Survey of the OTC Derivatives Market in Australia – May 2009 2. Background

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2.1 The OTC derivatives market

OTC markets emerged in the 1980s as a result of changes in financial regulation, advances in technology and the increased sophistication of risk-management practices. Relative to the standardised contracts and securities traded on traditional exchanges, products traded on OTC markets offer market participants a greater degree of flexibility. In particular, OTC contracts are negotiated bilaterally between the buyer and the seller, and typically incorporate bespoke terms to allow the contracting parties either to hedge specific risks or generate tailored exposures. OTC markets have also traditionally been subject to less direct regulation than exchange-based markets.

OTC markets facilitate trading in both ‘physical’ securities (such as government or corporate debt securities) and ‘derivative’ instruments (such as swaps and options). OTC derivatives markets, the focus of this Survey, have exhibited considerable innovation and are now available across all of the major underlying asset classes.

The BIS estimates that the total gross notional value of OTC derivatives outstanding globally almost doubled to USD 592 trillion in the three years to December 2008, although gross mark-to-market exposures are only around six per cent of this figure.[1] Australian dollar-denominated interest rate and foreign exchange derivatives (not all of which are actually traded in Australia) make up less than one per cent of the global total for these products, although trends in the Australian market are broadly consistent with overseas developments (Table 1).

More recently, there has been a decline in activity across products, with some counterparty types reportedly scaling back their activities significantly in response to turbulence in the financial markets.

The significant growth in the OTC derivatives market, both in Australia and internationally, reflects its perceived value to both hedgers and speculators. While activity in Australia is largely concentrated in interest rate and foreign exchange derivatives, turnover in credit derivatives has grown more quickly in recent years, almost doubling in the year to June 2008 (Graph 1).[2] Overall, annual growth in turnover across products in Australia's OTC derivatives market averaged more than 11 per cent over the four years to June 2008.

Since OTC derivatives markets offer sophisticated products, ‘sell-side’ participants are generally large banks (or their broking subsidiaries). There is a wide variety of ‘buy-side’ counterparty types, the most active groups being other financial institutions, governments, and large corporates.

A number of regulatory initiatives have been launched in recent years to improve the functioning of the OTC derivatives market. These include efforts overseen by the Federal Reserve Bank of New York to strengthen the operational infrastructure and, in particular, the establishment of an Operations Management Group to co-ordinate industry progress towards delivering efficiencies in this area.

More recently, with the aim of restoring confidence in OTC derivatives markets following recent market turbulence, a task force of the International Organisation of Securities Commissions (IOSCO) has developed a range of interim recommendations for the securitisation and credit default swap markets in the areas of transparency, disclosure and investor suitability. ASIC is co-chair of this task force along with the French securities regulator.[3]

2.2 The life cycle of an OTC derivatives contract

Securities and derivatives traded on exchange markets are subject to routine electronic trading,clearing and settlement. Trade and post-trade processes in the OTC markets, on the other hand, vary considerably by participant and product. Although electronic infrastructure is increasingly used to trade and confirm OTC derivatives transactions and to minimise the unique risks that arise during their life cycle, the penetration of such infrastructure differs widely across products. The key stages of a stylised trade life cycle are presented in Figure 1 and elaborated below:

  • Trade execution occurs in the OTC derivatives market when two counterparties agree to the terms and conditions of a particular contract, either directly or through their appointed brokers. Trades will typically be executed with reference to counterparty exposure limits. General terms and conditions – for example, relating to netting and collateral requirements – will also typically have been agreed between the counterparties in an overarching ‘Master Agreement.’
  • At the trade capture stage, trade details are passed into the counterparties’ internal systems in preparation for subsequent confirmation. If trade details are misunderstood or are input incorrectly, delays can arise that may compromise risk management or prejudice the enforceability of the agreed contract. These risks are heightened in manual, paper based processes.
  • OTC trades must be ‘matched’ or ‘affirmed’ prior to their confirmation. This is the confirmations processing stage of the life cycle. Traditionally, one counterparty sends the trade details to the other counterparty for final agreement (affirmation), or each party sends the other its own understanding of the trade details for review (matching). More recently, electronic facilities have emerged to facilitate more rapid straight-through processing of confirmations and to reduce the potential for human error associated with manual processes. Where a lag remains between trade capture and confirmation, risks may be mitigated by introducing an additional step in the process: ‘economic affirmation’, ie, affirmation of only the key economic terms of the contract.
  • Trade confirmation occurs when both counterparties have agreed the details of the executed trade. In some cases, details of confirmed trades may be held in a data warehouse, eg, the warehouse for credit derivatives operated by the Depository Trust and Clearing Corporation (DTCC) in the United States.
  • Where such facilities exist, a confirmed OTC derivatives trade may be submitted to a central counterparty for clearing. Under such an arrangement, the trade is novated to the central counterparty, which interposes itself between the buyer and the seller of the contract. A central counterparty typically manages its exposure to participants using a suite of tools, including: strict participation requirements; standardised margining arrangements; and the maintenance of a pooled guarantee fund. There is currently considerable international regulatory interest in expanding the scope of central counterparty clearing in the OTC derivatives market.[4]
  • Where bilateral counterparty exposures are retained, counterparty credit risk is typically managed over the life of the contract via the collateralisation of exposures. Collateral is exchanged daily to reflect mark-to-market changes in the value of outstanding exposures (subject to terms negotiated between the counterparties). Such collateral management requires the capability to: value positions accurately; call for/deliver collateral associated with any mark-to-market change in the value of positions; and manage any cash or securities collateral received. This is often facilitated by recourse to a third-party collateral management system.
  • In contrast with cash-market securities, for which there is typically a single cash settlement simultaneous with the transfer of the traded security, cash flows associated with OTC derivatives contracts often arise periodically over their life. Settlement of these cash flows generally takes place over the high-value interbank payment systems of central banks or via international settlement facilities such as CLS (Continuous Linked Settlement) Bank. Prior to settlement, counterparties may elect to net cash flows, in some cases using third-party systems to facilitate this.
  • Throughout the long life of many OTC trades, counterparties may initiate routine or ad hoc portfolio reconciliations to validate their exposures to each other. These might be prompted by disagreements over collateral obligations or contract valuations, or to facilitate an analysis of total economic exposures across counterparties.
  • The complexity of OTC derivatives and market participants’ overall trading activities mean economically redundant trades can accrue over time; these contracts continue to contribute to operational and counterparty risks. Portfolio compression, also known as a ‘tear-up’, terminates such contracts.[5]

2.3 Scope and coverage of the Survey

The aim of the Survey was to complement the volume and exposure data captured by AFMA and the BIS, respectively. In particular, the Survey sought information in three main areas:

  • Institutional information: details of group entities active in OTC derivatives markets; regulatory status; and membership of associations.
  • Risk and infrastructure: approvals processes; counterparty risk management; use of trade and post-trade infrastructure; and expectations for the evolution of the infrastructure landscape.
  • Product information: scale of activity; counterparty types; market conditions; and trade execution.

The Survey was initially circulated to 21 ‘sell-side’ (ie, dealer) market participants in late December 2008, for completion on a voluntary basis. Since these participants ultimately see all of the flow in the market and concentrate much of the risk, it was considered that this group would be able to offer a broad, market-wide perspective. In March 2009, a similar survey was circulated to a sample of 33 primarily ‘buy-side’ market participants, spanning investment managers, superannuation funds and corporate treasurers. The objective was to complement the observations made by sell-side participants and identify any specific issues and challenges facing the buy side.

Responses to the initial circulation were received from 18 sell-side entities and were followed up by a number of face-to-face meetings. Ten responses were received to the later circulation.[6]

The Survey covered the full range of OTC derivative products, including:

  • Interest rate and cross currency swaps (IR/CCSs): these include floating to fixed and fixed to floating rate AUD swaps, and AUD to non-AUD fixed and floating rate swaps;
  • Overnight index swaps (OISs) and forward rate agreements (FRAs);
  • Other interest rate derivatives: these include bond options, ‘swaptions’ (the right to enter into an interest rate swap), ‘cap’ and ‘floor’ interest rate derivatives, and any interest rate derivatives not separately specified;
  • Foreign exchange (FX) derivatives: these include all FX derivatives of any underlying currency, namely FX swaps, forward FX agreements and currency options;
  • Credit derivatives: these include single name credit default swaps (CDSs), total rate of return swaps, derivatives relating to credit indices comprising a portfolio of credit risks, and synthetic and cash correlation credit derivatives such as collateralised debt (or loan) obligations;
  • Equity derivatives: these include options, swaps, forward agreements on underlying equity securities or indices of equity securities, and contracts-for-difference (CFDs); and
  • Commodity, energy and electricity derivatives: these cover swaps, options, swaptions, collars and forward agreements on agricultural and resource commodities, greenhouse abatement certificates, carbon offset and reduction derivatives, and renewable energy certificates.

A number of industry associations assisted the financial authorities in compiling the Survey and identifying respondents. These included: AFMA; the Finance and Treasury Association (FTA); the Alternative Investment Managers Association (AIMA); and the Investment and Financial Services Association (IFSA).

Footnotes

See BIS semi-annual OTC statistics, December 2008: <http://www.bis.org/statistics/derstats.htm>. The BIS defines ‘gross notional value’ as the gross nominal value of all deals concluded and not yet settled on the reporting date. Gross mark-to-market exposures, or ‘gross market values’, are defined as the sum of the absolute values of all open contracts with either positive or negative replacement values calculated at market prices prevailing on the reporting date. [1]

See Australian Financial Markets Report, 2008: <http://www.afma.com.au/afmav6wr/_assets/main/lib90024/afmr08-final.pdf> [2]

See Unregulated Financial Markets and Products – Consultation Report, IOSCO, May 2009: <http://www.iosco.org/library/pubdocs/pdf/IOSCOPD290.pdf> [3]

See Financial Stability Review, March 2009, Reserve Bank of Australia, p. 69, for a discussion of developments in this area. [4]

Market participants engaging in portfolio compression first submit their portfolio details to a third-party agent. The third party then searches across all participants’ portfolios for multilateral opportunities to ‘tear up’ contracts, keeping overall market and counterparty credit exposures within stated tolerances, and ensuring that resultant cash flows do not exceed a given level. [5]

See Attachment for a list of institutions to which the Survey was circulated. [6]