Digital Finance Analytics (DFA) Blog
"Intelligent Insight"
I discuss a recent RBA release about correspondence between the Treasurer and RBA about risks from derivatives. While the focus of the letters is superannuation, there are wider issues at play here, as I explore with Robbie Barwick from the Citizens Party.
Go to the Walk The World Universe at https://walktheworld.com.au/
I discuss a recent RBA release about correspondence between the Treasurer and RBA about risks from derivatives. While the focus of the letters is superannuation, there are wider issues at play here, as I explore with Robbie Barwick from the Citizens Party.
Go to the Walk The World Universe at https://walktheworld.com.au/
Join us for a live Q&A as I discuss the state of the financial markets, and how derivatives like options are influencing the dynamics of what is going on with Michael Cornips Founder and Managing Director of Emerald Financial, a financial services firm founded in Melbourne in 2005.
You can ask a question live via the YouTube Live Chat!
https://www.emeraldfinancial.com.au/
We examine in basic terms what a derivative is, and how it works, as requested by a number of our followers!
I discuss the risks to our banks from the poorly understood derivatives sector with Robbie Barwick from the CEC. It’s one BIG problem!
Please share this post to help to spread the word about the state of things….
Caveat Emptor! Note: this is NOT financial or property advice!!
The Financial Stability Board (FSB), the Basel Committee on Banking Supervision (BCBS), the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) has published their final report on Incentives to centrally clear over-the-counter (OTC) derivatives.
The total value of OTC derivatives was recently reported at US$595 Trillion, a massive number. The approach is been to allow the growth of these instruments, but to encourage central clearing rather than bi-lateral dealer arrangements to give greater visibility to the exposures involved. They propose capital incentives for centrally cleared transactions.
We discussed this in a recent video. This is a highly speculative market, and whilst shining more light on them may help, the more fundamental question which should be asked is why allow these to exist at all. The financial markets would be safer if they were limited to only underlying transactions, not speculative positions. At the moment, there is a risk that the derivatives markets could swamp, and bring down the normal banking system in a crisis, and that risk remains un-quantifiable. Another reason for structural separation.
The central clearing of standardised OTC derivatives is a pillar of the G20 Leaders’ commitment to reform OTC derivatives markets in response to the global financial crisis. A number of post-crisis reforms are, directly or indirectly, relevant to incentives to centrally clear. The report by the Derivatives Assessment Team (DAT) evaluates how these reforms interact and how they could affect incentives.
The findings of this evaluation report will inform relevant standard-setting bodies and, if warranted, could provide a basis for fine-tuning post-crisis reforms, bearing in mind the original objectives of the reforms. This does not imply a scaling back of those reforms or an undermining of members’ commitment to implement them.
The report, one of the first two evaluations under the FSB framework for the post-implementation evaluation of the effects of G20 financial regulatory reforms, confirms the findings of the consultative document that:
- The changes observed in OTC derivatives markets are consistent with the G20 Leaders’ objective of promoting central clearing as part of mitigating systemic risk and making derivatives markets safer.
- The relevant post-crisis reforms, in particular the capital, margin and clearing reforms, taken together, appear to create an overall incentive, at least for dealers and larger and more active clients, to centrally clear OTC derivatives.
- Non-regulatory factors, such as market liquidity, counterparty credit risk management and netting efficiencies, are also important and can interact with regulatory factors to affect incentives to centrally clear.
- Some categories of clients have less strong incentives to use central clearing, and may have a lower degree of access to central clearing.
- The provision of client clearing services is concentrated in a relatively small number of bank-affiliated clearing firms and this concentration may have implications for financial stability.
- Some aspects of regulatory reform may not incentivise provision of client clearing services.
The analysis suggests that, overall, the reforms are achieving their goals of promoting central clearing, especially for the most systemic market participants. This is consistent with the goal of reducing complexity and improving transparency and standardisation in the OTC derivatives markets. Beyond the systemic core of the derivatives network of central counterparties (CCPs), dealers/clearing service providers and larger, more active clients, the incentives are less strong.
The DAT’s work suggests that the treatment of initial margin in the leverage ratio can be a disincentive for banks to offer or expand client clearing services. Bearing in mind the original objectives of the reform, additional analysis would be useful to further assess these effects.
In this regard, the Basel Committee on Banking Supervision issued on 18 October a public consultation setting out options for adjusting, or not, the leverage ratio treatment of client cleared derivatives.
The report also discusses the effects of clearing mandates and margin requirements for non-centrally cleared derivatives (particularly initial margin) in supporting incentives to centrally clear; and the treatment of client cleared trades in the framework for global systemically important banks.
The final responsibility for deciding whether and how to amend a particular standard or policy remains with the body that is responsible for issuing that standard or policy.
The BCBS, CPMI, FSB and IOSCO today also published an overview of responses to the consultation on this evaluation, which summarises the issues raised in the public consultation launched in August and sets out the main changes that have been made in the report to address them. The individual responses to the public consultation are available on the FSB website.
The five areas of post-crisis reforms to OTC derivatives markets agreed by the G20 are: trade reporting of OTC derivatives; central clearing of standardised OTC derivatives; exchange or electronic platform trading, where appropriate, of standardised OTC derivatives; higher capital requirements for non-centrally cleared derivatives; and initial and variation margin requirements for non-centrally cleared derivatives.
The Bank For International Settlements has released their OTC derivatives statistics to June 2018. They report that the notional value of outstanding OTC derivatives increased from $532 trillion at end-2017 to $595 trillion at end-June 2018. This increase in activity was driven largely by US dollar interest rate contracts, especially short-term contracts.
That said, the gross market value of OTC derivatives continued to decline, nearing $10 trillion at end-June 2018 from $11 trillion at end-2017 – compared with the peak of $35 trillion observed in 2008. This decline reflected in part ongoing structural changes in OTC derivatives markets.
The proportion of outstanding OTC derivatives that dealers cleared through central counterparties (CCPs) held steady, at around 76% for interest rate derivatives and 54% for credit default swaps (CDS).
Gross market values declined despite an increase in notional amounts
Activity in OTC derivatives markets increased in the first half of 2018, driven mainly by short-term interest rate contracts. The notional amount of outstanding OTC derivatives contracts – which determines contractual payments – increased to $595 trillion at end-June 2018, its highest level since 2015 (Graph 1, red line). Nevertheless, the gross market value of outstanding derivatives contracts – which provides a more meaningful measure of amounts at risk – continued to decline, to $10 trillion, its lowest level since 2007 (blue line). Gross credit exposures, which adjust gross market values for legally enforceable bilateral netting agreements, remained stable at $2.6 trillion at end-June 2018 (yellow line).
US dollar contracts drove the increase in notionals
Graph 2: Outstanding notional amounts of OTC interest rate derivatives, USD trillions (interactive graph). Source: BIS OTC derivatives statistics (Table D7)
The increase in notional amounts outstanding was driven mainly by OTC interest rate derivatives, in particular for US dollar-denominated contracts, which rose from $157 trillion at end-2017 to $193 trillion at end-June 2018 (Graph 2, red line). An increase in US dollar activity was also seen in exchange-traded derivatives markets, where the average daily turnover of futures and options on dollar interest rates climbed to a record high of $9.6 trillion in the month of February. This increased activity may reflect changing expectations about the path of future US dollar interest rates during the period. The notional amounts outstanding of euro-denominated interest rate derivatives also went up over this period, but more modestly, from $122 trillion to $129 trillion (blue line).
The increase in OTC interest rate derivatives activity was concentrated in the short-term segment. The notional amount of outstanding contracts with a remaining maturity up to and including one year rose from $191 trillion to $231 trillion between end-2017 and end-June 2018. The increase for contracts with a remaining maturity between one and five years was less pronounced, from $140 trillion to $155 trillion, and longer-term contracts (with a remaining maturity over five years) held roughly constant, at around $94 trillion.
Turning to OTC foreign exchange (FX) derivatives markets, notional amounts rose to a record high of $96 trillion at end-June 2018, up from $87 trillion at end-December 2017. This was also driven by activity in short-term instruments. In contrast to other OTC derivatives, most FX derivatives require counterparties to repay the notional amount at maturity and thus can be viewed as a form of collateralised borrowing, with the associated foreign currency repayment and liquidity risks.
Market value of interest rate and credit derivatives declined further
Graph 3: Outstanding gross market values, trillions USD (interactive graph). Source: BIS OTC derivatives statistics (Table D5.1).
Despite the increase in notional amounts in the first half of 2018, the gross market values of outstanding OTC derivatives continued to decline. Gross market values for all OTC derivatives stood at $10.3 trillion at end-June 2018, down from $11.0 trillion at end-2017 (Graph 3, red line). Over that same period, the gross market value of interest rate derivatives declined by $1 trillion, ending at $6.6 trillion (purple line). Other segments of OTC derivatives markets saw smaller movements, with FX derivatives increasing from $2.3 trillion to $2.6 trillion (yellow line) and credit derivatives decreasing from $0.3 trillion to $0.2 trillion (blue line).
The continuing decline in gross market values reflected in part ongoing structural changes in OTC derivatives markets. These changes include central clearing and greater possibilities for trade compression – that is, the elimination of economically redundant derivatives positions. In addition, in recent periods an increasing number of banks have been recording variation margin on cleared derivatives as settlement payments rather than as transfers of collateral. The practice of so-called settled-to-market (STM) allows counterparties to take ownership of the collateral that they receive. Consequently, daily payments of variation margin are recorded as settlements of the derivatives transactions rather than as transfers of collateral and the market value of the derivatives is reset daily to zero. STM, which is increasingly adopted for cleared swaps in particular, thus results in lower market values for a given derivative.
Clearing in credit default swap markets was steady at 54%
Graph 4: Outstanding notional amounts of CDS, USD trillions (interactive graph). Source: BIS OTC derivatives statistics (Table D10.1).
Notional amounts of CDS continued to decline, owing to decreased activity between reporting dealers. From end-June 2016 to end-June 2018, total notional amounts dropped from $12 trillion to $8 trillion, amounts vis-à-vis reporting dealers declined from $5 trillion to $2 trillion, and amounts vis-à-vis CCPs remained steady around $4.5 trillion (Graph 4). In the first half of 2018, the share of notional amounts cleared with CCPs was stable at 54%, in contrast to the upward trend over the past few years.
In OTC interest rate derivatives markets, the proportion of contracts cleared was also steady in the first half of 2018, at around 76% overall. Across currencies, the proportion ranged from 73% for euro interest rate contracts to 77% for US dollar contracts and 89% for Canadian dollar contracts. In OTC FX derivatives markets, clearing accounted for only 3.0% of dealers’ outstanding contracts at end-June 2018. While low, this was up from 2.4% at end-December 2017.
After successfully clearing a trade for one of its underlying clients, JP Morgan will be the first to launch the service for the Australian dollar.
The ASX operates the largest listed interest rate derivatives market in Asia with an annual turnover of $53 trillion and has a fully developed OTC Clearing service.
ASX executive general manager derivatives and OTC markets Helen Lofthouse said ASX had invested in a capital efficient clearing infrastructure and JP Morgan’s access demonstrated its commitment to clients.
“It also shows ASX’s determination to develop services valued by the market, which includes local clearing that’s open throughout the Australian and New Zealand time zone,” she said.
The launch underscores JP Morgan’s commitment to clearing, said Head of Asia clearing David Martin.
“This investment underlines our commitment to the Australian and New Zealand marketplace, and the Asian marketplace in general,” said Mr Martin.
Mr Martin said that the OTC derivatives clearing market was continually changing and JP Morgan needed to offer greater choices.
“Clients need a clearing broker whose business model continues to evolve and a product offering that continues to expand,” he said.
Mr Martin said that, globally, JP Morgan was broadening products for their clients and wanted to provide the local market support for investors.
“JP Morgan’s approach also allows our clients to use the depth of our local markets franchise and our ability to make markets at the ASX,” he said.
Futures & Options and OTC Clearing manager at JP Morgan David Stinson said that by using the ASX services, it allowed them to extend benefits to more clients.
“By supporting the cross-margining facility that ASX offers across its cleared interest rate derivatives, we are extending this benefit to buy-side clients and allowing them to access funding and margin efficiencies,” he said.
We review the latest ASIC report
ASIC has called on participants in the retail over-the-counter (OTC) derivatives sector to improve their practices after recent ASIC activities showed their conduct fell short of expectations.
The products offered by retail OTC derivatives issuers in Australia include binary options, margin foreign exchange and contracts for difference.
A recent review of 57 retail derivative issuers identified a number of risks associated with the products offered to retail investors by OTC derivatives issuers.
Our review found that client losses in retail OTC derivatives trades seemed high, with the percentage of unprofitable traders being up to 80% for binary options, 72% for CFD traders and 63% for Margin FX traders. ASIC will examine this area further as part of its ongoing focus on the sector.
ASIC’s recent supervisory activities have also revealed sector-wide concerns about certain practices.
The most concerning practices ASIC has identified during in its supervision of the sector and highlighted in our recent reviews include:
- actual client profits being inconsistent with marketing materials
- a lack of transparency around pricing
- risk management practices that relied on the use of client money were outdated and needed to be reviewed
- some referral arrangements that may be in breach of conflicted remuneration requirements and referral selling prohibitions
- some issuers that were providing wholesale services or allowing third parties to ‘white label’ their products did not have adequate risk management practices and operational capital to supervise counterparties and support their exposures.
Binary options may be the least transparent in terms of underlying pricing, strike prices and payout structures.
To address these risks, ASIC has called on issuers to:
- review and update their risk management and client money practices; and
- assess whether their arrangements with counterparties and referrers meet their AFS licence obligations.
ASIC Commissioner Cathie Armour said, ‘The retail OTC derivatives sector in Australia is an active and growing market, with an annual turnover of $11 trillion and over 450,000 investors. The integrity of the retail OTC derivatives sector is a key focus for ASIC. ASIC expects licensed issuers to conduct themselves appropriately and ensure consumers trade in retail OTC derivatives with a clear understanding of the products and the risks to which they’re exposed. We will be working with issuers to raise industry standards and improve compliance with their Australia financial services licence obligations.’
