An ISDA Research Study issued on August 11th provides statistical support of our experience as practitioners – the buy-side matters when it comes to over-the-counter (OTC) derivatives.
In this Q&A-styled posting, we we will explore a few highlights of this Research Study, as we believe that it offers valuable insights into the trends in the OTC derivatives markets and the importance of those markets to the overall health of the U.S. economy from “Main Street to Wall Street”…and everywhere in between.
Who are End-Users (a/k/a, the Buy-side)?
In “Dispelling Myths: End-User Activity in OTC Derivatives,” the International Swaps and Derivatives Association (ISDA) analyzed publicly available data published by the Bank of International Settlements (“BIS”). In the first instance, the BIS data and ISDA’s Research Study offer a helpful paradigm for answering the question, “Who are End-Users (a/k/a the Buy-side)?”
BIS categorizes statistical information about the derivatives users into what ISDA describes as, “three generic buckets”:
1) Trades conducted between so-called “reporting dealers,” which consists of approximately 400 of the largest banks and securities houses from 47 countries*;
2) Trades between reporting dealers and other financial institutions; and
3) Transactions between reporting dealers and non-financial customers.
P. 3 of the Research Study and * at p.17.
In the Research Study, ISDA further observes that, “End users are defined as the ultimate consumers of a product, a definition that broadly applies to two of the three generic buckets listed by the BIS: other financial institutions and non-financial customers. Entities in both of these categories would employ derivatives for a variety of hedging and investment purposes, with the aim of managing risk and enhancing returns.”
Who are end-users in the “other finanical institutions” category?
The “other financial institutions” category of end-users consists of pension funds, mutual funds, hedge funds, insurance companies, central banks, money-market funds, bulding societies, leasing companies and commercial and investment banks that do not constitute a reporting dealer (for example, non-swap dealer banks in the United States that do not report certain derivatives data in reponse to BIS survey requests).
Who are end users in the “non-financial” category?
The “non-financial” category of end-users consists primarily of corporations and sovereigns (i.e., governments).
What share of OTC interest rate derivatives activity is attributable to these two categories of end-users?
Based upon the BIS data, the share of OTC interest rate derivatives activity non-financial counterparties and other financial institutions has “increased sharply over the past decoade or so, climbing from just 34.1% in 2001 to 65% in 2013.” P. 9 of the Research Study. It is worth noting that ISDA focused on what is referred to as the BIS turnover figure, “which represents the gross value of all new derivatives trades entered into during the observation period, and is measured in terms of the notional value of the contracts.” P. 7 of the Research Study. The turnover data was selected, instead of the BIS outstanding notional data, since the former does not double-count cleared OTC derivatives (i.e., the “back-to-back” trade that is used to move a a trade into the central clearing system) and, as such, offers a more accurate view of who is “using” the derivatives and .
Why is this 65% end-user statistic important?
The fact that 65% of derivatives trading activity involves non-financial customers and non-dealer, financial institutions is important, according to ISDA, because:
1) The buy-side firms use OTC interest rate derivatives for genuine economic purposes, such as reducing risks and greater certainty in their financial outlook. P. 7 of the Research Study;
2) Efficienlty functioning OTC derivatives markets allows end-users to carry on their activities with greater security; and
3) Disruptions in the availability of derivatives for buy-side use could have adverse consequences for the broader financial markets and society.
The following is our summary of a few of the Research Study’s examples of how buy-side participants use derivatives and what the potential adverse that could result from decreased availbility OTC derivatives.
Pension Plan – Uses derivatives to manage interest rate and inflation risks that it faces due to the plan’s long-term liabilities owed to pensioners.
If derivatives were to become less available, then payments to pensioners could be reduced, resulting in a reduction in spending power of retirees – or governments may need to use public assets to avoid such reductions.
Insurance Company – Uses derivatives to manage interest rate and inflation risks that it faces due to the company’s long-term liabilities under variable annuities or disability or life insurance policies.
If derivatives were to become less available, then payments to beneficiaries could be reduced, resulting in a reduction in spending power of retirees, in the case of variable annuity obligations, or entire households, in the case of benefits owed by the company uponh the disability or death of an insured.
Large Corporation – Uses derivatives to manage interest rate and currency risks faced by it due to the issuance of debt securities to investors in in a foreign market that makes it less expensive for the corporation to issue its debt and finance its existing business operations.
If derivatives were to become less available, then it would be more expensive for the corporation to finance its existing business operations. As a result, there would be less money dedicated to new business and growth of the corporation’s business activities.
Regional or Community Bank – Uses derivatives to manage interest rate risks faced by it due to offering of fixed-rate loans, including residential mortgages that allow homeowners to prepay the mortgages prior to the scheduled maturity date.
If derivatives were to become less available, then there may be a reduction in the availability of residential mortgages. Also, prepayment options in mortgages may be restricted or eliminated.
Investment Manager– Uses derivatives to rebalance the risk of a mutual fund’s investment portfolio without incurring transactional costs that would otherwise be incurred if the manager had to sell some securities and then purchase different securities to achieve the same goal.
If derivatives were to become less available, then the shareholders of the mutual fund would be adversely affected by the increased transactional costs incurred by the fund.
In other words, with each example in the Research Study, ISDA is trying to make the point that derivatives activity is socially and economically useful.
What about the other 35% of the market? How does it relate to the buy-side?
The remaining 35% of the derivatives market represents what is called “interdealer activity,” or trades between the large reporting dealers or the largest banks and securities brokerage firms. ISDA posits that much of the inter-dealer activity is likely to relate to facilitating the use of derivatives by end-users, since many of the large U.S. financial institutions have stopped trading derivatives in order to generate profits for themselves (so-called, proprietary trading, which is banned under the Volcker Rule). As explained in the Research Study, the inter-dealer trades are, “critical for market liquidity and the facility of client trades. Without this, end users would not be able to put on risk-reducing and cost-effective hedges – potentially leading to less hedging and more balance sheet volatility.” P. 20 of the Research Study.
So, what does it all mean in about 20 words?
The buy-side matters when it comes to OTC derivatives – and derivatives matter from Wall Street to Main Street…and everywhere in between.
Good day. Good risk management matters.