FT Alphaville " Decoding the latest OTC derivative BIStimates Just when someone's gone and put a decent dataset together, someone has to go and mess it up. Thanks, Spain and Australia. Really, thank you. None of us really cared that much anyway about the data being comparable from one period to the next. Whatevs. FT Alphaville's Internal Monologue The latest Bank of International Settlement's over-the-counter derivatives survey came out on Wednesday. The data are available in half-yearly chunks, so this report takes us up to the end of 2011. If one wished to write a more scandalous headline about what the data show, this would probably be it: "Counterparty risk at highest level since 2008, at $3.9 trillion, Belgium splits into two countries, aliens impregnate millions of hamsters in Wales, Goldman Sachs successfully uses social media to develop reputation as a cute, cluddly bunny BIS says." Melodramatic. The remaining headline is true though. Read on for more detail on this. Fortunately, the report's coverage has expanded to include data from Spain and Australia. Unfortunately, this means that this period's data isn't strictly comparable to previous periods. That said, it looks like they are small enough to not cause too much of a dent. From the BIS report on the release: Across all instruments, 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. That's $12.9 trillion gross out of a total of $648 trillion, and $0.7 trillion out of $27.3 trillion, and $0.2 trillion out of $3.9 trillion. In conclusion, we'll wipe our tears at the loss of consistency. After all, this does mean more data!!! Anyhow, this is the highlight of the report: The graph on the left shows gross notional amounts. This is quite misleading for certain types of derivative where the notional is only used in calculations to determine payments and is at no time exchanged, or at risk of being exchanged for that matter. A fair amount of interest rate swaps where both legs are in the same currency will be like this. For other derivatives, the gross notional may be a meaningful metric, e.g. cross currency swaps or credit default swaps. Given the heterogeneity though, the graph on the right is more interesting. The bars report sums of the absolute values of all marks for each reporting bank, hence "gross" in "gross market value." This is why they don't net to zero here (they would if absolute values weren't taken, the BIS coverage was global, bank valuation methodologies were identical, and a straight sum was taken - but reporting a table of zeros wouldn't exactly be informative). More on their methodology available here. As always with this types of reports, the above gives perspective on just how big the rates market is compared to all other derivative markets. Concerning the increase in the overall gross market value seen in the latest reporting period, this is what the BIS had to say about it in the report that came with the release (emphasis ours): ... 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, 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. The value of interest rate contracts went up mostly because of lower interest rates in the US and for the euro during the latter half of 2011. It turns out though that gross market values also have a pretty major short-coming - they don't allow for legally enforceable netting arrangements. So if you believe in netting, the red dots in the graph on the right are the dots for you. They report the "gross credit exposure" and their scale is given on the left-hand axis (but we're still on the right hand graph). This metric does take into account legally enforceable netting arrangements between counterparties. Where such arrangements exist, the positive and negative marks facing that specific counterparty are netted against each other and when the netted amount is positive, it is aggregated with all the other net positive values, and out pop the red dots. FT Alphaville foot (type) note explaining a BIS footnote: CDS contracts weren't included in the statistics for non-US dealers prior to 2011. As US dealers are a huge part of the CDS market though, and CDS are themselves a relatively small sliver of the figures, we're not hugely concerned about it, but it's still worth bearing in mind when there are statements - like there will be below - that such-and-such is the biggest observation since 2008, as 2008 could have been understated relative to 2011. For those paying very close attention: the netted figures do not take into account any collateral posted. For example, if a bank is net $10m in-the-money to a hedge fund, but the hedge fund posts $8m of collateral to the bank, the net number in the BIS statistics is still $10m, even though some would argue that it's $2m, particularly if the collateral was high quality, like cash. BIS on the increase in gross credit exposures: Gross credit exposures rose to $3.9 trillion, their highest level since end-2008 (Graph 1, right-hand panel). 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. Put more bluntly: the counterparty risk that banks have on is at a level that hasn't been seen since 2008. But hopefully, a lot has been learned since then. There's more use of central counterparties, for one. For another, banks have gotten more strict about collateral arrangements and who they transact with to being with. Of course, as we love reminding you at FT Alphaville, sovereigns usually don't post collateral. Sovereigns are also the clients at the other end of large volumes of swaps, many of which are in-the-money (in the banks" favour) due to falls in interest rates. To say the least, the counterparty exposure arising from such contracts is rather uncomfortable for banks in terms of the capital that has to be held against it. Morgan Stanley, for one, managed to wiggle its way out of derivatives with Italy and no doubt other banks would like to. One can't help but wonder what the statistics will show halfway through 2012. Will even more counterparty risk build up in derivatives markets? It's going to be a long wait... Related links: BIStimates of the over-the-counter derivatives market - FT Alphaville Do you believe in netting? - Part 1, Part 2 - FT Alphaville This entry was posted by Lisa Pollack on Thursday, May 10th, 2012 at 12:38 and is filed under Capital markets. Tagged with bank of international settlements, bis, counterparty risk, OTC derivatives.