Lynn Strongin Dodds assesses the ISDA report on the impact the US, EU and UK’s changing monetary policies had on the IRD landscape.
It has been a busy time for interest rate derivative (IRD) traders in the Western world. Shifting and disparate interest rate policies have pushed volumes to new levels while the transition from LIBOR to alternative reference rates (ARR) has ushered in a new era for overnight index swaps (OIS).
These are the findings of the recent International Securities and Derivatives Association (ISDA) report – Interest Rate Derivatives Trading in the US, EU and UK: Growth, Structural Shifts and the Rise of OIS.
The research analysed the impact the fluctuating economic environment had on IRD activity between 2021 and 2024 across the US, EU and UK. The first two years were the most dramatic thanks to the pandemic and Russia/Ukraine conflict. Together they pushed inflation to new heights, forcing central banks to reverse their benign monetary direction.
For example, the Bank of England (BoE) increased interest rates from 0.1% in December 2021 to the peak of 5.25% in August 2023 while the Federal Reserve (Fed) in the US began hiking in March 2022, taking them from 0-0.25% to an acme of 5.25-5.50% in July 2023. The European Central Bank (ECB) also embarked on a series of interest rate rises in 2022 and 2023, raising them from 0% to 4.5% between July 2022 and September 2023.
The ISDA report showed IRDs benefitted during this period as market participants used the instruments for hedging, liquidity management and repositioning of their portfolios. The same trends were evident last year when rates started to fall in line with inflation. The Fed made three cuts in the latter part of 2024 to a target range of 4.25%-4.50%. The BoE started trimming in August, ending the year on 4.75% while the ECB pushed the button in June, lowering the benchmark to 3.75%.
Against this backdrop, the EU saw the biggest spike in activity with IRD traded notional rising by 66.4% to $76.1 trn in 2024 from $45.7 trn in 2022 culminating in a compounded annual growth rate (CAGR) of 29.0%. The US was in second place with a 59.3% gain to $366.3 trn in 2024 from $230.2 trn in 2021 or a CGR of 16.8%. The UK, on the other hand, recorded a 41.7% increase to $171.9 tr in 2024 from $121.3 trn in 2022, reflecting a 19 % CAGR.
The report also revealed the tenor composition of IRD trading activity varied across jurisdictions. In the US, trades with maturities of one year or less dropped to 68.2% of total traded notional in 2024 from 71.1% in 2022. The share of medium-term trades rose to 22.1%, while longer tenors were relatively unchanged.
By contrast, the EU experienced a more pronounced shift toward the short end, with one-year-and-under trades rising to 71.5% from 63.1%, alongside declines in both medium – and long-term activity. The UK had the largest concentration of short-dated trades, comprising 74.9% of total traded notional, with medium-term trades holding steady at around 15% and longer tenors declining.
The other trend highlighted in the report was the dramatic structural changes that took place in product composition as the industry moved from LIBOR to ARRs. This resulted in the share of OIS expanding significantly, while trading in fixed-for-floating interest rate swaps (IRS) and forward rate agreements (FRAs) dropping.
In total OIS traded notional climbed to $244 trn in 2024 from $54.7 trn in 2021 accounting for two-thirds or 66.6% of total IRD traded notional last year compared to 25.3% in 2021. By comparison, the share of fixed-for-floating IRS and FRAs fell to 18.4% and 4.9% in 2024 from 40.8% and 23.2% in 2021, respectively.
Market participants typically used FRAs to hedge fixing risk on three- or six-month LIBOR-based swaps, but risk free rates (RFR) – linked swaps use daily compounded rates, largely eliminating that threat. FRA activity has since been concentrated in euro denominated contracts, where market participants continue to hedge EURIBOR exposures. There were no FRA transactions reported in other major currencies in the second half of 2024.
Breaking it down by jurisdictions, the US saw Secured Overnight Financing Rate (SOFR) linked OIS traded notional soar from $6.1 trn in 2021 to $72.1 trn in 2024, while Effective Federal Fund Rate (EFFR) – linked OIS jumped from $17 trn in 2021 to a peak of $47.5 trn in 2023 before easing to $44.7 trn in 2024. The latter are typically used to express views on the direction of monetary policy, according to the report.
In the EU, its Euro Short-Term Rate (€STR)-linked OIS accounted for nearly 86% of total OIS traded notional in 2024 while the UK market featured a broader mix of reference rates. €STR surpassed Sterling Overnight Index Average (SONIA) as the most traded OIS benchmark in 2024, followed by significant volumes linked to SOFR and the EFFR.
In number terms, this translated into SONIA-linked OIS transactions totalling $34.4 trn in 2024, up from $19.3 trn in 2021, while €STR counterparts swelled to $61 trn from $2.5 trn, over the same period. This growth, the report said, was seen as particularly important given EURIBOR continues to exist and there are no plans to discontinue it.
