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Jian Cai |

Research Economist

Jian Cai

Jian Cai is a research economist in the Research Department of the Federal Reserve Bank of Cleveland. She is primarily interested in theoretical and empirical corporate finance and financial intermediation, and empirical asset pricing. Her current work focuses on interbank competition, executive compensation, and agency problems.

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08.12.11

Economic Trends

Has the Over-the-Counter Derivatives Market Revived Yet?

Jian Cai

Derivatives are financial instruments whose values depend on the values of other assets such as stocks, bonds, and commodities. Firms, banks, and investors can use derivatives to hedge various kinds of risks. However, derivatives can also be used for speculation, and consequently they can magnify the degree of risk-taking that market participants engage in. Trading in derivatives reached tremendous levels before the recent financial crisis, and that burst of activity received a great deal of criticism later, reflecting perceptions that risk-taking by financial institutions was excessive and that derivatives helped to elevate considerably the severity of the crisis.

There are two major types of derivatives markets: exchange-traded and over-the-counter (OTC). In contrast to the heavily regulated exchange-traded market, the OTC market is bound by little regulation and offers customized derivative products. Those features enable it to provide greater flexibility in terms of meeting individual investors’ hedging and speculation needs. As a result, the OTC market is much larger than the exchange-traded market. For example, as of December 2010, the notional amount outstanding (the gross nominal value of all deals) in the entire OTC market, excluding commodity contracts, was $598 trillion, nearly nine times the amount outstanding in the exchange-traded market ($68 trillion).

A look at recent trends in the global OTC derivatives market reveals that the market has stayed generally flat since trading volume fell significantly at the peak of the financial crisis. Although foreign currency derivative contracts have started to increase, and interest rate contracts have recovered to pre-crisis levels, trading in equity and commodity derivatives and credit default swaps continues to stay low and, in some cases, it has further declined.

Prior to the financial crisis, the global OTC derivatives market grew strongly and persistently. Over the ten-year period from June 1998 to June 2008, the market’s compounded annual growth rate was 25 percent. The total notional amount outstanding reached its peak of $673 trillion in June 2008, but just six months later it had fallen to below $600 trillion in the wake of the financial crisis. Since then, the market has stayed about 10 percent-13 percent smaller than it was at its peak. In December 2010, the total notional amount outstanding was $601 trillion.

While the notional amount outstanding measures the size of the derivatives market, the gross market value provides an estimation of market risk, that is, the potential for gains or losses from derivative transactions. Gross market value had an upward trend over time until 2008: It stayed around $2 trillion-$3 trillion during 1998-2001, increased to $6 trillion-$7 trillion during 2002-2003, grew to around $10 trillion during 2004-2006, reached $16 trillion in 2007, and finally rose to $35 trillion at the end of 2008. As the derivatives market experienced its first and biggest drop in size in December 2008, the risk level ironically increased to its historical high, which indicated how vulnerable and dangerous the market was then. By December 2010, the gross market value came down to $21 trillion, 40 percent lower compared to two years before. Yet, as a risk measure, it still seems quite volatile, ranging from $21 trillion to $25 trillion during the past two years.

There are six main categories of derivatives: foreign exchange, interest rate, equity, commodity, credit default swap, and other.

Foreign exchange contracts have the second-highest notional deal value among all types of derivative products. As of June 2008, they accounted for 9.4 percent of the entire derivatives market, with a notional amount outstanding of $63 trillion. Derivative trading in this category was down by 21 percent in December 2008. It stayed at that level in 2009 but started to recover in 2010. Its notional amount outstanding got back to $58 trillion in December 2010, which accounted for 9.6 percent of the derivatives market at that time. The recovery was mainly driven by an 18 percent increase in currency swaps, whereas the decline was the greatest in currency options (31 percent).

Interest rate contracts have the highest deal value, accounting for 68.1 percent of the derivatives market in June 2008, with a notional amount outstanding of $458 trillion. Trading in this category did not suffer as much as other categories, as it was down by only 4 percent-6 percent during the crisis. It reached $465 trillion in December 2010, even 1.5 percent higher compared to June 2008, and accounted for 77.4 percent of the entire derivatives market. An increase of 31 percent in forward rate agreements—contracts which lock in borrowing rates at a future time—is the main reason that this part of derivatives market has stayed strong. However, interest rate options experienced a 21 percent decline at the same time.

Although equity-linked contracts are one of the most commonly known types of derivatives, they account for only a tiny portion of the total derivatives market in terms of notional deal value. For example, in June 2008 the notional deal value was $10 trillion, which represented just 1.5 percent of the total market. After a 45 percent drop in the notional amount outstanding, the share of equity contracts further decreased to 0.9 percent ($5.6 trillion) in December 2010. All types of contracts on equity declined significantly: Options declined 49 percent and forward and futures declined 31 percent during this period.

Commodity derivatives are probably the category that experienced the most dramatic changes both prior to and after the crisis. The compounded annual growth rate of this type of derivative was 40 percent during the 10-year period from June 1998 to June 2008, or 65 percent during the three-year period from June 2005 to June 2008. Its notional amount outstanding was highest in June 2008 at $13 trillion, but it dropped by two-thirds six months later to $4.4 trillion. Since then, trading volume in commodities has continued to decline. In December 2010, the notional amount outstanding of commodity contracts was $2.9 trillion, accounting for only 0.5 percent of the total derivatives market. The notional value of gold contracts declined by nearly 40 percent during this period, whereas the drop in nongold commodity contracts was a more drastic 80 percent.

Intended to help financial institutions better manage counterparty risk, the credit default swap is a relatively recent innovation in the derivatives market. After its trading statistics started to be released in December 2004, its notional amount outstanding increased eight times and reached $58 trillion within three years. However, it dropped to $42 trillion in December 2008 and continued to decline during the next two years. In December 2010, the notional value of credit default swaps was slightly below $30 trillion, accounting for 5 percent of the total derivatives market. Both single-name and multi-name instruments in this category decreased by about half.