Report on the Australian OTC Derivatives Market – October 2012
4. Australian OTC Derivatives Market Activity
The Australian OTC derivatives market is a relatively small share of the global market, with activity mostly focused on Australian dollar-denominated contracts. The vast bulk of this activity in most product classes is intermediated by a small group of domestic and offshore dealers. The most widely used product classes in Australia are single-currency interest rate derivatives, cross-currency swaps and FX derivatives – particularly those with an Australian dollar component. There is also some activity in other types of derivatives, though on a much smaller scale.
4.2 The Global OTC Derivatives Market
The Bank for International Settlements (BIS) conducts a semi-annual survey of large banks and other institutions to collect data on the global OTC derivatives market; this is supplemented by a more comprehensive survey every three years. Data from the BIS indicate that the total gross notional value of OTC derivatives outstanding globally at end-December 2011 was US$650 trillion (Graph 1). This value has grown considerably in the past decade, although growth was interrupted in the years following the onset of the financial crisis in 2008. The largest component of the global market, measured by gross notional outstanding amounts, is interest rate derivatives. FX derivatives are the next largest class of derivatives. Credit derivatives grew very rapidly ahead of the financial crisis, but outstandings have declined since 2008.
The bulk of OTC derivatives positions reported to the BIS survey involve counterparties that are either dealers (mainly large banks) or other financial institutions, reflecting that the OTC derivatives market is primarily interbank (Table 1). For all major product classes, 85 to 90 per cent of positions are with financial counterparties. Non-financial counterparties are participants in FX and commodity derivatives, and (to a lesser extent) interest rate derivatives, reflecting their usage of derivatives to hedge payment and funding risks. In contrast, credit derivatives are used almost exclusively by financial institutions. Much of the large principal amounts outstanding between reporting dealers reflects the build-up of economically redundant trades, as discussed in Section 2.2. The gross market value of these contracts after adjusting for legally enforceable bilateral netting outstanding amounts, at around US$30 trillion.
Globally, the vast bulk of trading is in instruments denominated in four currencies: US dollars, euro, Japanese yen and pounds sterling (Graph 2). At the end of 2011, outstanding derivatives positions denominated in Australian dollars were around US$11 trillion, comprising around 2 per cent of the global market.
In terms of turnover (measured in gross notional principal amounts), the largest OTC derivatives markets are in the United Kingdom and United States (Graph 3). Australian market turnover is significantly lower than that seen in these largest markets, although it is of a similar size to the markets of several other G-20 countries.
4.3 Australian OTC Derivatives Market Survey
In July 2012 the regulators requested 65 institutions known to be active in the Australian OTC derivatives market to participate in a market survey (survey recipients are listed in Annex 1). This group included the market participants that provide data to the annual survey undertaken by the Australian Financial Markets Association (AFMA), along with other sell-side and buy-side institutions. Responses were received from 37 institutions, of which 18 self-identified as price-makers (that is, dealers) for at least one product class. Based on the institutions in this latter group, the regulators are confident that the survey captured the bulk of dealing activity in the Australian OTC derivatives market.
The survey requested information relating to ‘Australian’ market activity, defined as transactions booked or executed by an Australian-based entity (in turn defined as an entity incorporated in Australia, or the branch or office of an overseas entity registered in Australia), across eight OTC derivatives product classes:
- single-currency interest rate
- cross-currency interest rate
In addition to the high-level product class breakdown, the survey sought information on outstanding positions and trading activity across counterparties, maturities and currencies. Qualitative and more targeted information was also sought in areas such as product liquidity, use of centralised infrastructure (including trading platforms and central clearing arrangements) and bilateral risk-management practices; survey results on these matters are discussed further in Chapter 5.
4.4 Australian Market Size and Composition
As noted above, as at end-2011 around US$11 trillion of global OTC derivatives were denominated in Australian dollars, though not all of this is transacted in Australia or booked by Australian-domiciled entities. Measuring the size of the Australian OTC derivatives market is complicated by the large amount of cross-border activity that takes place. Many transactions executed in Australia involve a counterparty located in Australia and a counterparty located offshore. Even where both executing counterparties are located in Australia, it is common for foreign-domiciled counterparties (such as large global dealers) to record the transaction on the books of an overseas branch or affiliate.
Data from AFMA indicate that over the year to end June 2012, daily average turnover of OTC derivatives in Australia was around $180 billion (Graph 4). This figure includes transactions undertaken by an Australian-based counterparty, whether Australian- or foreign-domiciled, with either Australian- or foreign-based counterparties. Within this, turnover in OTC FX derivatives was around $120 billion, while OTC interest rate derivatives (both single-currency and cross-currency) turnover was around $65 billion; turnover in other derivatives products was much lower.
Turnover in the Australian OTC derivatives market is strongly Australian dollar-focused. AFMA data indicate that of FX derivatives turnover, around 55 per cent had an Australian dollar-denominated leg. Of interest rate derivatives, around 80 per cent of turnover across all products was in fully Australian dollar-denominated products, with an additional 4 per cent of turnover being cross-currency swaps with one leg denominated in Australian dollars. Data from the BIS indicate that trading in Australia accounts for the bulk of global turnover in Australian dollar-denominated derivatives.
4.5 Australian Market Participants
In the absence of widespread usage of trading platforms in OTC derivatives markets, dealers (large banks or other financial institutions) play a key role in intermediating these markets. The local dealer community consists of a range of foreign banks along with the larger Australian-owned banks. While some domestic and foreign dealers are market-makers in many classes of OTC derivatives, others take a more specialist role. Both AFMA data and the regulators' July 2012 survey indicate that the Australian OTC derivatives market is highly concentrated among a relatively small number of dealers. Within each product class, the market share of the top eight dealers is around 80 to 90 per cent of all transactions.
Based on the responses received for the regulators' July 2012 survey, the largest 10 dealers are counterparties to around 90 per cent of the aggregate notional value of all outstanding positions. Given these 10 dealers are on one side of the vast majority of positions in the Australian market, the relative sizes of the notional amounts outstanding on a representative book of one of these dealers reflect the product-class composition shares of the aggregate market (Table 2). The Australian dollar-focus of the local market is evident, with around 80 per cent of the notional outstanding value of combined interest rate and FX derivatives positions denominated in the local currency.
Trading activity is highest among FX derivatives, with the largest dealers executing around 225 transactions per day on average. The largest dealers had an average of around 19,000 FX derivatives transactions outstanding as at June 2012. Daily activity in single-currency interest rate derivatives is much lower; although owing to the long maturities of many of these contracts, the number of transactions outstanding is still quite high. The large number of transactions outstanding relative to notional amounts in credit, equity and commodity derivatives reflects the much lower principal amounts in these product classes. The lower daily average number of transactions in equity and commodity derivatives in part reflects these markets being more concentrated than other asset classes, with the bulk of market turnover being accounted for by a very small number of dealers.
4.6 Product Classes
4.6.1 Single-currency interest rate
Australian dollar-denominated interest rate derivatives comprise the largest component of notional positions outstanding in the Australian OTC derivatives market. According to AFMA data, the majority of the amount outstanding in this product class is comprised of fixed-to-floating interest rate swaps (Graph 5), 70 per cent of which have maturities greater than one year. Dealers are also active in shorter term contracts, such as overnight indexed swaps (OIS) and forward rate agreements (FRAs). Interest rate options (including swaptions, caps and floors) are also used, though relatively less than other classes of interest rate derivatives.
The dealers surveyed by the regulators in July 2012 reported that they indexed most Australian dollar-denominated single-currency interest rate derivatives to the bank bill swap rate (BBSW) or bank bill swap bid rate (BBSY). Other indices, such as OIS and AONIA–OIS compound rates, are less commonly used as reference rates; the Australian dollar LIBOR is only used in a very small number of transactions by a few participants.
AFMA data indicate that around 75 per cent of trading activity in Australian dollar-denominated single-currency interest rate derivatives in Australia is interbank activity – both Australian-incorporated ADIs and foreign bank branches (Graph 6). Within this, interdealer trading accounts for almost half of annual turnover. Similar shares for the interbank and interdealer segments of the market also apply to the notional amount outstanding.
Activity in Australian dollar-denominated single-currency interest rate derivatives is quite liquid, with average daily turnover across all product classes of more than $50 billion in 2012, representing growth of around 100 per cent in the past five years, mainly reflecting increased activity in OIS (Graph 7). As reported in Table 2, daily transaction volume is also high relative to most product classes apart from FX, with the average large dealer transacting in single-currency products around 40 times per day.
Across the most actively traded single-currency interest rate products (swaps, FRAs and OIS), respondents to the regulators' survey generally reported relatively tight bid-ask spreads of between 1 and 2 basis points on average, with some participants noting sub-basis point spreads. Dealers indicated that standard transaction sizes in the local market generally ranged between $50–$100 million for swaps, while transaction sizes for FRAs and OIS tended to be larger, up to $500 million. Depth in the swaps market is also evident, with dealers reporting a 1–3 basis point average price impact from a five times larger-than-average transaction. These results are similar to those reported in the regulators' May 2009 survey, suggesting there has been little change in market liquidity and pricing over recent years.
4.6.2 Cross-currency interest rate
Around 70 per cent of aggregate outstandings in cross-currency interest rate derivatives reported to the regulators' survey involve the Australian-US dollar cross. Smaller amounts of transactions involve the New Zealand dollar, as well as the euro and Japanese yen. Responses to the regulators' survey indicated small amounts of activity in a broad range of other currencies, with trades reported in a total of 15 different pairs. Data from AFMA indicate that around 90 per cent of the notional amount outstanding in cross-currency swaps involving the Australian dollar has a floating Australian dollar leg.
According to AFMA data, average daily turnover in Australian dollar-denominated cross-currency interest rate derivatives was around $2.5 billion in 2012, substantially lower than for single-currency products. Based on evidence from the regulators' survey, on average the largest dealers only conduct around 10 trades per day, with bid-ask spreads commonly around 2–4 basis points (and possibly narrower for the Australian-US dollar pair). Standard transaction sizes are typically $50 million or $100 million, although there is some evidence to suggest that sizes for transactions that mature within three years tend to be larger at around $200 million. As with single-currency interest rate derivatives, these results suggest there has been little change in market liquidity and pricing in recent years.
4.6.3 Foreign exchange
As noted above, the notional value of turnover in FX derivatives is the highest of all OTC derivatives product classes. Survey participants generally reported the greatest number of transactions outstanding in outright FX forwards and FX swaps. A number of dealers also reported activity in foreign exchange options and non-deliverable forwards. Similar to activity in the single- and cross-currency interest rate product classes, most activity in FX derivatives occurs in the interbank market, with less than 5 per cent of turnover occurring with non-financial counterparties (Graph 8).
The market for FX derivatives is very liquid. According to the regulators' survey, dealers reported narrow bid-ask spreads of around 1 basis point or less for FX swaps; standard transaction sizes ranged from $10 to $100 million for the most active dealers. Depth in FX derivatives is also quite good, with the market generally able to absorb larger-than-average trades without significant price impact (the impact of a five times larger-than-average trade is reportedly 2 basis points or fewer).
FX forwards are also liquid, with most dealers indicating relative ease in executing transactions and facing bid-ask spreads of around 2 basis points or fewer. The reported standard transaction size for forwards varied considerably, and ranged up to $250 million. For other FX derivatives, such as non-deliverable forwards (NDFs) and options, survey responses suggest that standard transaction sizes are lower and bid-ask spreads are higher relative to swaps and forwards.
The Australian-US dollar cross comprised 45 per cent of the aggregate notional value of dealers' outstanding positions in OTC FX derivatives. A little over 10 per cent of the aggregate involved the euro-US dollar currency pair, with around 5 per cent of activity in each of the sterling-, yen- and NZ dollar-US dollar pairs. The remaining activity takes place across a broad range of currency pairs.
Credit default swaps (CDS) are the most commonly used OTC credit derivatives, with respondents to the regulators' survey reporting only limited use of other products, such as total return swaps and synthetic correlation products. According to AFMA data, single-name CDS accounted for around 55 per cent of notional outstandings (including in-house) in Australia in 2012, with most of the remainder in index-based products (Graph 9). There was a greater prevalence of trading in credit derivatives with longer maturities (that is, those that with a maturity of three years or more), which accounted for over 60 per cent of outstanding positions.
Survey responses from dealers indicated that a number of institutions used CDS referencing the iTraxx Australia index. Data from DTCC indicates that the iTraxx Australia index is quite actively traded, though activity is substantially lower than that of the most heavily traded credit indices globally (Graph 10). There is also activity in Australian single-name CDS contracts, particularly for those referencing Australian banks and mining companies. However, trading volumes for CDS on Australian reference entities are typically well below those seen in the most actively traded single-name contracts globally.
While total notional outstanding for all single-name CDS is larger in aggregate than for credit indices, amounts outstanding against many individual reference entities are quite small. Reflecting the larger market for credit indices, AFMA data indicate that average daily turnover for these products was around $720 million in 2012, compared with $360 million for single-name CDS. Responses to the regulators' survey suggest that local dealer activity in credit derivatives is mainly in Australian reference entities and indices.
Information provided to the regulators' survey on the characteristics of a standard credit derivatives transaction was somewhat limited and quite varied. However, there is some evidence to suggest that bid-ask spreads are lower for CDS referencing indices rather than single names, and that the standard size of these contracts is larger.
The limited notional outstanding in OTC equity derivatives markets is more dispersed across different products than that in other OTC derivatives product classes. The regulators' survey suggests equity options are the most common contract type, including options over both single stocks and major Australian equity indices. While respondents generally reported activity in vanilla options, some reported use of less-standardised options, including exotics, barriers and auto-callable structures. Use of equity swaps was also reported, both for single stocks and indices. Typical trade sizes and bid-ask spreads vary widely across contract types.
The participants in OTC commodity markets predominantly trade commodity swaps and forwards, with more limited use of commodity options. Survey respondents reported exposures in metals (particularly gold, copper and aluminium), oil and agricultural products (including wheat and sugar). Bid-ask spreads and standard transaction sizes varied widely with the underlying commodity.
The participants in the OTC electricity derivatives market consist of a small number of financial intermediaries and a larger number of electricity generators and retailers that participate in the National Electricity Market (NEM). The survey results indicate approximately a quarter of the transactions in this market are conducted with a financial intermediary, with the remainder of the transactions in this market conducted between physical or NEM market participants. A range of products are traded in the OTC electricity derivatives market, with the most frequently traded products being flat and peak swaps followed by caps. Other products traded in this market include load-following and weather, and some swaps include a carbon pass-through component. The tenors of swap contracts are commonly by quarter, or by financial or calendar year.
Survey responses indicate participants predominantly rely on OTC transactions, rather than futures contracts traded on the ASX 24 exchange, to hedge their physical exposures. Participants that own both generation and retail businesses also rely on internal hedging. For the most commonly traded swap contracts, a number of participants reported generally consistent transaction sizes but reported some differences in bid-ask spreads. There was some dispersion in transaction size and spreads for other, less commonly traded, contracts. The ease of finding a counterparty can vary in some states.
Forwards and options on Renewable Energy Certificates (RECs) constitute the bulk of the Australian market for OTC environmental derivatives. Activity related to NSW Greenhouse Gas Abatement Certificates (NGACs) and Gas Electricity Certificates (GECs) largely makes up the remainder of the market, with very limited activity in carbon-related products.
According to AFMA data, activity in the market is highly concentrated, with just three to four entities accounting for over 90 per cent of turnover in each of the main classes of certificate. Responses to the regulators' survey also show that the vast majority of activity is between Australian-based entities. Overall activity in this market is very small relative to that seen in most other OTC derivatives markets in Australia.
- 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.