Central Clearing of OTC Derivatives in Australia – June 2011 3. OTC Derivatives Markets in Australia

3.1. Introduction

In order to consider what opportunities for central clearing might exist in Australian OTC derivatives markets, this section sets out some details of the types of products transacted, and the various participants. As with many countries, the Australian OTC derivatives market has grown rapidly in recent decades, reflecting a number of factors. Negotiated tailored contract terms in OTC markets are often more attractive to many market participants than the standardised contracts traded on traditional exchanges. With less prescriptive regulation of financial intermediaries, more of these trading opportunities have been exploited, which in turn has been supported by improvements in participants' operational and risk management capacities.

Various components of the domestic OTC derivatives market have therefore come to play a significant role in the domestic financial system, even though the absolute scale of the local market is small by global standards. Utilisation of derivatives is widespread among the banking sector, as well as among smaller financial and nonfinancial users. The functioning of these markets is supported by the cross-border activity of many participants, with global dealers playing an important role. However, as with many smaller markets, the activity of global dealers is complemented to a significant extent by locally based market participants.

3.2. Australian Market Structure and Characteristics

Derivatives are used quite extensively by many sectors of the Australian economy. As at December 2010, the estimated market value of cross-sectoral bought (or sold) positions across all derivatives classes (both exchange traded and OTC) was around $350 billion (Table 3).^[39] The largest component of this was positions bought and sold between domestic financial institutions and offshore counterparties (largely financial institutions). However, the public sector and the non-financial corporate sector are also significant users, each with around $30 billion of bought and sold positions outstanding as at December 2010.

Although the net value of bought and sold positions for each sector was fairly balanced as at December 2010, changes in underlying financial prices can result in large movements in positions. For instance, exchange rate fluctuations over the past few years have seen large swings in domestic sectors' net derivatives positions vis-à-vis offshore counterparties (Graph 2). Movements in domestic and international interest rates have also contributed to swings between the domestic banking sector and other counterparties. To the extent that these various bilateral positions are covered by CSAs, the movements in mark-to-market valuations can result in significant transfers of collateral within and between sectors.

These net market valuations of positions are significantly smaller than gross positions on large counterparties' books. Because redundant OTC derivatives positions are not generally closed out (unlike exchange-traded derivatives), turnover volumes result in a significant build-up of gross outstanding positions for dealers. As at December 2010, the gross notional amount of derivatives outstanding on Australian banks' books (off balance sheet) was around $15 trillion dollars, a much larger figure than the estimated market value of these positions (Graph 3). The bulk of this build-up is due to interest rate derivatives, reflecting both the longer maturity of many interest rate derivatives contracts, and the heavy utilisation of these as hedging instruments by banks and their counterparties. FX derivatives comprise a smaller, though still significant, share. The relatively slower build-up in these positions over time largely reflects the much shorter duration of many FX instruments (in general, these may last only a few days or weeks, compared with many months and years for interest rate derivatives). The interdependencies of counterparties and operational complexities resulting from the build-up of these positions are prime reasons why some central clearing of these positions is desirable (though separate portfolio compression facilities can also play a useful role in reducing some of the complexities of gross outstanding positions).

Data from AFMA indicate that over the year to end June 2010, daily average turnover in Australia of OTC FX derivatives was a little above $100 billion, while OTC interest rate derivatives turnover was around $30 billion (Graph 4).^[40] Turnover in other derivatives products was much lower; the next most active market was credit derivatives, with daily average turnover of around $650 million over this period.

A large part of the turnover in FX and interest rate derivatives markets is inter-bank activity, with these institutions hedging positions built up through market-making activity, or for proprietary purposes. According to data from the Bank for International Settlements (BIS), around 70 per cent of total turnover reported by Australian-located counterparties is undertaken with another bank, either domestically or offshore (Graph 5).^[41]

Within this inter-bank activity, a smaller number of institutions play a dealing or market-making role for the local market. For the domestic OTC interest rate derivatives market, around $12 billion, or 40 per cent, of average daily turnover is between local dealers (Graph 6). (Equivalent data is not available for the FX derivatives market.) A slightly smaller share of interest rate derivatives turnover consists of transactions between a dealer and another local bank (either Australian-incorporated banks or local branches of foreign banks). Smaller amounts of turnover are seen for end-users such as fund managers and government users. Other counterparties include domestic corporate treasuries, as well as offshore non-financial and financial counterparties (a further breakdown of these categories is not available). Within each class of interest rate derivatives, shorter term instruments (such as overnight indexed swaps and forward rate agreements) are less used by non-financial counterparties, with these instruments mainly used by banks to hedge short-run funding requirements. Longer-term instruments, such as single- and cross-currency interest rate swaps, are also heavily used by banks to manage interest rate risk on their balance sheets. Non-financial counterparties use them for a similar purpose, though turnover is more sporadic.

As would be expected, domestic market activity in OTC derivatives is highly concentrated in products with an Australian dollar-denominated component (Graph 7). This reflects the underlying demand of local participants using these instruments to hedge their domestic and cross-border borrowing, lending and payment flows. Unsurprisingly, counterparties located in Australia account for the bulk of global turnover for Australian dollar-denominated interest rate derivatives, given much of the underlying global demand for hedging Australian dollar borrowing and lending arises within Australia (Graph 8). Around 90 per cent of Australian dollar-denominated transactions (by notional principal value) involve at least one counterparty that is located in Australia. In contrast, partial data on FX derivatives with an Australian dollar component indicate that only around 35 per cent of global turnover in these instruments involves counterparties located in Australia (a detailed geographical breakdown of these instruments is not available). The less dominant role of domestically located counterparties reflects the fact that the Australian dollar is one of the most actively traded currencies around the world.

The local dealer community consists of a range of foreign banks along with the larger Australian-owned banks (Table 4). While some domestic and foreign dealers are market-makers in many classes of OTC derivatives, others take a more specialist role. Overall market turnover activity is quite highly concentrated, with the top eight dealers in each market segment generally accounting for 90 per cent or more of total turnover.

The presence of foreign-owned dealers in Australia, along with the offshore operations of Australian banks, facilitates trading across a larger range of counterparties than is available within Australia alone, thereby increasing liquidity and facilitating the transfer of risk for domestic market participants. As well as a considerable amount of cross-border activity, the distinction between domestic and offshore activity is further blurred by the common practice of foreign banks booking activity undertaken through an Australian branch or subsidiary in the name of an offshore legal entity (such as a global headquarters). In this way, an internationally active bank can consolidate large parts of its global derivatives activity in a single entity, which can result in capital, liquidity or taxation efficiencies.

3.3. Comparison of the Australian and Global OTC Derivatives Markets

Notwithstanding the significant scale of market activity in Australia, by global standards the domestic OTC derivatives market is relatively small. According to data from the BIS, the aggregate gross notional value of all OTC derivatives products was around US$600 trillion as at December 2010 (Graph 9). Global gross notional outstandings doubled in the five years to December 2010, though have fallen 10 per cent from their peak in June 2008. The difference between gross notional amounts and gross mark-to-market exposures is as significant in the global market as it is in Australia, with the market value of global positions as at December 2010 estimated to be only around 5 per cent of notional outstanding amounts. As with Australia, global activity is dominated by interest rate and FX derivatives, though credit derivatives have grown strongly over the past decade.

The vast bulk of instruments are denominated in only a handful of currencies. Across interest rate derivatives, for example, the outstanding value of euro-denominated contracts was around US$180 trillion and US dollar-denominated contracts around US$150 trillion as at December 2010. These two markets jointly account for over 70 per cent of the global aggregate notional amount outstanding (Graph 10). A further 20 per cent of the global market is attributable to yen- and sterling-denominated contracts. Outstanding amounts of interest rate derivatives in other currency denominations (of which available data suggest there are active markets for 50 or more) make up less than 10 per cent of the total. Similarly for FX derivatives, the vast bulk of activity is accounted for by transactions with a US dollar, euro, yen or sterling leg. Australian dollar-denominated interest rate and foreign exchange derivatives comprised only 1 per cent of outstandings.

Counterparties trading in these instruments are concentrated in a small number of jurisdictions. The United Kingdom is by far the largest financial centre, followed by the United States (Graph 11). Australia is one of the ten or so largest financial centres for these instruments, but like other European and Asian financial centres, the level of local activity is significantly smaller than that seen in the largest global centres.

Activity in global derivatives markets is dominated by a relatively small group of large dealers. Data from TriOptima's trade repository for interest rate derivatives gives a detailed picture of the role of this group – similar data is not currently available for FX derivatives. According to these data, the largest fourteen global (G14) dealers had around US$550 trillion of notional outstanding interest rate derivatives as at May 2011.^[42],^[43] Around 70 per cent of this can be considered inter-dealer activity: 20 per cent of transactions by value were with other G14 counterparties, and around 50 per cent of transactions were inter-dealer transactions centrally cleared using CCPs operating in offshore markets. Only around 30 per cent of transactions were with other counterparties, such as non-G14 dealers and banks, and buy-side financial and non-financial market participants.

However, this aggregate picture masks significant variation in the dominance of the largest dealers across different currency denominations. The G14 dealers are clearly dominant within the US dollar-denominated interest rate derivatives market. The bulk of these transactions are intra-G14 – either bilateral positions with other G14 counterparties or centrally cleared – while transactions with non-G14 dealer counterparties make up only 25 per cent of outstandings (Graph 12). Similarly, for the sterling, euro, yen and Swiss franc, transactions with non-G14 counterparties make up only 30 to 40 per cent of the relevant totals.

But moving beyond this handful of largest markets, the importance of smaller counterparties to the G14 dealers increases substantially, with a notable increase in the share of transactions undertaken with non-G14 counterparties. For Australian dollar-denominated products, for instance, around 55 per cent of G14 dealers' transactions involve counterparties outside this group of global dealers. This pattern is similar for most smaller markets; for particularly small markets, the share of non-G14 counterparties increases to 70 per cent or more. The greater share of transactions undertaken outside the G14 dealers reflects the significant role of non-G14 banks and dealers in these markets. Furthermore, the true significance of non-G14 counterparties in many of these markets is almost certainly understated by these data.^[44]

Overall, these figures clearly indicate that, outside the small number of very large markets, global dealers have a much less dominant role. Their presence is an important one, though, and the global nature of their activity is a key factor in the interconnectedness of global markets. However, the significant degree of variation in the scope and scale of dealers active in OTC derivatives markets, and the extent of cross-border activity around the world, pose a challenge for developing suitable central clearing solutions across jurisdictions, Australia included.

Footnotes

The market value of every derivative position is a positive for one counterparty and a negative for another. In aggregate, therefore, the net value of all bought and sold derivatives outstanding is zero. [39]

Note that these turnover figures measure the notional principal of contracts. Because of the derivative nature of these transactions, the full principal is generally not exchanged at the time the transaction is initiated, nor might it ever be exchanged over the lifetime of the contract. This is unlike transactions in securities such as equities or bonds, where the full amount of consideration is exchanged at the time the transaction is settled. [40]

Note that data sourced from AFMA and BIS are not strictly comparable, in part due to differences in the data collection basis, and different categorisations of the Australian operations of foreign banks. [41]

Note that BIS data and TriOptima data are not strictly comparable, with some differences in product coverage and methodology. [42]

The G14 dealers are: Bank of America–Merrill Lynch; Barclays Capital; BNP Paribas; Citi; Credit Suisse; Deutsche Bank AG; Goldman Sachs & Co; HSBC Group; J.P. Morgan; Morgan Stanley; The Royal Bank of Scotland Group; Société Générale; UBS AG; Wells Fargo Bank, N.A. [43]

The TriOptima trade repository is not yet receiving much in the way of direct reporting by non-G14 market participants, meaning that the figures do not reflect non-G14 dealers’ transactions with other non-G14 counterparties. Data from TriOptima do not permit a breakdown of the categories within non-G14 counterparties. [43]