Today we commence a series on the derivatives market. This sector of financial services has grown significantly in recent years, and the amounts involved are large. This review is timely given the recent announcements in Europe of the potential introduction of a financial transaction tax (FTT). We start with a basic set of definitions, and start to explore the size of the market.
The derivatives market is where products like futures and options, and a wide range of other products are traded. They will be derived from a range of assets, including commodities, interest rates, currencies, shares or bonds. They are the essential tools of financial engineers. Derivatives may be directly linked to an underlying asset, for example a futures contract to deliver corn at a price agreed today, in three months time; or may be leveraged; for example, buying an option to allow you to deliver corn at an agreed price in three months time. We will look in more detail at the products later.
Derivatives can either traded on an established exchange, or over the counter (OTC).
Exchange traded derivatives are traded on an exchange like the Chicago Mercantile Exchange and are traded in standard derivative contracts. These may be futures, or options contracts on a wide range of underlying products. Participants on the exchange will take positions in these contracts, trading via the exchange which is a central counter-party. Traders will take positions, either buying a contract (said to be long) or selling a contract (said to go short). There will also be a net sum of zero, but market movement risk is transferred from one party to another.
Over the counter derivatives are built and sold by investment banks. They make markets in these derivatives and their clients will include corporations, hedge funds, commercial banks and government. This is more complex process, because whilst end customers will normally contract with the derivative provider, how the investment bank chooses to hedge the contract is down to the traders. Often they will use complex “black box” systems to match and net exposures and hold positions depending on rate expectations. They may well hold large open positions, although these days, positions within the banks are monitored more closely than they use to be. Products sold via OTC include swaps, forward rate agreements, forward contracts and a range of other credit derivatives.
So, lets look at the size of the market. According to the latest available data from the BIS, there was about US$70 trillion futures and options contracts (based on the principal) in play in December 2013. Note the significant growth from 2000 onwards, and the slight fall in options after the GFC in 2007.
Another way to look at the contracts is based on turnover. Again, according to BIS, in December 2013 this totalled US$500 trillion. We see that turnover in futures contracts was higher than options (because option premiums are a fraction of the cost of taking a position in the underlying).
Finally, we look at the number of contracts on the exchanges. BIS reports that there were 300 million contracts in December 2013. Note they reached an all time high, and the spike in options, reflecting the expectation that US tapering will start, and creating a need (or opportunity) to hedge.
Turning to the OTC market, again the BIS provides us with some good data. “The latest BIS statistics on OTC derivatives markets show that notional amounts outstanding totalled US$693 trillion at end-June 2013. Of this total, $668 trillion was reported by dealers in the 13 countries that participate in the BIS’s semiannual survey, and US$25 trillion by dealers in the 34 countries that participate only in the Triennial Survey. The gross market value of all contracts – that is, the cost of replacing all outstanding contracts at current market prices – stood at $20 trillion at end-June 2013.”
We can drill into the data by product type. Interest rate contracts make up the bulk of the transactions. “Interest rate contracts are the largest segment in the global OTC derivatives market, with notional amounts totalling $577 trillion at end-June 2013. However, the global figures mask diversity among reporting dealers. The Triennial Survey indicates that derivatives activity by dealers based in emerging markets tends to focus on the management of foreign exchange risk. Interest rate derivatives account for a much smaller share of contracts reported by these dealers than those based in the largest derivatives markets (ie than those headquartered in the 13 countries that participate in the semiannual survey)”.
These are big numbers. By way of contrast global GDP was US$72 trillion in 2012. Another way to look at it is the total derivatives market equates to more than $100,000 per person on the planet!. So, whilst this growth in derivatives trading makes bankers richer, is it good for economies? According to a recent US report, 95% of all U.S. derivatives are monopolised by just five large players. There seems to be a prima facie case to add a small tax to every speculative transaction. This could raise significant revenue for governments who are seeking new sources. Of course some argue this would make a particular market less attractive (this is why the UK resisted the EU initiate to bring in an FTT). Of the 27 EU member states, the 11 going ahead with the FTT are Germany, France, Italy, Spain, Belgium, Austria, Portugal, Greece, Slovenia, Slovakia and Estonia.
In later posts we will look further at the derivatives market, including examining some of the products in more detail; examine how capital controls are being strengthened, and also look at the derivatives market in Australia. This whole area is one which needs to be better understood. Some believe it could become the cause of the next great crash.