Atkeson, Α., Eisfeldt, Α. & Weill, P. O. (2014) “Entry and Exit in OTC Derivatives Markets“, VoxEU Organisation, 17 Σεπτεμβρίου.
Entry and trading in over-the-counter (OTC) derivatives markets have received considerable attention. However, many critical questions remain unaddressed. This column describes a formal study of banks’ incentives to enter and trade in OTC derivatives markets. In equilibrium, only large banks enter to become dealers, and middle-sized banks only enter as customers. Care should be given not to reduce rents so much when dealer participation costs are high.
Several observations regarding entry and trading patterns in over-the-counter (OTC) markets for interest rate and credit derivatives have recently received considerable attention from policymakers and the public alike.
OTC derivatives markets are large. For example, the total gross notional of derivatives contracts on US bank balance sheets is over 17 times the size of their assets.
The large volume of bilateral trades at varied prices creates an intricate liability structure between participating banks. These liability linkages are thought to potentially create systemic risk (see Stultz 2010 for a detailed discussion in the context of CDS markets).
OTC derivatives gross notionals are concentrated on the balance sheets of the largest dealer banks. In the US, on average, about 95% of OTC derivatives gross notional held on bank balance sheets was concentrated in the top five banks (Atkeson et al. 2013 describe the stylised facts characterising CDS markets).
These large banks intermediate a large volume of trade. They trade many contracts in both directions, long and short, and they have very large gross positions relative to their net positions.
In contrast, medium-sized banks act as ‘customers’ – they trade mostly in one direction, either long or short, so their gross and net positions are close to each other.
To put a few of these facts into context, Figure 1 plots the net to gross notional for index credit default swap (CDS) contracts reported by the Bank for International Settlements (BIS) in the first half of 2013. The figure shows that reporting dealer banks and central clearing parties tend to net almost all of their long and short trades, while other institutions are either long or short on net. Gross notional is not plotted, but, as we will show below, reporting dealers trade the majority of notional value, followed closely by central clearing parties.
Figure 1. Net/gross trades H2 2013 (CDS bought-CDS sold)/(CDS bought+CDSsold)
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- Moreira, A. & Savov, A. (2014) “Shadow banking and the economy“, VoxEU Organisation, 16 Σεπτεμβρίου.
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- Visco, I. (2013) “The aftermath of the crisis: Regulation, supervision and the role of central banks“, Centre for Economic Policy Research, Policy Insight No.68, Δεκέμβριος.