The volume of interest rate derivatives (IRDs) entered into by corporates and other organizations exempted from clearing requirements jumped by nearly 50% between the middle and end of 2015, although it still represents a sliver of the overall derivatives market.
The International Swaps and Derivatives Association (ISDA) recently released a report showing that the volume of derivative trades exempt from clearing, increased to $13 trillion at the end of 2015, up from $9 trillion six months earlier, a 44% leap. Exempted derivatives are generally those sought by nonfinancial corporates and other derivative end users that use the financial instruments to hedge risk exposures. The increase, while significant, is unsurprising given recent interest-rate uncertainties, given countries worldwide adopting negative rates and the U.K.’s recent vote to leave the European Union.
The trade group notes that 67.5% of total IRD notional outstanding was cleared at the end of 2015. The remaining notional outstanding comprises the $13 trillion in exempted transactions as well as $52 trillion in derivative products that are not yet accepted for clearing over swap execution facilities, including swaptions, cross-currency swaps and options. The clearing rate for transactions that can be cleared is quite high, indicating the derivative reforms required by the Dodd-Frank Act are having the desired impact.
“ISDA therefore estimates that approximately 98% of the clearable IRD market is currently cleared,” the ISDA report says.
The data was generated by the Bank for International Settlements (BIS), which publishes derivatives notional outstanding data biannually. In terms of the overall market, the BIS reported an 11.7% decrease in IRD notional outstanding in the latter half of 2015, to $384 trillion from $434.7 trillion. ISDA argues, however, that those numbers are misleading, since the BIS overlooks factors that have recently come into play.
For one, derivative clearing requirements have only been in effect since 2013, and derivative trades cleared through a central counterparty (CCP) are counted twice by the BIS, which counts each counterparty’s bilateral trade with the CCP. That serves to significantly reduce the trade volume number. However, the BIS data does reflect trade compression activity, which has the opposite effect by netting redundant positions in a derivative portfolio and so reducing notional principal outstanding. The report notes compression has reduced IRD notional by 67% as a result of portfolio compression.
“After factoring out the effect of clearing and compression, gross notional volume increased by 2.5%, from $680.2 trillion to $697.5 trillion, over the same period,” the report says.
The increase arrives as the global derivative market is about to enter a period with fragmented margin requirements, since the U.S. will begin imposing margin on uncleared swaps at the start of September but Europe has postponed such requirements until next year. A fragmented derivative market will limit potential counterparties and potentially reduce derivative trading activity and/or make it more costly. Such fragmentation will likely impact margin-exempted corporates indirectly, since their financial-firm counterparties will find it more challenging to mitigate exposures through subsequent swaps with other financial counterparties.
Comparing derivative volume over a longer period, from December 2011 to December 2015, BIS reports IRD gross notional falling by 23.8%. Over the same period, and factoring in clearing and compression, ISDA says gross notional volume actually increased by 33%.