Over the counter swaps remain critical for non-financial end users, and while the derivatives industry has made significant progress moving toward central clearing and trading on electronic platforms, a significant portion of the interest-rate derivatives market remains unclearable.
So say two research papers published last week by International Swaps and Derivatives Association (ISDA). And while market participants see moving swap trading to electronic exchanges as improving transparency, an ISDA note also published last week finds that trading on swap execution facilities (SEFs) is fragmenting the market.
In “The Value of OTC Derivatives: Case Study Analyses of Hedges by Publicly Traded Nonfinancial Firms” the two academics examine four real-world examples of OTC derivatives used by nonfinancial corporates and replicate those OTC hedges with exchange-traded derivatives. The authors, Ivilina Popova, an associate professor at Texas State University, and Dr. Betty J. Simkins, a professor at Oklahoma State University, found that exchange-traded derivatives suitable for replacing OTC hedges sometimes don’t exist.
In addition, the professors found that OTC hedges can be more efficient, and can reduce earnings volatility, compared to exchange-traded alternatives, whose marked-to-market and potential margin requirements can impact the liquidity of non-financial firms and increase operations costs. In addition, exchange-traded derivatives can lead to greater hedging ineffectiveness and might not qualify for hedge accounting, which can increase income-statement volatility.
“Academic research shows that derivatives also help lower the cost of capital of non-financial firms, both debt and equity, and this in turn increases the enterprise value,” the paper states. “Overall, the success of non-financial firms in managing risks benefits the macro economy and can help reduce systemic risk.”
A second study conducted by ISDA, “Size and Uses of the Non-Cleared Derivatives Market,” found that despite 65 percent of notional outstanding interest-rate derivatives (IRD) was cleared by the end of 2013, a significant portion of the IRD market remains uncleareable. That includes $30 trillion in swaptions, $30 trillion in cross-currency swaps, $12 trillion in options, and $3 trillion in inflation swaps.
Nevertheless, the study says, non-clearable derivatives have an important “social value” for corporates, pension funds, insurance companies and retail banks.
“Without non-clearable derivatives, users of these products may experience greater earnings volatility due to an inability to qualify for hedge accounting, or be unable to offset the interest rate, inflation and longevity risks posed by long-dated pension or insurance liabilities,” the study says.
OTC swaps may be moving steadily toward electronic trading over SEFs, but the market appears to be fragmenting, potentially raising logistical hurdles for multinational corporates seeking to mitigate interest-rate risk across international markets.
ISDA’s end user survey published last week found that nearly half of respondents agree that market fragmentation is occurring along geographic lines, and 61 percent of those respondents believe fragmentation could negatively impact their risk management. In terms of fragmentation, the trade association’s note says that made-available-to-trade (MAT) regulation, which clarifies by law the products that must be traded on SEFs, appears to be fragmenting the IRD market.
The research found that MAT swap volume made up 70 percent of SEF trading in interest-rate derivatives in the week ending March 28, during which MAT swaps denominated in US dollars comprised 91 percent of total MAT trading, while those in Euros (EUR) made up only 6 percent and in pound sterling (GBP) only 3 percent.
“Following the February 15, 2014 implementation date for the first MAT determinations, SEFs likely became more US-centric, with USD MAT volume increasing and EUR MAT volume declining sharply,” the note says.
Before and after the rule came into effect, the average daily notional volume of EUR MAT swaps declined by 30 percent, while the average daily trade count fell by 11 percent.
“The MAT rule appears to have created smaller, less liquid pools for EUR and GBP swaps on SEFs relative to USD swaps and has reduced the dispersion of daily trade size for all MAT swaps,” the note says.