Download Who are the end-users in the OTC derivatives market?

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Who are the end-users in the OTC derivatives market?
December 4, 2015
Available data suggests that OTC derivatives are primarily used to hedge business risks. The perception
that the OTC derivatives market is an inter-dealer market looks exaggerated; by contrast, non-dealers are
the investors in the majority of trades. Derivatives may thus help the efficient distribution of risk in
financial markets.
Derivatives, in a nutshell, allow investors to manage their business
risks efficiently and improve the price discovery of the underlying
assets. They usually have bespoke features due to the varied
needs of investors and are traded on over-the-counter (OTC)
markets. Especially in recent years, financial markets have been
subject to frequent episodes of intense volatility, so reducing market
uncertainty via the use of derivatives has become even more
crucial. This presumably has increased market participants’
demand for derivatives. At the same time though, in the aftermath
of the financial crisis, tighter regulation has driven up the cost of
derivatives trading, thus putting pressure on the supply side of the
market. Derivatives have also been criticised for being an interdealer market only and having a weak connection to the real
economy. Hence, it is worth shedding some light on the trading
objectives of derivatives market participants and their deals’
relevance to the real economy.
Figures from the Bank for International Settlements (BIS) provide
interesting insights into the counterparties on the OTC landscape.
More specifically, they distinguish between the trades of reporting
dealers and (1) non-financial-counterparties (NFCs) i.e. mainly firms and governments, (2) other financial
counterparties (FCs) including for instance central counterparties, pension funds, insurance companies, regional
banks and hedge funds and (3) other dealers such as large investment banks. Starting with the derivatives market
turnover, BIS figures show that around 65% of OTC trades involve a non-dealer; either an NFC or an FC (figures
from 2013). A further breakdown with respect to outstanding notional amounts of different derivative classes
demonstrates the heterogeneity in terms of counterparties. Here, non-dealers account for as much as 82% of the
total market.
NFCs are parties to a relatively small proportion of all derivative contracts (by amounts outstanding). However,
their shares of the various segments differ strongly. At 21%, it is the largest in commodity derivatives (as of
2014).* NFCs often use raw materials for their production or produce these materials themselves. The fact that
NFC end-users aim to hedge their exposures to price changes in crude oil, natural gas, precious metals as well as
agricultural commodities and even livestock largely explains their active role in the commodity derivatives
segment. NFCs are relatively active in foreign exchange (FX) derivative trades as well and account for around
13% of the volumes outstanding in this segment. Indeed, being importers and exporters in increasingly
interconnected international markets, NFCs are exposed to FX risk as never before, and they seek to hedge this
risk via derivatives.
FCs account for the lion’s share of interest rate derivatives (IRDs), with around 83% of these transactions being
done between a dealer and a FC. Market participants use IRDs to hedge the future path of interest rates, which
has become even more important with the extraordinary measures taken by central banks following the crisis.
What is more, IRDs are important for insurance companies and pension funds that have to meet obligations from
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their policies in the distant future and need to offset the risk from transactions involving fixed and floating rates. In
the equity linked derivatives segment, FCs are fairly active as well: 62% of the total outstanding volume is
between reporting dealers and FCs. Considering the episodes of heightened volatility in financial markets in
recent years, it is not surprising to see FCs hedge against volatility risks using equity linked derivatives.
Inter-dealer trades have a higher share among credit default swaps (CDSs) and in the FX segment, where they
account for 47% and 41% of the notional volume respectively. CDSs are one of those products that received a lot
of criticism due to limited transparency regarding counterparty exposures and inadequate collateral posting
practices before the crisis – as CDSs involve jump risk, collecting and updating sufficient initial and variation
margins is particularly relevant in this segment. However, it is important to note that CDSs constitute only a small
part of the OTC derivatives landscape, representing around 3% of the outstanding amounts. More importantly,
dealers are market makers (liquidity providers) that themselves have to hedge imbalances in their trading books.
This is indeed a part of their business model. Even though limited data availability prevents deeper analysis of
market makers’ trading motives, aggregate survey data does shed some light on the trading motives in OTC
derivatives. Around 73% of all derivatives market participants cite “hedging” as their trade motive; 17% respond
“arbitrage” and only 10% cite “speculation” as their trade motive.
All in all, the perception that the OTC derivatives market is an inter-dealer market looks exaggerated. The efficient
redistribution of risk through hedging probably has a positive impact on the cost of capital for firms and their
investment decisions.
* For the commodity derivatives segment, available data only differentiates between FCs (including dealers) and NFCs.
Authors:
Orcun Kaya (+49) 69 910-31732
Svenja Frieß
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