Factors influencing the development of the derivatives markets

Abstract

According to the BIS survey, global daily turnover in foreign exchange and interest rate derivatives contracts, including traditional foreign exchange derivatives (outright forwards and foreign exchange swaps) rose by an estimated 74% in the period 2001-2001, to $2.4 trillion. At constant exchange rates, the increase was 51%, far outstripping the 10% growth recorded in the previous three-year survey. Activity grew in both segments of the global OTC market, namely interest rate and currency products. This contrasts with the previous three-year period, when business in foreign exchange products fell even as interest rate derivatives trading rose strongly. Still, growth in the interest rate segment (up 110%) continued to exceed that in the foreign exchange segment (51%). In terms of total turnover, interest rate derivatives are now very close to exchange rate derivatives. Daily business in the two segments stood, as of end-April 2004, at $1,025 and $1,292 billion respectively, against $489 billion and $853 billion as of end-April 2001. Over the same three-year interval daily activity in exchange- traded derivatives expanded by 114%, to $4.7 trillion. Since this volume is almost completely made up of interest rate products, the expansion of the two markets has been almost identical. The growth of business in exchange rate derivatives is related to the 57%expansion in turnover in traditional foreign exchange markets. Higher demand in both the traditional and the derivatives segments reflects the greater role that such products have recently been playing as an alternative investment class to equity and fixed income investments, as well as the larger role of hedge funds and asset managers. In addition, the large swing in the exchange rate of the dollar vis-à-vis other major currencies between 2001 and 2004 may have increased hedging-related demand for currency derivatives. In the interest rate segment activity was boosted by changes in hedging and trading practices in theUS market, which contributed to turnover in the swap segment. Business in the US swap market was probably also fuelled by the increasing demand to hedge the duration of mortgage-backed securities after the summer of 2003. Beyond these factors, turnover in the interest rate segment seems to have reflected an exceptional rise in volatility, which was both more pronounced in the United States than in Europe, and more pronounced in the short- and medium-term segments. Trading between reporting banks and other financial institutions, mainly hedge funds, mutual funds and insurance companies, increased the most, by 132%. However, business also rose substantially with non-financial customers, i.e. firms, by 77%. For both interest rate products and currency products, activity within the group of reporting dealers recorded the lowest growth rates. Interest rate business with firms has been increasing particularly rapidly with respect to interest rate products, while trading with other financial institutions saw an expansion for both interest rate and currency instruments. While London and New York remained the two largest marketplaces, Paris tookthird place for the first time. There was a slight increase in the concentration of trading. The five largest marketplaces now account for 74% of trading, up from 70% three years ago. This occurred despite the fact that concentration, measured at the dealer level, has remained stable over the last six years.