The Bank for International Settlements quarterly review, issued over the weekend, looks at two of the biggest derivatives trades, foreign exchange and interest rates. The pattern is complex, but overall the BIS report concluded: “Since 2009, the trading of derivatives on exchanges has shown no trend, whereas their OTC trading has trended upwards.”
Trades done OTC are done bank-to-bank, increasing the risk of contagion. One key reason for the proposed shift was that derivatives traded via an exchange and centrally cleared reduce the domino effect if a bank fails. However, despite seven years passing since the G20 edict, some of the regulatory reforms that are key to driving the trade onto exchanges – such as Europe’s Mifid II – have yet to take effect. Even though the G20 governments were unanimous in their call, regulators have also held back the move through poor co-ordination and turf wars – particularly across the Atlantic.
At the same time, OTC markets have evolved and improved. Some reforms have driven OTC trades into clearing houses which captures some of the benefits of moving onto a formal exchange. In the US trading has partly moved onto swap execution platforms, created under Dodd-Frank rules to reduce risk.
Andy Ross, chief executive of CurveGlobal, a new derivatives venture backed by the London Stock Exchange, several major investment banks and the Chicago Board Options Exchange, said: “I actually don’t think the end users of derivatives want OTC derivatives to go away.
“They may want to clear and trade OTC derivatives because it gives them the risk management hedge they want and need.” Foreign exchange derivatives remain overwhelmingly traded privately in OTC markets, where trading was worth an average of $ 3.4 trillion per day in April 2016. The comparative figure for on-exchange activity was $ 0.1 trillion.
In interest rates, exchange trading has gone backwards. The majority of interest rate derivatives trading still takes place mainly on exchange, with a daily average turnover of $ 5.1 trillion versus $ 2.7 trillion in OTC markets. But the proportion traded on exchange fell to 66% in April from roughly 80% in the 2000s.
BIS said: “This shift towards OTC markets is explained partly by weak activity in derivatives on short-term interest rates, which dominate trading on exchanges.”
According to the quarterly review, daily average turnover of foreign exchange and interest rate derivatives traded worldwide – on exchanges and OTC – rose to $ 11.3 trillion in April 2016 from $ 10.5 trillion in April 2013. The exchange-traded share remained at roughly 46%, however.
In the wake of the financial crisis, the G20 leaders agreed to adopt of series of reforms designed to reduce risk in derivatives markets, ranging from greater reporting, to the adoption of central clearing as well as promotion of electronic trading. The difficulty for exchanges is that only those contracts that are highly standardised are suited to move into the realm of order book trading. And investors still like to be able to tailor contracts to meet their specific needs. Ted Leveroni, the chief commercial officer of GlobalCollateral, a joint venture between post-trade giants Euroclear and DTCC, said the OTC market exists because it serves a valuable function.