How big is OTC really?

(Subtitle: What do the hundreds of trillions mean and how can we compare this with other markets?)

Scarcely a day goes by without a press article or speech mentioning in its introduction the “more $600+ trillion OTC derivatives market”.    Whilst this may liven up the subject, this unnecessarily inflames concern.  Here’s why.

 

What are the figures?  The quoted figures come from the Bank for International Settlements (BIS) half yearly reporting on OTC derivatives market activity – published on their website.  The latest is: BIS OTC 2012 H1 which notes $639 trillion open notional. 

Why inflammatory?  Because $639 trillion is:

  • bigger than the global aggregate of almost anything (GDP, government debt, global securities issued, … etc. etc.) and
  • is not a measure of the value of OTC trades outstanding.  

Why not?  Unlike bonds where the notional value and market value are close together (one being within a few % of the other), an on-market interest rate swap has near zero market value on trade date whereas notional could easily be $100m or more.   Only through interest rate movements through the swap’s life does it acquire significant value (which can be both positive or negative).  Even then the value will likely remain a very small fraction of the notional value.

 

How has ISDA tried to help?  ISDA produces companion half yearly figures which eliminate double counting of CCP trades (makes sense) and also all of FX derivatives (not sure I understand the rationale).  The latest is: ISDA OTC 2012 H1 which notes $417 trillion adjusted open notional.   This also emphasizes the point that after netting and collateral the real aggregate exposure is a tiny fraction of the notional.   Whilst helpful, $417 trillion is in practice just as inflammatory as $639 trillion and it is worth further emphasizing the market value and credit exposure numbers produced.  

Are market value and credit exposure available?   Yes.   BIS also collects gross market value as part of the survey which collects notional values.  ISDA combines this with netting and collateralization effectiveness percentages it collects to estimate further credit exposures:

  • $25.4 trillion gross market value[1] – a decent measure of the current value of all gross swap assets held by banks and directly comparable with other financial instruments (see below).  This also implicitly eliminates double counting at CCPs because an in the money trade for one bank will be out of the money for the other.
  • $3.7 trillion gross credit exposure (after netting before collateralization) and $1.1 trillion net credit exposure (after netting and collateralization).  This last figure measures the total counterparty “current” exposure in the market. 

[1] Gross market value is the sum of in the money trade values across all reporting banks – before netting out of the money trades and before collateral

Is that all the risk?  No.  Potential future exposure beyond current market value on OTC products is significant given it is a longer duration product.  Note: market values in other instruments do not measure potential future exposure either.  Initial margin and Basel III capital both aim to buffer against potential future exposure.

So how does OTC compare with other markets?  Comparing global market values at the same point in time i.e. end 2011, we have:

Asset Class

Global Market Value ($trn)

Bonds

93

Loans

64

Equities

54

OTC Derivatives

27

Sources: OTC figures from BIS OTC 2011 H2, Other figures from McKinsey end 2011 global financial stock

I hope that this insight will contribute in some small way to a measured and productive conclusion to the discussions around re-regulation of the swaps market.

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