An Outstanding Question

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

The semiannual over-the-counter (OTC) derivatives statistics published by the Bank for International Settlements (BIS) have long been closely scrutinised as a reliable barometer of the derivatives market. And the latest figures, released last month, have thrown up some headline numbers that have troubled some commentators.

The overall size of the OTC derivatives market climbed to $710 trillion in notional outstanding at the end of 2013, from $693 trillion six months earlier. This increase, coming on the back of a sharp rise in the first half of last year, has kindled warnings that regulators aren’t doing enough, or that they’ve taken their foot off the regulatory reform pedal.

Nothing could be further from the truth, and a closer analysis of the data explains why. First, though, let’s just recap on what notional outstanding actually represents. It simply measures the total face value of all trades that currently exist, regardless of whether certain trades can be offset or netted against each other. As such, it’s not an accurate reflection of the amount of risk being transferred, the payments that are exchanged between counterparties, or the maximum loss that would be incurred should every outstanding derivatives contract be closed out – a point regularly acknowledged by the BIS in its studies.

In contrast, gross credit exposure – which measures the gross market value of outstanding derivatives after legally enforceable netting is taken into account but not considering the impact of collateral – actually fell from $3.8 trillion in June 2013 to $3 trillion six months later. Including the collateral that counterparties have posted to each other would reduce that exposure even further.

But even recognising what notional outstanding represents, and the limitations of what it tells us about derivatives risk exposure, there are some technical issues that need to be kept in mind. Most significantly, the BIS figures count each cleared trade twice: one between counterparty A and the central counterparty; and one between counterparty B and the clearer. A single $10 million trade between two parties subsequently cleared therefore becomes $20 million in notional outstanding for the purposes of the BIS data.

To adjust for that, the outstanding notional volume of cleared trades (themselves adjusted for double counting) would need to be subtracted from total notional. Looking at interest rate derivatives alone, approximately $226 trillion in cleared notional at the end of 2013 would need to be subtracted from the $584 trillion in interest rate derivatives notional, leaving $358 trillion. That’s more or less unchanged from the adjusted interest rate derivatives figure six months earlier. In other words, new regulation, and in particular, the push for greater amounts of centrally cleared trades, is the driver behind much of the apparent increase in notionals.

Nonetheless, a lot of work is being done to reduce the size of these figures. Compression has already reduced the outstanding notional of cleared and uncleared derivatives by $453 trillion as of April 2014, according to figures from Stockholm-based TriOptima. Industry efforts are under way to build on that – in part to reduce the operational burden for dealers, but also encouraged by regulations like the leverage ratio under Basel III, which sets capital based on gross notional, rather than net risk, exposures.

Far from taking their foot off the pedal, then, regulators have introduced rules that are very much driving these numbers. With clearing leading to double counting of notional, and compression cutting back on gross exposures, it’s difficult to know which way the next BIS numbers will run. One thing’s for sure, though – the notional figures reported won’t be an accurate reflection of risk.





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