledged against potential losses in derivatives transactions is a cornerstone of risk management.3

Unfortunately, though, the crisis demonstrated that derivatives trading can also concentrate and heighten risk. Some commentators have demonised derivatives as a product class. I do not agree with this analysis. Nevertheless, a misunderstanding of derivatives can expose market participants who use them to significant risk. The global financial crisis highlighted the counterparty risk, where, even though the instrument might well have been sound, the counterparty could not pay.

The International Organization of Securities Commissions’ (IOSCO) report on the subprime crisis published in May 20084 highlighted the fact that a number of structured products relying on leverage magnified both risks and returns.

A January 2010 report from the Joint Forum5 made up of the financial sector’s international standard-setting bodies, including IOSCO, reminds us that “one of the factors contributing to the crisis was the inadequate management of risks associated with various types of products designed to transfer credit risk. This resulted in severe losses for some institutions. These products transfer risks within and outside the regulated sectors.”

My view is that derivatives trading contributed to the global financial crisis, but was not the main cause. Like poor valuations, mis-selling of products, misuse of off-balance sheet vehicles and poorly understood securitisations, they were a contributor. Some derivatives destroyed value because of significant opacity in pricing valuation, and because many were traded over the counter rather than in regulated exchanges, and therefore there was an absence of transparency in relation to positions. As Gary Gensler of the US Commodity Futures Trading Commission has observed,6 the crisis demonstrated that OTC derivatives added leverage to the financial system, with more risk being backed up by less capital.

BIS semiannual OTC derivatives statistics

BIS triennial central bank survey of FX and derivatives

In April this year, 53 central banks and monetary authorities participated in the eighth Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity ("the triennial survey"). The objective of the survey is to provide the most comprehensive and internationally consistent information on the size and structure of global foreign exchange markets, allowing policymakers and market participants to better monitor patterns of activity in the global financial system. 1 Coordinated by the BIS, participating institutions collect data from some 1,300 reporting dealers on turnover in foreign exchange instruments and OTC interest rate derivatives. The triennial survey has been conducted every three years since April 1989, and has been modified since April 1995 to include OTC interest rate derivatives.

Previous triennial surveys have used the expression "traditional foreign exchange markets" to refer to spot transactions, outright forwards and foreign exchange swaps. This expression excludes currency swaps and currency options, which are under OTC instruments. Beginning with the 2010 survey, the expression "global foreign exchange markets" will include all five foreign exchange instruments. Turnover on global foreign exchange markets and in interest rate derivatives is analysed in Tables 1 to 5 and in Tables 6 to 9, respectively.

The headline figures from the April 2010 survey are the following:

1. Turnover on the Global foreign exchange market

Global foreign exchange market turnover was 20% higher in April 2010 than in April 2007, with average daily turnover of $4.0 trillion compared to $3.3 trillion.

The increase was driven by the 48% growth in turnover of spot transactions, which represent 37% of foreign exchange market turnover. Spot turnover rose to $1.5 trillion in April 2010 from $1.0 trillion in April 2007.

The increase in turnover of other foreign exchange instruments was more modest at 7%, with average daily turnover of $2.5 trillion in April 2010. Turnover in outright forwards and currency swaps grew strongly. Turnover in foreign exchange swaps was flat relative to the previous survey, while trading in currency options decreased.

As regards counterparties, the higher global foreign exchange market turnover is associated with the increased trading activity of "other financial institutions" - a category that includes non-reporting banks, hedge funds, pension funds, mutual funds, insurance companies and central banks, among others. Turnover by this category grew by 42%, increasing to $1.9 trillion in April 2010 from $1.3 trillion in April 2007. For the first time, activity of reporting dealers with other financial institutions surpassed inter-dealer transactions (ie transactions between reporting dealers).

Foreign exchange market activity became more global, with cross-border transactions representing 65% of trading activity in April 2010, while local transactions account for 35%.

The percentage share of the US dollar has continued its slow decline witnessed since the April 2001 survey, while the euro and the Japanese yen gained relative to April 2007. Among the 10 most actively traded currencies, the Australian and Canadian dollars both increased market share, while the pound sterling and the Swiss franc lost ground. The market share of emerging market currencies increased, with the biggest gains for the Turkish lira and the Korean won.

The relative ranking of foreign exchange trading centres has changed slightly from the previous survey. Banks located in the United Kingdom accounted for 36.7%, against 34.6% in 2007, of all foreign exchange market turnover, followed by the United States (18%), Japan (6%), Singapore (5%), Switzerland (5%), Hong Kong SAR (5%) and Australia (4%). 2. Turnover in OTC interest rate derivatives

Activity in OTC interest rate derivatives grew by 24%, with average daily turnover of $2.1 trillion in April 2010. Almost all of the increase relative to the last survey was due to the growth of forward rate agreements (FRAs), which increased by 132% to reach $601 billion. More detailed results on developments in the foreign exchange and OTC derivatives markets and comprehensive explanatory notes describing the coverage of and terms used to present the statistics are included in the separate statistical release of the data. Explanatory notes follow statistical tables.

The BIS plans to publish, in November 2010, the detailed results of the activity in April 2010 and of the positions at end June 2010 on FX instruments. A specific press release will also be published in November on the global OTC positions at end June 2010. In addition, special features will be devoted to the Survey in the December 2010 BIS Quarterly Review.


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