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OTC Derivatives Activity Rises Again

Activity in the OTC derivatives market, as measured by the Bank for International Settlements’ (BIS) semi-annual survey of outstandings continues to rise, however for the second successive survey period the pace of growth has slowed.

Overall notional amounts outstanding (excluding credit derivatives) rose to $284,819 billion as at end-December 2005, compared to $271,282 billion at end-June 2005 and $251,499 billion at the end of 2004. Gross market values, which measure the cost of replacing all contracts, declined to $9,139 billion from $10,417 billion at end-June 2005.

All published figures in the statistics are adjusted for double-counting resulting from positions between reporting institutions. Notional amounts outstanding were adjusted by halving positions in relation to other reporting dealers. Gross market values were adjusted by adding the total gross positive market value of contracts to the gross negative market value of contracts with non-reporting counterparties only.

Outstandings in the largest segment of the OTC derivatives market (interest rate contracts) rose to $215,237 billion from $204,795 billion six months previously. Within this, the numbers in all three categories (FRAs, interest rate swaps (IRS) and interest rate options rose) FRAs from $13,973 billion to $14,483 billion; IRSs from $163,749 billion to $172,869 billion; and options from $27,072 billion to $27,885 billion.

Regarding the pace of growth in the interest rate secto)r, which stood at 5% compared to double-digit growth during the first half of the decade, the BIS says it is too early to say whether it is a temporary blip or the start of a more permanent trend, perhaps reflecting the maturing of the market. ‘What is clear is that the rates of growth in the OTC market outstrip those recorded on organised derivatives exchanges,’ the BIS states.

Financial institutions dominate usage of interest rate products, with just $25,092 billion of the $215 billion outstandings being with non-financial customers. Conversely, in terms of currencies and tenors, the data is more evenly spread. Up to one year (residual maturity) recorded $69,091 billion, from one-to-five years $88,402 billion and over five years $57,744 billion.

In currency terms, the euro continues to be the most actively-traded currency, with $82,641 billion outstanding, followed closely by the US dollar with $75,354 billion outstanding. There is then a sizeable gap to outstandings in Japanese yen ($26,561 billion) and sterling ($15,248 billion).

Exchange traded interest rate contracts outstanding stood at $52,300 billion at the end of the year, a drop from end-June’s $53,794 billion, but well up on the previous year’s $42,769 billion.

FX Continues Steady Progress

Outstanding amounts in foreign exchange contracts also continued to rise, and again it was at a slower pace than previously. Total outstandings stood at $31,609 billion as at end-December 2005, up from $31,081 billion six months previous and $29,289 billion a year before.

The most dominant sector was outright forwards and forex swaps with $15,915 billion outstanding (up very slightly from $15,801 billion in June 2005), followed by currency swaps at $8,501 billion ($8,236 billion) and FX options at $7,193 billion ($7,045 billion). Exchange traded contracts outstanding stood at $172 billion, slightly up from June’s $170 billion.

Gross market values in FX contracts fell back from June’s $1,141 billion to $998 billion; this represents a continued decline from December 2004’s $1,546 billion outstanding.

Reporting Dealers ($12,092 billion, a slight decline from six months before) and Other Financial Institutions ($13,039 billion from $12,334 billion) made up the majority of FX activity, with Non-Financial customers accounting for $6,479 billion from $6,568 billion at end-June.

FX activity is heavily weighted at the shorter end, with $24,134 billion having less than a year to maturity, $5,180 billion from one-to-five years and $2,295 billion more than five years. Unlike the interest rate segment, the US dollar dominates activity, being responsible for $26,364 billion of outstandings, followed by the euro at $12,870 billion, the yen at $7,793 billion and sterling at $4,422 billion. The BIS does note, however, that the US dollar’s share of the market; at 83% – is its lowest since the BIS started collecting data in 1983.

As well as highlighting strong growth in outstandings in the yen (from $6,907 billion to $7,793 billion), the BIS also notes strong growth in the Australian (20%) and New Zealand dollars (60%). “This may be related to the strong issuance of eurokiwi and uridashi bonds,” the BIS suggests. “The New Zealand dollar has recently overtaken the Australian dollar as the leading currency in [the uridashi] market due to the high yields offered in that currency.”

Issuers of eurokiwis and uridashis tend to swap the proceeds into other currencies, and as such in this case are a natural counterparty for New Zealand banks issuing in foreign currency or for traders speculating on a decline in the NZ dollar (which was in fact very stable during the survey period). “Another factor behind the massive growth of the NZ dollar derivatives market could be the increased use of currency swaps for liquidity operations by the Reserve Bank of New Zealand, at least to the extent that these operations are with reporting dealers and not local or Australian institutions not included in the sample,” adds the BIS.

Credit Growth Also Slows

Notional amounts in credit default swaps (CDSs) also rose during the second half of 2005, also at a slower rate than previously. Total notional outstandings stood at $13,698 billion at end-December 2005, up from $10,211 trillion at end-June 2005 and $6,397 billion at the end of 2004, the first time the BIS collated CDS statistics. Gross market values rose from $264 billion to $346 billion. The total notional amount is calculated by adding together contracts bought and sold and deducting 50% of the total of contracts bought and sold between reporting dealers, who make up almost 65% of the market.

“The data do not confirm fears that the emergence of a liquid credit derivatives market has led to a large-scale transfer of risks from the banking to the insurance sector,” states the BIS. “Insurance corporations accounted for $180 billion (2%) of the protection bought, and purchased $60 billion (less than 1%) of the protection sold by the reporting dealers.

“While it is possible that these aggregates hide some sizeable individual exposures, they certainly do not support a picture in which insurance companies purchase CDSs to take on credit risk on a massive scale,” it adds. “That said, it must be pointed out that the BIS data do not contain information on instruments other than CDSs (including synthetic CDOs) that could be used to transfer credit risk across sectors.”

Single name instruments made up the majority of CDS outstandings at $10,217 billion, up from $7,311 billion at end-June and $5,116 billion at end-December 2004.

Elsewhere, activity increased in the other segments measured by the BIS. Equity-linked contracts outstanding rose from $4,551 billion at end-June 2005, to $5,057 billion; and commodity contracts outstanding rose from $2,940 billion to $3,608 billion. The two segments were the fastest growing in the second half of 2005.

Profit & Loss

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