The US Federal Reserve’s series of interest rate hikes, which started with a 0.25% increase in March 2022 and was followed by 10 additional increases to August 2023, has likely contributed to significant growth in interest rate derivatives (IRD) trading activity. This appears to have been driven by the need to manage risk, protect against adverse rate movements and optimize borrowing or investment strategies.
While total IRD trading activity has surged, the composition of over-the-counter (OTC) IRD products has undergone substantial structural changes, predominantly due to the industry-wide transition from LIBOR to risk-free rates (RFRs). Notably, the share of overnight index swaps (OIS) has expanded significantly, while trading in US dollar-denominated fixed-for-floating interest rate swaps (IRS) referencing US dollar LIBOR and forward rate agreements (FRAs) has dropped.
ISDA analysis of IRD trading activity shows:
Total IRD traded notional rose by 16.8% to $181.6 trillion in the first half of 2023 from $155.5 trillion in the first half of 2022. Trade count climbed by 18.2% to 1.4 million from 1.1 million over the same period.
The increase in IRD trading activity was driven by a rise in OIS trading. OIS traded notional increased by 59.1% in the first half of 2023 versus the first half of 2022, while fixed-for-floating IRS traded notional fell by 42.1%.
The significant growth in OIS transactions is linked to increased trading activity in the effective federal funds rate (EFFR) and RFRs. Market participants typically use the EFFR to express their views on the direction of monetary policy. OIS traded notional linked to the EFFR grew by 60.6% in the first half of 2023 compared to the first half of 2022. OIS traded notional referencing SOFR increased by 58.4% over the same period, while €STR- and SONIA-linked traded notional grew by 57.8% and 44.6%, respectively.
Publication of all euro, Japanese yen, sterling and Swiss franc LIBOR tenors and one-week and two-month US dollar LIBOR ceased on a representative basis at the end of 2021, and various regulators stated that firms should not enter new US dollar LIBOR contracts from the beginning of 2022, except in limited circumstances. As a result, use of fixed-for-floating swaps declined, with US dollar-denominated fixed-for-floating IRS virtually replaced by OIS referencing SOFR. The remaining US dollar LIBOR settings ceased publication on a representative basis on June 30, 2023.
The transition from LIBOR to RFRs reduced the need for market participants to use FRAs to hedge fixing risk, which led to a significant drop in FRA trading in 2022. There were no sterling-, Swiss franc- and yen-denominated FRA transactions in 2022 and the first half of 2023, while US-dollar denominated FRA traded notional declined significantly. Despite this, market participants continued to use euro-denominated FRAs to hedge EURIBOR.