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Business as Usual? Derivatives Volumes Compare Well to Pre-Euro Era

The latest BIS survey on derivatives balances outstanding sees further growth in the market, continuing a recent trend in the data series. This latest report also gives the market its first chance to study data that is unaffected by the legacy currencies that continued in existence until early 2002 before being replaced once and for all by the euro.

Colin Lambert takes a look at the data and sees how things have developed since the euro became a market currency unit.

The two most recent seminal events in the FX markets have been, in no particular order, the introduction of the euro and the advent of online trading. The euro launched at the start of 1999, while by the middle of that year, a handful of early adopters began releasing the first of the Internet-based trading services. Another noteworthy development during this period is the extraordinary growth of the OTC derivatives market.

The latest semi-annual survey (end-June 2002) from the Bank for International Settlements (BIS) reveals that outstanding balances in derivatives continued to climb. (Although not by as much as the headline figures would suggest because the bank collates its data in US dollars, and therefore the value of contracts denominated in euro and yen are overstated in percentage growth terms.)

All segments of the market saw increased outstanding balances, the overall value of contracts rising by just under 15% to $127,564 billion (notional) and by just over 17% in gross market value terms to $4,450 billion at the end of June 2002 compared to end-December 2001.

Within these numbers, foreign exchange outstandings rose by just under 8% to $18,075 billion notional ($1,052 billion gross market value versus $779 billion at end-December 2001). Equity linked contracts also rose, but remain a small proportion of the overall balances ($2,214 billion notional; $243 billion gross value), commodity contracts did likewise, $777 billion notional and $78 billion gross value and “Others”, or outstandings with institutions that are non-regular reporters, rose from $14,375 billion notional as at end-December 2001 to $16,503 billion in June 2002.

The biggest increase of all however, was once again reserved for the interest rate segment which continues to go from strength to strength. Outstanding notional balances in this segment rose by more than 16% to $89,995 billion. The value in gross market terms of these contracts failed to keep track of the pace of growth however, which stood at $2,468 billion from $2,210 billion as at end-December 2001.

A Longer Term Perspective

It is interesting to look at the outstanding balances in the context of those at the time of the euro’s launch. So many reports compare the latest statistics to the previous year or reporting (half year) period, but perhaps a true reflection of the impact of the euro (and e-commerce for that matter) is found by comparing the data to that at end-December 1998.

Perhaps unsurprisingly, given that so many legacy currencies had been replaced by one, foreign exchange outstandings fell sharply in the initial semi-annual reports. However, the recent trend has been higher and for the first time, in June 2002, the total outstanding balances in FX exceeded December 1998. The outstanding notional balance as at December 1998 in FX contracts was $18,011 billion (gross value $786 billion). This fell immediately to $14,899 ($582 billion) as at June 1999, but has recovered steadily since then, with every reporting period revealing an increase. At $18,075 billion outstanding, it is fair to say that the balances have somewhat limped past December 1998; however, the more than 21% increase from June 1999 represents a very healthy recovery in business.

Within these numbers, the balances of currency swaps have risen from $2,253 billion in December 1998 to $4,220 billion in June 2002. However both remaining categories have seen a decline: outright forwards and forex swaps from $12,063 billion to $10,427 billion, and options from $3,695 billion to $3,427 billion. Of these numbers, all segments have seen an increase from June 1999.

Given that the June 2002 data is the first “clean” set since the removal of legacy currencies from circulation in favour of the euro, the latest BIS data represents probably the most accurate set of data available to the market since the euro age commenced. The data also reflects the change in demographics in the banking industry towards client solutions from proprietary operations. Traditional volumes dipped in the latest BIS survey of turnover (Profit & Loss, November/December 2001), reflecting this shift; however, the semi-annual surveys are now suggesting that the use of derivatives is at least back to pre-euro levels.

By far the most dramatic increase in outstanding balances (and as noted the area that has driven the extraordinary growth in derivatives trading) is in interest rate products. At the end of December 1998, interest rate product balances outstanding stood at “just” $50,015 billion. In the latest survey, this had risen by 80% to $89,995 billion.

The increase was driven by interest rate swaps (IRS) trading. In December 1998, notional balances stood at $36,262 billion, which nearly doubled to $68,274 billion in June 2002. Similarly, FRA balances rose from $5,756 billion to $9,146 billion and interest rate options from $7,997 billion to $12,575 billion. In gross market value terms, IRS balances rose from $1,509 billion to $2,214 billion, FRA balances from $15 billion to $19 billion, those in options from $152 billion to $235 billion.

In the same period, outstanding balances with non-regular reporting institutions rose from $10,388 billion in December 1998, to $16,503 billion in June 2002. Commodity derivatives rose from $415 billion notional to $777 billion and equity-linked contracts from $1,488 billion to $2,214 billion.


Given that FX balances are barely changed from the start of the euro era, the latest data also provides an interesting snapshot of how the balance of trading has changed vis-a-vis client segments.

Outstanding balances as of June 2002 with reporting dealers stood at $6,595 billion in notional terms, those with other financial institutions at $7,210 billion and with non-financial customers at $4,270 billion. This compares to the December 1998 numbers which saw other reporting dealers at $7,284 (a fall of 9.5% from 1998 to 2002), other financial institutions at $7,440 (-3%) and non-financial institutions at $3,288 (+30%). This provides evidence of the increased sophistication of corporate treasuries through the use of derivative contracts for hedging purposes. The role of FX derivatives in structured deals for corporates is also probably reflected here. As far as other financial institutions are concerned, the data reflects the steady usage of derivatives in this segment over the past few years wherein increased interest has been in cash FX rather than more sophisticated products.

In terms of the (residual) maturities of the FX contracts outstanding, the shift in maturities has been towards the longer end of the market. Outstanding balances up to one year fell from $15,791 billion as at December 1998 to $14,403 billion in June 2002. This shortfall was compensated by a rise in the one-to-five year maturities from $1,624 billion to $2,541 billion, as well as in over five-year maturities from $592 billion to $1,131 billion.

The breakdown in currency terms also reflects the shift in the market’s actions since the euro’s launch. Outstanding euro balances are actually little changed in June 2002 ($7,298 billion) from December 1998’s $7,658 billion (this number is converted from legacy currencies at their conversion rates as at end-December 1998), but the balances are well up on the $4,998 billion registered in June 1999.

This recovery in euro volumes almost back to pre-euro levels is reflected by the stability elsewhere in the report. US dollar balances stood at $15,979 billion at June 2002, up from $15,810 billion at December 1998, while Japanese yen balances fell from $5,319 billion to $4,461 billion in June 2002. Elsewhere, sterling outstandings fell slightly from $2,612 billion to $2,512 billion, Swiss franc balances from $937 billion to $861 billion, while Canadian dollar balances rose from $594 billion to $746 billion, as did Swedish krona balances, from $419 billion to $766 billion. Both Canada and Sweden have seen a loosening of investment rules for domestic pension funds within this period, which has led to greater offshore investments and the need perhaps to hedge increased levels of currency risk. Other currencies saw outstandings rise from $2,674 billion to $3,517 billion.

The Growth Area

The interest rate derivatives data does not provide the opportunity to compare periods as easily as the FX space, primarily because volumes are so much higher in general. In terms of counterparties, all segments have of course risen strongly. With other reporting dealers, balances are up more than 77% from December 1998’s $24,442 billion to $43,300 billion in June 2002. Balances with other financial institutions rose 83% from $19,790 billion to $36,310 billion, that with non-financial institutions by a fraction less than 80% to $10,385 billion.

Just as growth has been spread across counterparty segments, so it has in terms of residual maturities. Up to one year has risen by 85% to $33,688 billion outstanding; from one-to-five years by 61% to $34,458 billion; while in the over five years, outstanding balances have more than doubled from $10,420 billion in December 1998 to $21,849 billion in June 2002.

Every currency contributed to the growth, but the surge has been dominated by the US dollar and the euro. Dollar volume has multiplied more than two and a half times from $13,763 billion to $32,178 billion. During this period, dollar volumes have overtaken the euro, in spite of the latter’s strong gains. The BIS suggests that the rapid pace of growth in the dollar swaps market is due to a shift in hedging and trading practices in the market since the Russian debt default of 1998 which highlighted the risks inherent in the use of government bonds as hedging instruments for non-government securities. This led to market participants switching to US dollar denominated IRS’s, a move that has been reinforced by a reduction in liquidity of US government debt following the government’s net debt repayments.

The more volatile US rate environment of the past few years is also seen responsible for an increase in hedging as is the increased use of swaps and swaptions in hedging mortgage prepayment risk by originators.

The surge in euro-denominated balances, by 86% to $30,671 billion, was chiefly fuelled by market practitioners switching to euro-denominated IRS’s as Eurozone governments continued to issue debt in legacy currencies until late 2001. The more recent increases in euro-denominated balances (from $27,422 billion as at end-December 2001) were chiefly the result of a 13% increase in the euro/dollar exchange rate in the corresponding period.

The same can be said for the Japanese yen IRS market, which saw a rise from $11,799 billion as at December 2001 to $13,473 billion in June 2002, but this was a result of a 10% climb in the exchange rate. Since December 1998 yen volumes have risen from $9,763 billion to $13,473 billion. Perhaps the significant indicator in terms of the yen figures is that after a year of depressed numbers (a low of $11,278 billion) due to the lack of activity in Japanese monetary policy, volume appears to have picked up and balances are back above the recent peak of $13,107 billion set at end-December 2000.

Sterling balances also rose in the period since the euro came into being, from $3,911 outstanding to $6,978 billion as at June 2002. In the past, the BIS has suggested the rise in sterling balances was due to risk diversification since the euro’s inception.

Elsewhere things remain steady. Swiss franc balances rose slightly from $1,330 billion to $1,591 billion, Canadian dollar balances from $747 billion to $859 billion and Swedish krona from $939 billion to $1,070 billion. Other currencies were also relatively unchanged, rising from $3,113 billion in December 1998, to $3,175 billion in June 2002.

Overall, the latest set of data provides backing to those that believe there are still many opportunities in the markets, and also supports the moves by many institutions to upgrade their skills in the derivatives markets as they become more client facing. Clearly from this data, clients are using the derivatives markets more and more, which provides an opportunity for many banks in the market, not just the top tier.

Given that this is the first set of data since the legacy currencies disappeared off the market scope, it is probably significant that levels have reverted to early 1999 levels. The latter period was probably more volatile than the past six months to a year; therefore there are grounds for optimism. The next semi-annual report, it is to be hoped, will reinforce the evidence of a recovery in the market. Looking further ahead than that, there will be much interest in the next triennial FX turnover survey, which takes place in April 2004. That, hopefully, will provide further evidence that rather than being on its last legs, the FX and OTC markets in general are healthy.

Profit & Loss

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