Usage of OTC derivatives to manage risk and hedge is increasing according to new figures released by SuperDerivatives (SD), the derivatives benchmark.
The report is the first of its kind from an independent multi asset derivatives market data source to cover overall OTC derivatives activity and will be released on a quarterly basis.
Figures cover both vanilla and complex derivatives across interest rates, foreign exchange, credit, commodities and equity derivatives and are sourced from SD’s system which is used by a large portion of the professional derivatives market and reflects derivatives pricing activity by banks, corporates and funds across the globe.
The SD figures follow a report from the Bank for International Settlements (BIS)* into usage of OTC derivatives trading figures which revealed that the notional amount of OTC derivatives trades outstanding bounced back to reach USD 605 trillion by the end of June.*
David Gershon, ceo, SD comments on the findings: “Our analysis reveals continued growth in the use of FX, interest rates, energy and commodity derivatives because they retain a crucial role supporting real, physical markets, in terms of hedging currency risk, managing resources and enabling cross border trade.
“Overall, the OTC derivatives market continues to perform effectively in helping companies and investors to manage their risks in a time of higher than usual rates of default, and the credit events that have occurred thus far are being settled in an orderly fashion.
”Institutions and investors in the future still need to be prepared for unusual market circumstances with the proper tools before the event happens, during it and after it.
“SD is seeing increasing demand from corporates, funds and banks for our valuation and derivatives management tools.
“Used and valued effectively, these instruments remain useful insurance policies, which allow firms to manage the fundamental risk in currency and commodities fluctuations, interest rates moves, supporting trade, investment and economic output.
“There remains a key role for independent, effective pricing across the whole derivatives universe to set the benchmark price for valuations for derivatives.
“The push to create a central counterparty would be a valuable step to regain confidence in the global financial market and in these instruments that have a real-world application to help manage risk and hedge effectively against fluctuations in currencies, energy costs and interest rates, for example.
“I am convinced that the direction financial markets took in the 2000s, excluding credit derivatives, will in time return and derivatives will continue to evolve and volumes will soar as they offer a customisable and practical way to manage risk.”
SuperDerivatives analysis of OTC derivatives usage by asset class
Interest rate derivatives
• Increasing demand for interest rate derivatives. Customer feedback suggests this will be a focus area in 2010 as institutions seek to manage and hedge the risk of global interest rates going up
• A shift in activity from exotic to vanilla trading in interest rate options, consistent with what we see in the market in terms of broker activity and client feedback
• There is still a drive in the market to trade vanilla structures as opposed to highly exotic structures where there has been a relative slowdown
• The percentage of exotic interest rate trades priced is consistent at around 15% – 20% of overall priced instruments throughout 2009, as opposed to the 30% – 40% for the last few months of 2008
• Callable fixed rate and range accrual structures continue to be the most heavily priced exotics which is in line with activity in the market
• BIS reports that the notional value of trades outstanding increased by 13% to USD 437 trillion.*
Foreign exchange
• A drive in the market to trade simple FX structures as opposed to highly exotic structures
• FX exotic structures such as target redemption notes (TARN), basket options and partial barrier options – knock in and knock out – are still used heavily. Basket options enable cheaper hedging (for those with a multi-currency exposure), or those looking to invest in a multi-underlying structure, as opposed to a series of vanilla options
• Banks and other financial institutions have reduced their exposure to exotics as bid/ask spreads are wider and it’s hard to get out of positions, plus the cost of friction – this applies more to the buy-side
• Currency markets are trading in narrower ranges as opposed to six months ago
• The partial barriers family of options offers additional flexibility. Knock ins give hedgers the ability to sell this option to finance the purchase of a vanilla option
• Knock outs continue to be purchased by clients for a reduced premium, as opposed to a vanilla option, hoping that the option will never knock out
• Increased market activity led notional outstanding to rise 10% to USD 49 trillion at the end of June according to the Bank for International Settlements*
Commodity derivatives
• Commodity derivative usage has rebounded
• Institutions continue to seek risk management and hedging across energy and fuel derivatives
• Vanilla commodity derivatives usage is predominant with a corresponding upswing in exotics
• The notional outstanding value of commodity derivatives contracts stabilised in June 2009 at USD 3.7 trillion, after a 71% freefall in the second half of 2008. Gold contracts recovered 28%, to stand at USD 0.4 trillion outstanding at the end of June 2009.
Credit derivatives
• Demand for exotic credit derivatives remains very low
• We expect this pattern to continue for some time with the likelihood of a longer term resurgence
• BIS reports that the outstanding values of credit default swaps (CDS) shrank by 14% to USD 36 trillion in the first half of 2009 as confidence began to return to markets, pushing down the costs of taking insurance against default
• Notional amounts outstanding of CDS fell for the second half-year period in succession, but far more slowly than in the second half of 2008*
• The gross market value of CDS contracts declined 42% due to declines in inter-dealer business and contracts with other financial institutions.*
Equity derivatives
• Use of equity derivatives peaked in April-May 2009 before slowing slightly throughout the summer months
• Volumes of both exotic and vanilla options were consistent and closely related throughout the year
• By September 2009, volumes had stabilised to the level reported in December 2008. We expect the growth in their usage to continue
• According to BIS, in the first half of 2009, notional amounts of equity derivatives rose by 7% to USD 6.6 trillion, while market values remained 16% below the level of end-year 2008.*
*Bank for International Settlements, November 2009
