TWN Info Service on Finance and Development (May12/03)
21 May 2012
Third World Network

Global OTC derivatives market falls to $648 trillion
Published in SUNS #7369 dated 14 May 2012

Geneva, 11 May (Kanaga Raja) -- The global market for over-the-counter (OTC) derivatives declined between end-June and end-December 2011, with total notional amounts outstanding of these derivatives reaching $648 trillion at the end of last year, the Bank for International Settlements (BIS) has said.

Reporting on the latest OTC derivatives market statistics, BIS said that data at end-December 2011 are not fully comparable with previous periods because of an increase in the reporting population.

Australia and Spain reported for the first time, expanding the reporting population to dealers headquartered in 13 countries.

Across all instruments, said BIS, dealers in Australia and Spain added $12.9 trillion to total notional amounts outstanding at end-2011, $0.7 trillion to gross market values and $0.2 trillion to gross credit exposures.

"The increase in the reporting population impacted the counter-party breakdown because positions vis-a-vis Australian and Spanish dealers began to be reported as positions vis-a-vis reporting dealers instead of vis-a-vis (non-reporting) other financial institutions," BIS added.

(Derivatives are financial instruments whose prices are derived from the value of other instruments, such as stocks, bonds, commodities, currencies, interest rates and even stock market indices. They are normally used to hedge against risk but are also being used increasingly for speculative purposes, and essentially to evade or get around regulatory restrictions.)

[The latest data on derivatives comes just as US banking giant JPMorgan Chase on Thursday reported a trading loss of more than $2 billion as a result of hedging its holdings using derivatives that had gone wrong, according to media reports. In a sudden and unscheduled conference call to announce the expected second quarter loss, JPMorgan CEO, Jamie Dimon (an opponent of the "Volker rule") is reported as having said that the bank had determined that its Value at Risk, or VaR model, was "inadequate" and it would be using an older (standard) model.

[Commenting on the JPMorgan disclosure, Yves Smith at her "Naked Capitalism blog", one of the most authoritative blogs on the financial sector and the shenanigans there, has underscored that the VaR is a lousy metric. "There is a tremendous bias towards scientism, towards undue faith in quantification and statistics ... which leads to overconfidence. And when people are paid bonuses annually, with no clawbacks for losses, and banks show profits a fair bit of the time, who is going to question bad metrics when the insiders come out big winners regardless." While VaR isn't the only risk model JPMorgan is using, Smith says, "it has served to allow the inmates to run the asylum."

[The good news, she adds, is that regulators are a step ahead of Dimon, and refers to the latest comment of the Basel Committee on Banking Supervision (BCBS) that they don't like the VaR and want to move to other metrics, in particular "expected shortfall" (see SUNS #7366 dated 9 May 2012 for the BCBS proposals). Even this, Smith adds, will not be enough, citing the views of Nassim Nicholas Taleb in his book, "The Black Swan", about the difficulties of tail risk estimates and that the type of risks embodied in trading books aren't suited to statistical measurements.

["The best approach," Smith, a former Wall Street trader herself, says, "is likely to be to use a variety of measures and models and apply judgements. But the authorities, and Dimon along with them, have not given up their hunt for a philosopher's stone to turn lead into gold." - SUNS]

According to BIS, total notional amounts outstanding of OTC derivatives amounted to $648 trillion at end-2011. Notwithstanding the increase in the reporting population, total notional amounts declined between end-June and end-December 2011.

At the same time, gross market values, which measure the cost of replacing existing contracts, increased to $27.3 trillion, driven mainly by an increase in the market value of interest rate contracts.

Consequently, said BIS, gross market values rose from 2.8% of notional amounts at end-June 2011 to 4.2% at end-December 2011. The rise in gross market values was the largest since the second half of 2008.

Gross credit exposures, which take account of legally enforceable bilateral netting agreements, also increased, but not by as much as market values, said BIS, noting that these exposures rose to $3.9 trillion, their highest level since end-2008.

At the same time, they declined from 15.2% of gross market values at end-June 2011 to 14.3% at end-2011 as dealers made greater use of netting to reduce their credit and settlement risk.

According to BIS, interest rate derivatives represent the largest risk category in the OTC derivatives market.

While notional amounts fell to $504 trillion at end-2011, gross market values rose to their highest level since end-2008, reaching $20.0 trillion.

Relative to notional amounts, said BIS, gross market values increased noticeably for swaps as well as options.

"The increase in gross market values is explained largely by the impact on outstanding contracts of the decline in long-term euro and US dollar interest rates in the second half of 2011."

BIS also found that the notional amounts of FX (foreign exchange) derivatives totalled $63 trillion at end December 2011. Gross market values rose to $2.6 trillion.

With respect to Credit Default Swaps (CDS), BIS said that notional amounts outstanding of these instruments declined to $29 trillion at end-2011.

The decline was most pronounced among multi-name CDS, which fell from 44% of total contracts at end-June 2011 to 41%.

"CDS gross market values were up slightly to $1.6 trillion. The increase in gross market values was relatively larger for multi-name contracts, which rose to 39% of total gross market values at end-2011 from 36% at end-June 2011."

According to the Basel-based central bank, the rating categories behind the decline in notional amounts differed for single-name and multi-name contracts.

"Among single-name CDS, non-rated contracts fell from 11% of total contracts at end-June 2011 to 10% at end-2011. By contrast, among multi-name contracts, the investment-grade category drove the decline, falling from 57% to 51%."

With regard to maturities, BIS found that there was a clear shift to the short segment (remaining maturities of less than one year), with corresponding declines in the medium- and long-term buckets. In terms of underlying sectors, positions on sovereigns increased slightly.

Turning to equity derivatives, BIS said that notional amounts outstanding of equity-linked contracts dropped to $6.0 trillion, due to declines in both equity-linked options and forwards and swaps.

Option market values remained roughly unchanged at $523 billion, while those in forwards and swaps declined to $156 billion (12% and 9% of notional amounts, respectively), it added.

Amounts outstanding of commodity derivatives declined slightly to $3.1 trillion, although there was an increase in contracts on gold, to $521 billion.

Gross market values on gold contracts rose to $82 billion (16% of notional amounts, up from 11% at end-June 2011), said BIS. +