OTC derivatives volume hit new lows since financial crisis – what is the role of trade compression?The toll of regulation can clearly be seen in the global derivatives market in the second half of 2015. Volumes shrank to their lowest level since the financial crisis mainly due to trade compression, according to data released by the Bank for International Settlements.
Figures from BIS showed that the notional amount of outstanding contracts slid by 11% between end-June 2015 and end-December 2015, from $552 trn to $493 trn. The fall in notional amounts was accompanied by a sharp drop in the gross market value of outstanding derivatives contracts, which provides a more meaningful measure of amounts at risk. They plumbed new depths since 2007, dropping by 6% between end-June 2015 and end-December 2015, from $15.5 trn to $14.5 trn.
Interest rate swaps, which account for almost 80% of the market, and are used by a wide swathe of participants, were the main culprit. Overall, the gross notional amount of all OTC derivatives fell, from $552tn to $493tn.
Trade compression, which the BIS cited as the driver behind the decline, has been gaining momentum over the past year as banks look to mitigate the impact of the new more onerous requirements. This is because the outstanding notional of derivatives trades contributes to the leverage ratio. In other words, the larger the outstanding notional, the larger the capital requirement, which can also affect investors as banks pass on the hike in transaction costs.
Trade compression enables one or more offsetting derivative contracts to be torn up and replaced with a single contract with the same economic exposure. For example, if a bank buys one contract for $100m and sells another for $50m, then it has a gross notional of $150m. However, this can be compressed into a single trade where the bank buys $50m.
Trade compression has also received a boost from the increase in central clearing. The share of credit default swaps booked with central counterparties rose to 34% at end-December 2015, up from 31% at mid-2015 and less than 10% at mid-2010. Clearinghouses have been the beneficiaries on both fronts as they run some of the largest compression services.
The practice also helps explains how the large outstanding numbers are falling at the same time as trading volumes remain stable. The regulatory treatment of large notional positions may be punitive, but the ability to tear up contracts and reduce this number eases the pain and makes it more manageable.
The BIS also notes that other contributing factors behind the decline in the market value of derivatives include rises in long-term yields, as well as currency fluctuations.
