Twice a year, the Bank for International Settlements releases global aggregate data regarding the derivatives markets. It provides an often illuminating window into broad trends in the derivatives markets. The data sets constitute some of the original “big data” given the volume and value of the contracts involved.
The most recent round of data was released today, just in time for next week’s Group of 7 meeting, the Group of Twenty meeting later this month and various other international regulatory policy meetings planned between now and June. The most notable of these will be the Financial Stability Forum and the Basel Committee.
The data is released as debate rages over whether or not the post-crisis reform initiatives have stifled economic growth and whether certain reforms should even be implemented. A range of policymakers from France, Japan, and the United States have all recently signaled an interest in reconsidering the scale, scope and substance of remaining reform initiatives. The FSB has been tasked by the G20 to undertake a comprehensive review. Recently, the U.S. House of Representatives passed the Financial CHOICE Act which is designed to roll back many of post-crisis reforms.
One of the signature reforms following the crisis focused on the derivatives markets. The vast majority of derivatives market activity occurs in the interest rate market. Consequently, this post looks at BIS data regarding those markets. The remaining market segments (equity derivatives, foreign exchange derivatives, commodities derivatives) are much smaller markets which include comparable data trends to the interest rate segment.
Central Counterparties — Did the reforms work?
One key reform following the financial crisis involved policymaker efforts to shift transactions away from bilateral deals towards transactions effected with a central counterparty. The policy imperative was to ensure that documentation and liquid resources served as a quality check on transactions. Entry requirements (“initial margin”) and ongoing maintenance requirements set in relation to transaction volumes (“variation margin”) at the clearinghouse would enhance systemic stability by ensuring that traders had sufficient liquid resources to support their market activity.
Implementation efforts designed to move away from “over the counter” (OTC) markets and towards central clearing have been slow and incomplete globally . The European Union and the United States have adopted different technical implementation measures. They remain at loggerheads over these divergences, but that is another story.
This post asks whether data indicate whether (or not) the reforms achieved their intended goal? The answer is: Yes and no.
The BIS indicates that central clearing for credit default swaps (CDS) jumped from 37% of notional amounts outstanding at end-June 2016 to 44% at end-December. They also note that central clearing for OTC interest rate derivatives markets “was more or less unchanged at 76%.” The data above suggest strongly that increased clearing has occurred apparently at the expense of reporting dealers.
This mirrors a parallel debate in the financial services industry regarding whether post-crisis reforms have adversely impacted market liquidity by driving market-makers out of the trading business.
Clearing activity seems to have had no impact on market activity by “other financial institutions.” Note that in the time series activity by “other financial institutions” grew during the early days of the financial crisis. These entities have been the majority participants in the market ever since, with their share of transactions only dropping once central clearing became operational.
Definition of “Other Financial Institutions”
If reporting dealers have effectively exited the market, who are these “other financial institutions?” The BIS Glossary does not tell us, exactly.
It defines “financial institution” as “financial corporation.” In turn, “financial corporation is defined as an “entity that is principally engaged in providing financial services, such as financial intermediation, financial risk management or liquidity transformation. Financial corporations include the following entities: central banks, banks and non-bank financial corporations.” (emphasis added)
Based on these definitions, it would seem that the vast majority of interest rate derivatives trading since the crisis has involved counterparties from central banks, insurance companies, pension funds, and possibly sovereign wealth funds. It is unclear how state-owned financial institutions are treated based on these definitions as well.
This is not exactly what policymakers had in mind when they set out to make the financial system safer by creating central clearinghouses.
Don’t Jump to Conclusions Yet
This story is not yet over. The first two reporting periods (from 2016) indicate that central clearing is slowly taking market share from “other financial institutions.” These entities may yet fulfill their intended function of providing the market with a central location where cash and collateral can secure trading activity, thus decreasing volatility and systemic risk.
In the process, however, policymakers will have created non-bank entities in the financial markets that are indeed too big to fail. This risk is not lost on policymakers. Debate rages on how to address this second-order problem as well.
Subsequent posts will assess different aspects of the policy debate as officials attempt to pivot towards growth-friendly policies.
Barbara C. Matthews is Managing Director and Founder of BCM International Regulatory Analytics LLC, a specialized consultancy that uses proprietary, patented process to quantify policy risks and anticipate policy trajectories.