Notional Amount Research Articles

The Clearing of Euro OTC Derivatives Post Brexit Why a Uniform Regulation and Supervision of CCPs Is Essential for European Financial Stability

With a notional amount outstanding of more than USD 500 trillion, the market for OTC derivatives is of vital importance for global financial stability. A growing proportion of these contracts are cleared via central counterparties (CCPs), which means that CCPs are gaining in importance as critical financial market infrastructures. At the same time, there is growing concern that a new too big to fail problem could arise, as the CCP industry is highly concentrated due to economies of scale. From a European perspective, it should be noted that the clearing of euro-denominated OTC derivatives mainly takes place in London, hence outside the EU in the foreseeable future. For some time there has been a controversial discussion as to whether this can remain the case post Brexit. CCPs, which clear a significant proportion of euro OTC derivatives and are systemically relevant from an EU perspective, should be subject to direct supervision by EU authorities and should be established in the EU. This would represent an important building block for a future Capital Markets Union in Europe, as regulatory or supervisory arbitrage in favour of systemically important third- ountry CCPs could be prevented. In addition, if a systemically relevant CCP handling a considerable portion of the euro OTC derivatives business were to run into serious difficulties, this may impact ECB monetary policy. This applies both to demand for central bank money and to the transmission of monetary policy measures, which can be significantly impaired, particularly in the event that the repo market or payment systems are disrupted. It is therefore essential for the ECB to be closely involved in the supervision of CCPs. Against this background, the draft amendment of EMIR (European Market Infrastructure Regulation) presented on 13 June 2017 is a step in the right direction. In addition, there is an urgent need to introduce a recovery and resolution mechanism for CCPs in the EU to complement the existing single resolution mechanism (SRM) for banks in the eurozone. Only then can the diverse interdependencies between banks and CCPs be adequately taken into account in the recovery and resolution programmes required in a financial crisis.

LIBOR—Hazards on the Road to Reform

The London Interbank Offered Rate (LIBOR) is one of the most widely used reference rates in the world of finance. Recent information indicates that nearly $200 trillion in contractual exposures reference USD LIBOR, of which roughly 95% is notional amount exposure under derivatives contracts, with approximately $8 trillion in exposure under corporate loans, consumer debt (primarily mortgages), floating-rate notes, and securitized products. As described in this article, the future of LIBOR is uncertain, and it may be phased out altogether in favor of new reference rates based on much more robust market data. This article describes the reasons for LIBOR’s potential demise, its replacement in the United States, and the impact on legacy assets and asset-backed securities (ABS) transactions in the United States. <b>TOPICS:</b>Legal and regulatory issues for structured finance, legal/regulatory/public policy

Profitability patterns in the interest rate derivatives market

This study identifies profitability patterns and their determinants in the global interest rate derivatives market. Although this market is the world’s largest financial market in terms of nominal value, there has been basically no academic research on profitability owing to missing data. To address this problem, a new analytical method has been developed. Using this new method, the study shows that interest rate derivatives have been a substantial source of profitability that have netted a total average annual profit of more than USD 82 billion for banks since 2009. Furthermore, the study shows that counterparty type, market position (i.e. being one of the Top 5 banks), and trade currency are determinants of the profitability of a trade. For other features of a trade, such as duration or notional amount, no correlation with profitability is found. Finally, the impact of changes of the market structure on profitability driven by regulatory initiatives is discussed qualitatively.

Counterparty Credit Risk in OTC Derivatives under Basel III

Recent financial crises were the root of many changes in regulatory implementations in the banking sector. Basel previously covered the default capital charge for counterparty exposures however, the crisis showed that more than two third of the losses related to this risk emerged from the exposure to the movement of the counterparty’s credit quality and not its actual default therefore, Basel III divided the required counterparty risk capital into two categories: The traditional default capital charge and an additional counter-party credit valuation adjustment (CVA) capital charge. In this article, we explain the new methodologies to compute these capital charges on the OTC market: The standardized approach for default capital charge (SA-CCR) and the basic approach for CVA (BA-CVA). Based on historical calibration and future estimations, we built internal models in order to compare them with the amended standardized approach. Up till June 2015, interest rate and FX derivatives constituted more than 90% of the traded total OTC notional amount; we constructed our application on such portfolios containing and computed their total counterparty capital charge. The analysis reflected different impacts of the netting and collateral agreements on the regulatory capital depending on the instruments’ typologies. Moreover, results showed an important increase in the capital charge due to the CVA addition doubling it in some cases.

Why Do Investors Buy Sovereign Default Insurance?

We provide a comprehensive analysis of the determinants of trading in the sovereign credit default swaps (CDS) market, using weekly data for single-name sovereign CDS from October 2008 to September 2015. We describe the anatomy of the sovereign CDS market, derive a law of motion for gross positions and their components, and identify the key factors that drive the cross-sectional and time-series properties of trading volume and net notional amounts outstanding. While a single principal component accounts for 54 percent of the variation in sovereign CDS spreads, the largest common factor explains only 7 percent of the variation in sovereign CDS net notional amounts outstanding. Moreover, unlike for CDS spreads, common global factors explain very little of the variation in sovereign CDS trading and net notional amounts outstanding, suggesting that it is driven primarily by idiosyncratic country risk. We analyze several local and regional channels that may explain the trading in sovereign CDS: (a) country-specific credit risk shocks, including changes in a country's credit rating and related outlook changes, (b) the announcement and issuance of domestic and international debt, (c) macroeconomic sentiment derived from conventional and unconventional monetary policy, macro-economic news and shocks, and (d) regulatory channels, such as changes in bank capital adequacy requirements. All our findings suggest that sovereign CDS are more likely used for hedging than for speculative purposes.

It’s all in the hidden states: A longevity hedging strategy with an explicit measure of population basis risk

In this paper, we propose the generalized state-space hedging method for use when the populations associated with the hedging instruments and the liability being hedged are different. In this method, the hedging strategy is derived by first reformulating the assumed multi-population stochastic mortality model in a state-space representation, and then considering the sensitivities of the hedge portfolio and the liability being hedged to all relevant hidden states. Inter alia, this method allows us to decompose the underlying longevity risk into components arising solely from the hidden states that are shared by all populations and components stemming exclusively from the hidden states that are population-specific. The latter components collectively represent an explicit measure of the population basis risk involved. Through this measure, we can infer that a portion of population basis risk depends on how the longevity hedge is constructed while another portion exists no matter what the notional amounts of the hedging instruments are. We present the proposed hedging method in both static and dynamic settings.

Derivatives holdings and market values of U.S. bank holding companies

ABSTRACTWe examine the impact of derivatives held by US bank holding companies on their market valuations over the period 2000 to 2010. By using bank-level data with detailed information on the notional amounts of derivative positions according to holding purposes and underlying asset types, our regression analyses provide three main findings. First, derivative instruments held for hedging rather than trading purposes contribute to enhancing market values. Second, the positive effects exhibit nonmonotonic patterns indicating that excessive amounts of derivatives holdings deteriorate market values. Third, interest rate derivatives are the main source of high valuations.

Proposed Rule 18f-4 on the Use of Derivative Instruments by Registered Investment Companies: Data and Economic Analysis

I present data and analysis suggesting that the SEC’s proposed rule 18f-4, in its current form, is an inefficient and ineffective way for the Commission to achieve its regulatory goals of protecting investors and limiting the extent to which registered investment companies can take leveraged exposure to market risks. The rule as proposed uses a limit on risk exposure based on gross notional amounts which places an equal restriction on the use of derivatives whether they are used to take highly speculative positions or whether they are used as part of conservative, low-risk strategies. The proposed rule is likely to have unintended consequences, such as inducing certain types of funds to take on risk exposures using less liquid instruments. Alternative approaches that take risk into account can achieve the Commission’s regulatory goals without depriving investors of the benefits of efficient access to low-volatility, low-correlation strategies achievable through the responsible use of derivative instruments.

Corporate Hedging: An Agency Costs &amp; Accounting Perspective

This study provides empirical evidence on the determinants of the various types of hedging activities conducted by US manufacturing firms. Using a hand collected data set on the notional amounts hedged, I find that agency costs & managerial ability positively impact a firm's decision to hedge their interest rate and foreign exchange risks. To test for capital market benefits, I demonstrate that firms that hedge are able to take on more debt, and hold less cash as a result of the reduced cash flow variance and agency conflicts achieved by hedging. I also show that firms that hedge interest rate risks experience lower stock market volatility around a global economic shock. In order to analyze how firms and auditors account for corporate derivative usage, I split the amounts hedged by their accounting designation as under FAS 133. I provide evidence that firms and auditors find the accounting complexity of foreign exchange hedges greater than that of interest rate hedges.

Can the Credit Default Swap Market Be Salvaged? Issues for Borrowers and Investors

Trading volumes in credit default swaps (CDS) have fallen by more than 75% since the 2008 financial crisis to less than $9 trillion notional amount outstanding as of June 2015. This dramatic decline in volumes comes, in part, because of new laws and regulations focused on reducing the risk of these over-the counter (OTC) derivatives products. Despite significant changes in the regulation of these products, there remain a number of defects in the market structure of OTC credit derivatives, flaws which arguably intensified the impact of the 2008 financial crisis and disadvantage both borrowers and investors. These defects in market structure limit competition, make it difficult for investors to understand the risks taken by large universal banks, create the potential for the manipulation of borrower credit spreads, and even affect the recognition of when default events occur under CDS contracts.

The determinants of CDS open interest dynamics

It has been argued that the CDS market may be a threat to financial stability. Such concern may stem from the counterparty risk assumed by market participants and the high sensitivity of these instruments to the business cycle. The open interest of the CDS market mirrors investors’ maximum exposure and captures aggregate inventory risk, liquidity risk, and trading activity. In this paper, we aim to identify the main determinants of the dynamics of two alternative measures of open interest, the gross and net notional amounts. Our results suggest that both asymmetry of information and divergence of opinions on firms’ future performance help explain the growth of the net notional amount of single-reference contracts, but systematic factors have a much greater influence. Net notional amount growth of different obligors co-varies in time and the dynamics of open interest is pro-cyclical. The CDS market expands following a positive stock market performance and contracts when large negative (positive) jumps in stock (CDS) prices are perceived by investors. In line with the market microstructure theory, funding costs and counterparty risk reduce CDS market players’ willingness to incur inventory risk, thus contracting gross notional amounts.

Capital controls in Brazil: Effective?

A large theoretical literature emerged in recent years analyzing the positive and normative effects of capital controls, begging for empirical studies to validate it. No emerging market experimented as actively with controls on capital inflows as Brazil did since late 2009. This paper analyzes the impact of those measures. These policies had some success in segmenting the Brazilian from global financial markets, as measured by the spread between onshore and offshore dollar interest rates, as well as ADR premia relative to the underlying local stocks. The measures adopted from late 2009 to mid-2011 did not translate into significant changes in the exchange rate, suggesting limited success in mitigating exchange rate appreciation. However, the exchange rate strongly depreciates after a tax on the notional amount of derivatives is adopted in mid-2011. The last of the three restrictions studied may have depreciated the Brazilian real in the range from 4 to 10 percent. That strong response may have been driven by complementarities with the previous measures, as well as an unexpected easing in monetary policy.

Growth in Financial Derivatives: The Public Policy and Accounting Incentives

During the period 1995-2012, U.S. financial institutions had contributed significantly to the growth in financial derivatives. The notional amount of total derivatives held by the 25 largest U.S. bank holding companies grew eighteen times from $16.6 trillion in 1995 to $308 trillion in 2012, while the U.S. GDP merely doubled from $7.7 trillion to $16.2 trillion over the same period. In this paper, we examine three possible drivers of this growth: (a) the Gramm-Leach-Bliley Act of 1999, (b) the Commodity Futures Modernization Act of 2000, and (c) FAS 133 (now ASC 815), Accounting for Derivative Instruments and Hedging Activities, which became effective in 2000. Using a sample of U.S. bank holding companies, we find a temporal association between the passage of the two Congressional Acts and the abnormal growth in trading/over-the-counter derivatives. We also predict and find that the use of cash flow hedge accounting treatment helps reduce earnings volatility/equity risk, and that firms increase their use of non-trading derivatives when facing high level of earnings volatility/equity risk.

Growth in financial derivatives: The public policy and accounting incentives

During the period 1995–2012, U.S. financial institutions had contributed significantly to the growth in financial derivatives. The notional amount of total derivatives held by the 25 largest U.S. bank holding companies grew eighteen times from $16.6trillion in 1995 to $308trillion in 2012, while the U.S. GDP merely doubled from $7.7trillion to $16.2trillion over the same period. In this paper, we examine three possible drivers of this growth: (a) the Gramm-Leach-Bliley Act of 1999, (b) the Commodity Futures Modernization Act of 2000, and (c) FAS 133 (now ASC 815), Accounting for Derivative Instruments and Hedging Activities, which became effective in 2000. Using a sample of U.S. bank holding companies, we find a temporal association between the passage of the two Congressional Acts and the abnormal growth in trading/over-the-counter derivatives. We also predict and find that the use of cash flow hedge accounting treatment helps reduce earnings volatility/equity risk, and that firms increase their use of non-trading derivatives when facing high level of earnings volatility/equity risk.

Volatility Derivatives in Practice: Activity and Impact

We use unique regulatory data to examine open positions and activity in both listed and OTC volatility derivatives. Gross vega notional outstanding for index variance swaps is over USD 2 billion, with dealers short vega in order to supply the long vega demand of asset managers. For maturities less than one year, VIX futures are far more actively traded and have a higher notional amount outstanding than S&P 500 variance swaps. To the extent that dealers take on risk when facilitating trades, we estimate that the long volatility bias of asset managers puts upward pressure on VIX futures prices. Hedge funds have offset this potential impact by actively taking a net short position in nearby contracts. In our 2011‐2014 sample, the net impact added less than half a volatility point, on average, to nearby VIX futures contracts but added between one and two volatility points for contracts in less liquid, longer‐dated parts of the curve. We find no evidence that this price impact forces VIX futures outside no‐arbitrage bounds.

The Transaction Costs of Trading Corporate Credit

To examine whether corporate credit risk is cheaper to trade in the bond or credit-default swap (CDS) market, we estimate individual roundtrip transaction costs for 851 CDSs traded during 2009-2014. Effective half-spreads are 14 bps of the notional amount for dealer-to-enduser and 12 bps for dealer-to-dealer trades for the most common notional traded, $2.5-7.5M. Cross-sectionally, effective spreads are weakly correlated with indicative quoted spreads, higher for more actively traded contracts, and related to reference obligation/entity characteristics. For institutional-size trades up to $500K, bonds are three times as expensive as the corresponding CDSs, but at larger trade sizes this pattern reverses.

CDS, Strategic Behavior, and Credit Spreads

Credit Default Swaps (CDS) introduce renegotiation frictions in contracting by permitting bondholders to hedge against default. Such renegotiation frictions can increase bond credit spreads because they increase the risk of inefficient liquidity default ex-post. Or they can decrease credit spreads because they lower the risk of strategic default ex-ante. Proxying for CDS-related renegotiation frictions using the net notional amount of CDS outstanding as a percentage of debt outstanding (CDS exposure), we show that both effects are operative – credit spreads increase with CDS exposure when liquidation costs are high, but decrease with CDS exposure when borrower bargaining power is high. In the net, credit spreads are positively related to CDS exposure, implying the CDS impose costs associated with ex-post liquidity default that outweigh the ex-ante benefits associated with deterring strategic default. Our evidence indicates that CDS are not redundant securities and that they increase the cost of debt.

Derivatives and Depository Interest Rate Risk: An Empirical Analysis

This paper empirically examines the relationship between the use of on-and-off-balance sheet derivatives and the interest rate risk of US savings associations during 1993-1997. Unlike prior studies, this analysis uses market values, not notional amounts, of all derivatives obtained from the Office of Thrift Supervision?s (OTS) Net Portfolio Value (NPV) Model. The(NPV) model calculates the value of a thrift?s entire portfolio, both on-and-off-balance sheet, to determine each firm?s interest rate risk. We use these data to examine how various factors affect the decision to use or not to use derivatives, whether or not firms use derivatives for hedging. An additional advantage of examining thrifts is that they are end-users of derivatives contracts ? not dealers. The use of derivatives, such as forwards, futures, options, and swaps, by thrifts has not been an industry-wide phenomenon. As of March 1997, only 9.8 percent of savings associations use derivatives. Looking at simple industry averages shows that thrifts using off-balance sheet derivatives, have lower levels of capital, less interest rate risk, and lower net interest margins, than large stock owned-thrifts. However, we also find that thrifts use of derivatives is consistent both with profit maximization and with hedging. After controlling for portfolio and other firm characteristics, we find that thrifts use derivatives to reduce interest rate risk and lessen their vulnerability to capital compliance problems. Further, we find that, after controlling for interest rate risk and credit risk, firms using derivatives have higher net interest margins. We also find that the notable lack of usage by smaller institutions is consistent with rational profit-maximizing behavior as the tendency to avoid derivatives by small institutions is far more pronounced for dealer market products, such as swaps (where low transactions costs can only be obtained by large players), than for exchange-traded products, such as futures. Nevertheless, the lack of derivatives use by most thrifts suggests that a significant segment of the industry is limited in the way it manages interest rate risk.

Currency and Interest Rate Derivatives

Currency derivatives are an important tool to manage foreign exchange risk, hedging. Organizations transacting, investing, or operating in other nations appreciate the possibility of managing currency risk. Investors, financial institutions, and businesses use currency derivatives to complement their foreign exchange positions, again mitigating exchange risks in investment, and speculation. The main benefit obtained by firms using currency derivatives is the reduction of variation in future cash flows or earnings. Interest rate derivatives are instruments in which the underlying asset is the right to pay or receive a notional amount of money at a given interest rate. The objective for their use is to mitigate interest rate risks, the major users of these instruments are corporations, agencies, and governments from nations to municipalities. Because of the typically unique characteristics of these derivatives, the bulk of this trade is done over-the-counter and generally brokered by dealers and financial institutions. According to the Bank for International Settlements (2013), the outstanding amount of single-currency interest rate derivatives in June 2013 surpassed USD 15 trillion, and only in the OTC market, involving a notional value of USD 561.3 trillion. On this survey the nature of such instruments, their valuation, and risk management strategies are analyzed.

Endogenous Derivative Networks

This paper proposes a network formation model of an OTC derivatives market where both prices and quantities are bilaterally negotiated. The key feature of the framework is to endogenize the network of exposures, the gross and net notional amounts traded and the collateral delivered through initial and variation margins, as a function of idiosyncratic counterparty risk and regulatory collateral and clearing requirements. Using the framework, we investigate numerically the size of the derivatives network, the aggregate collateral demand and the pricing of the contracts under the following schemes: (i) various levels of collateralization for uncleared transactions, (ii) rehypothecation of received collateral and (iii) clearing through a central clearing party (CCP). Overall results suggest that dynamic effects due to the endogeneity of the derivative network to the collateralization and clearing requirements have sizeable consequences on both contract volumes and prices. Intermediary trading and market liquidity are reduced by higher collateralization requirements and enhanced by rehypothecation, while the potential for contagion is reduced. Not accounting for dynamic effects in current market conditions may lead to over-estimate collateral demand induced by mandatory central clearing by up to 22%.