Survey of the OTC Derivatives Market in Australia – May 2009 3. Products and Participants in the Australian OTC Derivatives Market

The Survey first sought a broad overview of the OTC derivatives market landscape in Australia. The questions in this area were designed to yield complementary data to those published annually by AFMA, which concentrate largely on turnover across products. In particular, questions were asked around:

• trading activity and market presence;
• counterparty types;
• market conditions; and
• trade execution.

This section describes the responses to questions in this area, drawing out a number of key messages. The discussion reveals that the greatest depth is in interest rate and foreign exchange derivatives, with domestic banks highly active as sell-side participants in these market segments. Overall, domestic banks tend to trade in a wider range of products than the Australian-based branches and subsidiaries of overseas banks.^[1] Across respondents, and across products, trading activity seems to be relatively highly concentrated among a few large, often financial, counterparties. A significant proportion of trade is conducted with overseas counterparties.

Follow-up meetings with several respondents cast additional light on the implications of recent financial market turbulence for OTC derivatives market activity. In particular, there has been a shift away from structured to more vanilla products, as well as a shift in buy-side business in favour of the domestic banks as the credit ratings of some overseas market participants have declined. Liquidity conditions have also deteriorated considerably in recent months, with a reduction in the standard transaction size and a larger price impact from a trade of any given size.

3.1 Trading activity and market presence

Just two of the sell-side participants surveyed are active across all products, both of them large domestic banks. A further three banks, two of them domestic, are active across all products with the exception of electricity and energy/carbon. The Australian-based branches and subsidiaries of overseas banks tend to be more specialised (Table 2). The deepest and most strongly contested market segments are those for interest rate and foreign exchange products, with activity spread widely across both domestic and overseas banks. With the exception of the non-bank providers of CFDs, all surveyed sell-side participants are active in IR/CCSs, many of these executing in excess of 500 trades per month. Activity in OTC equity derivatives is also highly dispersed across domestic and overseas banks, with the larger providers of CFDs also reporting a high volume of trade.

Trade in the other products is typically more concentrated. For instance, sell-side activity in credit derivatives is largely concentrated among five overseas banks, with the five domestic banks active in this market segment each conducting fewer than 100 trades per month. In commodity derivatives, on the other hand, domestic banks predominate. Finally, the electricity and energy/carbon segments remain relatively small, with all but one of the five participants reporting activity in energy/carbon derivatives executing fewer than 10 trades per month.

Data received from buy-side respondents confirmed the broad messages from sell-side participants. Foreign exchange derivatives and interest rate and cross-currency swaps were cited as the most commonly traded products, with interest rate products traded primarily with domestic banks, and foreign exchange traded with a mix of domestic and overseas banks. Buy-side respondents also tend to be more specialised, typically recording activity only in two or three products. Observations in the remainder of this report will be made predominantly with reference to the most actively traded products (ie, those in Table 2).

Respondents to the Survey noted some changes in market share in response to recent financial system difficulties. In particular, as counterparty credit concerns have mounted internationally, the large domestic banks have gained an increased share of business, reflecting their relative financial strength. Another important development is a renewed emphasis on basic vanilla business, as demand for complex or leveraged product structures has retreated. This has again benefited the domestic banks, for which business was predominantly vanilla even prior to the recent market difficulties.

3.2 Counterparty types

Survey respondents were asked to provide some details on the profile and mix of their counterparties across products. Although not all respondents were able to provide a detailed breakdown of counterparty types, these responses offered a useful insight into the scale of participation of various key groups (such as government bodies, investment managers and corporates) and the level of international buy-side involvement in the Australian OTC derivatives market.

Across the main products, most sell-side respondents’ principal counterparties are other financial institutions, either domestic or overseas-based (Graph 2). Indeed, some products, including certain interest rate and credit derivatives, have tended to be used principally to facilitate hedging and exposure management for the financial sector, rather than for the non-financial sector.

Within the financial institutions category, more than half of the volume traded is typically with commercial and investment banks, and the remainder typically with investment managers or ‘other’ financial institutions such as insurance companies. In the equity derivatives segment, hedge funds also feature quite prominently. Overseas-based financial counterparties account for practically all of the business in the credit derivatives product area, which may also explain the predominance of overseas dealers in this segment (as revealed in Table 2).

As one might expect, corporate involvement is highest in commodities derivatives, followed by FX and interest rate derivatives. While most trade takes place with large ‘wholesale’ counterparties, the detailed Survey responses reveal a material presence of small- and medium-sized enterprises in some products, including commodities and foreign exchange. Individual investors (including self-managed superannuation funds) also account for a material share of trade in equity derivatives.

Domestic and overseas banks have different counterparty profiles (Table 3). Overseas banks tend to trade extensively with overseas counterparties, with the more active overseas banks typically conducting at least half of their business with financial institutions, government bodies, and corporates based overseas. Domestic banks by contrast typically carry out most of their OTC derivatives business with Australian-based counterparties.

Finally, as an indicator of market depth, respondents were asked to provide the share of total trade accounted for by their top 10 counterparties. From the responses to these questions, it would seem that trade is reasonably highly concentrated in most products, with the majority of sell-side respondents reporting that at least two-thirds of overall value was transacted with their top 10 counterparties. Graph 3 shows the frequency with which Survey respondents reported a share of trade with their top 10 counterparties falling within each specified interval.

The highest concentrations tend to arise in the product areas with least involvement of non-financial counterparties, such as credit derivatives and OIS/FRAs. Trading activity in interest rate swaps, foreign exchange and equity derivatives is relatively more dispersed, reflecting the somewhat greater breadth of counterparty types active in these products.

3.3 Market conditions

Most respondents reported a significant deterioration in liquidity conditions over the preceding 18 months. In particular, it has become noticeably more difficult to find a counterparty, the standard transaction size has fallen sharply across products, and the price impact of even a standard-sized transaction has increased considerably (Graph 4).

Anecdotally, some counterparties have withdrawn from the OTC derivatives market, including some hedge funds. It is considered that this has impaired price discovery, particularly in credit derivatives. Some dealers have also relocated at least part of their OTC derivatives trading out of Australia, or are in the process of doing so. While these entities have not ceased activities in the Australian OTC derivatives market, some respondents consider that they are trading Australian products less intensively, with this contributing to the decline in liquidity. Again, the impact was deemed to be strongest in credit derivatives.

3.4 Trade execution

A significant proportion of activity in the Australian OTC derivatives market is conducted via brokers, sometimes across electronic facilities that these brokers support. Where brokers are not used, trades are executed via direct negotiation with the counterparty (via e-mail or telephone); there is currently limited use of multilateral trading platforms.

For more standardised products, and those with broad participation and greater depth, such as those for interest rate swaps and foreign exchange derivatives, extensive use is made of brokers (Graph 5). By contrast, in smaller or more bespoke market segments, such as those for credit, equity and commodity derivatives, a proportionately lower volume of business is channelled via brokers. Where used, flow is typically concentrated among a few leading brokers.

Footnote

Although not all of these entities are authorised deposit-taking institutions (ADIs) in Australia, the term ‘overseas banks’ is used throughout this report to describe this group. [1]