International Capital Markets
Published by the International Monetary Fund
E. Expanding and Maturing Derivative Markets
Three general tendencies have shaped the evolution of global derivative markets. The first and most important tendency is that over-the-counter (OTC) derivatives markets are increasingly becoming the hub of derivative markets. In 1987, the notional principal of outstanding OTC interest rate and currency swaps and interest rate options was 20 percent larger than the global exchange-traded derivatives market, but by 1995 it was 90 percent larger. In 1995, turnover on the major North American, European, and Asia-Pacific derivatives exchanges actually declined while OTC activity rose by 40 percent. Although the OTC markets continued to be the major sources of growth in 1996, exchange activity increased on renewed interest in EMU. In 1996, the notional principal of outstanding OTC currency and interest rate swaps and interest rate options reported by the International Swaps and Derivatives Association (ISDA) rose to more than $24 trillion in 1996, and a more comprehensive survey conducted by the BIS estimates outstanding OTC contracts (foreign exchange, interest rate, equity, and commodity) at $47.5 trillion in early 1995 (after adjusting for double counting and including estimated gaps in reporting). The volume of exchange-traded futures and options (currency, interest rate, equity) rose to 1.2 billion contracts at end-1996, and the total notional principal outstanding approached $10 trillion (Tables 9 and 10).13
Important reasons for the OTC markets' dominance are the flexible, customized nature of OTC contracts, and regulatory advantages. These regulatory advantages may soon be reduced in the United States. Legislation pending in the U.S. Congress would amend the Commodity Exchange Act to formally recognize the distinction between "professional" and "retail" market segments, and to reduce the regulatory burden for product innovation and reporting requirements in the professional segment. U.S. exchanges are hailing the legislation as contributing to a "truly more competitive industry world-wide."14 In the medium term, exchanges could benefit from the activity in the new exchanges in emerging markets and by introducing new emerging-market products.
The second tendency in global derivatives markets has been consolidation, in both the exchange-traded and OTC market. In the U.S. OTC markets, the top 8 banks account for about 94 percent (almost $19 trillion at end-1996) of the total notional principal outstanding. Consolidation in the exchange-traded markets is exemplified by the proliferation of trading links among exchanges. In Europe, consolidation has also occurred via mergers and closures, reflecting the increase in competition between exchanges as they seek to establish market shares before the introduction of the euro. For instance, the Swiss (Soffex) and German (DTB) exchanges announced in late 1996 a strategic alliance that will create a common technical platform for trading derivatives and integrate the two clearing and settlement systems. In London, LIFFE's takeover of the London Commodity Exchange expanded significantly the range of products traded, and in Ireland the Irish Futures and Options Exchange was closed in 1996.
The third tendency is commoditization (or standardization). The predominant derivative product, the swap contract, has become commoditized, and as a result swap margins have narrowed sharply as product volumes have risen. The tendency toward commoditization has been attributed to well-publicized losses incurred on derivative exposures some years ago, the riskiness of which may not have been fully understood. Although losses were not always associated with exotic products, they stimulated an awareness and re-evaluation of the purposes and risks of derivative instruments. As a result, there was a sharp and widespread reduction in the demand for exotic, highly leveraged structures, and a shift toward well understood structures—especially currency and interest rate swaps. Nonetheless, some structures that have traditionally been regarded as exotic (such as digital and barrier structures) have become mainstream, commoditized products.15
The continued expansion of derivatives has been fueled by structural changes, such as the trend toward securitization and the increased understanding of the capabilities of derivatives for unbundling, packaging, and reallocating cyclical and balance sheet risks. A mark of their success is that the use of derivatives is now an essential component of risk management in the major international banks and corporations. The growing use of derivatives has been aided by advances in analytical and information technology for evaluating and pricing the risks inherent in derivative contracts. Despite their rapid growth, there is still capacity for entities in a wide range of advanced and developing countries to take fuller advantage of them. One example is credit derivatives—one of the fastest growing derivative product areas—which represent an unbundling of credit risk from various types of on-balance sheet and off-balance sheet items (see Background Material—Part I). Given the size and concentration of credit risk exposures, and the absence of an active secondary market for most of them, this market is likely to develop very rapidly.
Derivative markets present significant challenges for both private and public risk management, as demonstrated by the recent loss of about £85 million by a U.K.-based derivatives dealer due to its mispricing of interest rate options. In November 1996, the Basle Committee on Banking Supervision and the International Organization for Securities Commissions' Technical Committee released a joint survey on the trading and derivatives activities of international banks and securities firms. The study reported continuing improvements in disclosure practices, but also noted that significant disparities in practices existed. The study urged banks and securities firms to strengthen further both their quantitative and qualitative disclosure. Market transparency will also be enhanced by the agreement of central banks to establish a system of regular derivatives reporting by major dealers, beginning in June 1998. Aggregate data on global trading activities will be collected in a manner that avoids double counting, and publicly released to enable firms to assess their own activities in relation to the markets.
13Derivative markets are large relative to the size of cash markets: for example, outstanding debt securities in the EU, Japan, and North America totaled $25.8 trillion in 1995, whereas the notional principal of related derivatives amounted to $44.5 trillion.
15A digital (or all-or-nothing) option is an option with a fixed, predetermined payoff if the underlying instrument is at or beyond the strike price at expiration; the value of the payoff is unaffected by the magnitude of the difference between the underlying and the strike price. Barrier options are path-dependent options for which both the payoff pattern and survival to the nominal expiration date depend not only on the final price of the underlying instrument but also on whether the instrument sells at or through a barrier price during the life of the option. Examples of barrier options include down-and-out and up-and-in puts and calls, early trigger CAPS options, and a variety of similar instruments.