Thursday, May 15, 2014

OTC Derivatives – Is the market getting safer?


„Generally, I did not talk about the speculative aspects of derivatives. If pushed, I resorted to the National Rifle Association (NRA) defence – ‘Guns don’t kill people, people kill people’. Derivatives, I argued, were entirely safe, at least in the right hands and when used in the right way.“
Satyajit Das in „Traders, Guns, and Money“ - 2006


It's some time now that derivatives have bad press. We all know Warren Buffet's famous quote about derivatives constituting weapons of mass destructions. But is this still justified? Or are recent reforms showing first effects?

Let's have a look at some BIS data.





OTC Derivatives – Notional Amounts Outstanding

Notional amounts outstanding include all deals concluded and not yet settled. They provide an idea of the market size because they report the nominal basis from which contractual payments are determined. However, it does not represent the amount truly at risk, as this risk is a function of

  • the price level,
  • the volatility of the underlying financial reference index,
  • the duration and liquidity of contracts, and
  • the creditworthiness of counter-parties.

BIS' data shows that interest rate contracts always represent the highest portion of derivatives (81 % on June 30, 2013). Foreign exchange derivatives are another, albeit much less important, business sector (11 % market share on June 30, 2013).

The total notional amount outstanding increased by 10 % since December 31, 2012. Today, it stands at roughly 700 trillion USD. To give you an idea about the size, this is 44x GDP of the U.S. in 2013 or 100,000 USD per habitant of our planet.


“In truth, a good chunk of the activity in derivative markets is driven by speculation. Part of it is obscured by semantics – the boundary between speculation and investment is always hazy. If you lost money you speculated. If you made money you were investing. Or was it the other way around?”
Satyajit Das in “Traders, Guns, and Money” - 2006


OTC Derivatives – Gross Market Value

The gross market value is the cost of replacing all outstanding contracts at current market prices. The term gross indicates that positive and negative replacement values with the same counter-party are not netted. Nor are the sums of positive and negative contract values within a market risk category such as foreign exchange contracts, interest rate contracts, equities and commodities set off against one another. The gross market value supplies information about the potential scale of market risk in derivatives transactions.

Interest rate derivatives represent still the highest portion (75 % on June 30, 2013), followed by foreign exchange derivatives (12 % on June 30, 2013).

Most notably, the gross market value has declined by 26 % since December 31, 2011. In total, the gross market value is 20 trillion USD. This is substantially less than the notional amount outstanding, but still huge. To refer to my above examples again, it represents 30 % more than the 2013 GDP of the U.S. or an exposure of 3 USD per habitant of our planet.


Herfindahl Index

The Herfindahl index measures market concentration and is defined as the sum of the squares of the market shares of each individual institution. It ranges from 0 (fully diversified) to 10,000 (fully concentrated, i.e. only one financial institution)





Both for equity linked forwards and swaps as well as equity linked options, the Herfindahl index in Europe and the U.S. is very low and stable since 2001. Asian countries represent a second group with a somewhat higher index and volatility. Finally, Latin American markets are highly concentrated and volatile.





Foreign exchange derivatives markets are highly diversified for both forwards and swaps as well as options.


Let's go back to my initial question: Is the market getting safer? Looking at the above statistics, the notable recent decline of the gross market value since the end of 2011 strikes me most. The weapons of mass destruction seem to become less dangerous...


Resource:

BIS Statistical Release – OTC Derivatives Statistics at end-June 2013 – November 7, 2013