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Corporates are driving growth in global derivatives market Back  
The uncertain and changing global economic environment in the past few years has fuelled a dramatic increase in turnover in the euro derivative market. Interest rate derivatives are a cost-efficient and price effective way of neutralising or hedging exposure to future interest rate moves. Uncertainty regarding the future path of interest rates greatly impacts economic decisions across finance and industry. Thus, both corporate and financial institutions are increasingly relying on interest rate derivatives to manage their exposure to undesirable interest rate moves writes Conor Dooley in this market overview.
<Economic review
Volatility is the fundamental feature of global financial markets (see fig 1 gives one such example of interest rate volatility). Since 1999, the global economic landscape has changed significantly and currently the prevailing level of interest rates is lower than it was at the birth of the new euro currency. At the launch of the euro in 1999 the repo rate was 3 per cent, and the global economy was in good health, thanks to a strong US economy, buoyed by the IT sector and the euphoria over the potential of the internet. The above trend growth was of some concern to global central banks and they increased official rates to cool economies.

In Europe, the repo rate was increased to 4.75 per cent by October 2000. In the US, high interest rates began to take their toll on the economy and the internet euphoria cooled as the ‘dot.com’ stock market bubble burst. This was subsequently followed by the events of 9/11 that had a dramatic effect on global interest rate markets. The outlook for global growth changed direction very rapidly and now appeared highly uncertain. Central banks took action to provide support to weakening economies and to prevent deflation taking hold. In Europe, the ECB cut rates to as low as 2 per cent in June ’03, and kept them at that level as economic uncertainty took hold.

Most recently, in April of this year there was intense speculation regarding a further rate cut following comments by the ECB governor, Jean-Claude Trichet. This rate cut did not materialise but the speculation and hedging ahead of this potential rate cut was intense, and led to significant volume increase in the Eonia swap market, the IRS market and the euro interest rate futures and options markets.

Since then there are signs that a global recovery is taking hold and there have been interest rate rises in a number of economic areas, notably the UK and the US. Market expectations for official rates in Europe are to remain unchanged in the near term with rate increases priced in for 2005 and beyond.

Market activity in derivative OTC market
I am a member of the dedicated Euro interest rate management team in AIB Global Treasury with responsibility for neutralising and managing the euro interest rate exposure in AIB plc. As well as using euro interest rate derivatives to manage exposure we are also market makers to other financial institutions. This is primarily in interest rate swaps and specifically Eonia swaps. Briefly, Eonia swaps fix against the daily Eonia fix, ie, the computed weighted average of all overnight unsecured lending transactions in the interbank market. All money market banks are very sensitive to this rate and need to hedge this on an ongoing basis. In general this fix is close to the repo rate set by the ECB. Eonia activity comprises of market making activities, arbitrage opportunities (versus FRAs or Euribor Futures), position taking and importantly, hedging activities resulting from underlying cash positions.

With the increased demand for derivative products has come a requirement for finer pricing and greater liquidity in all market conditions. The users of the market have become more sophisticated and the product suite available has grown in size and complexity. Derivative markets comprises both ‘Over-the-Counter’ (OTC) and exchange-traded products however, enhanced sophistication has led to the OTC market outstripping the exchange-traded market in importance. OTC advantages include specific tailoring of risk management products, no margin calls, and have led to the evolution of electronic trading platforms thereby increasing transparency and reducing transaction costs. One disadvantage of OTC derivatives versus the exchange-traded market is the inherent credit risk (i.e. default risk) exposure they possess. But great advances in credit risk measurement and credit support annexes (CSAs) can mitigate the credit risk impact on further interest rate derivative growth.

The main products utilised are interest rate swaps, interest rate swaptions, and Eonia swaps. The global OTC derivatives market in 1998 was $80 billion and rose to $197 billion in 2003 (see fig 2). Of this, interest rate swap activity tripled from $36 billion (’98) to $111 billion (’03). As such, we will primarily concentrate on swaps for remainder of this article. Note that during this period, exchange-traded markets averaged an annual turnover of $20 billion.

A few major market participants dominate the Eonia swap market. They distinguish themselves in their ability to make a market (prices), manage sizeable portfolios and to trade in substantial size (ticket sizes of €10 billion are not uncommon). The intense competition results in tight bid-offer spreads and deep liquidity, which ultimately attracts other participants (price-takers) to the Eonia market, i.e., other banks, hedge funds, corporates etc. However, there remain doubts regarding the pricing power of these few large market participants especially in times of extreme volatility. Figure 3 reflects the recent importance of the Eonia market relative to other OTC products.

Further developments
Even though the Eonia market is highly evolved, there is room for further development. An introduction of daily Eonia fixings for term maturities up to one year is an innovation that would further refine this market. This would allow Euribor FRA styled Eonias to be traded. Eonia fixings would properly reflect their growing importance especially over the traditional Euribor fixings. A common perception is that the quality of Euribor fixings has deteriorated in recent years as the relevance of the unsecured cash market diminishes relative to the secured and derivative market.

Furthermore, Eonia fixings may promote the embryonic forward Eonia market. These discussions are currently ongoing at ACI Euribor and Banking Federation working group levels.

Further refinements to interest rate derivatives will result from the adoption of Basel II and IAS 39.
• The new Basel Capital Accord proposals, Basel II are aimed to encourage banks to manage their capital more efficiently and improve risk controls. It is suggested that credit ratings will be influenced and opportunities will exist to enhance competitive advantages. As a consequence, derivative capacity should increase for those banks that appropriately adopt Basel II.
• IAS 39, the new accounting proposals are due to be implemented in Jan ’05, subject to an I A S B review in Sept ’04. IAS 39 will affect all interest rate derivatives, including options, rights, warrants, futures contracts, forward contracts, and swaps. In short, it proposes stricter criteria around the accounting treatment of hedging involving the use of interest rate derivatives. Total derivative hedging activity is uncertain post IAS 39 but generally accepted that there should be more trades but of lesser notional amounts.

Positive outlook
In conclusion, whereas the interest rate derivative market is well established in the interbank market future growth is envisaged to come from the corporate sector. Corporates need to hedge against interest rate exposures as banks do but traditionally are reluctant to do so. The International Swaps and Derivatives Association (ISDA) reported recently on changes to corporate behaviour with evidence that over 90 per cent of the world’s 500 largest companies are currently using financial derivatives. The percentage is much lower for smaller companies and especially those in Europe. It is estimated by some sources that over €600 billion is trapped in inefficient cashflow management strategies, such as leaving monies on deposit instead of utilizing money market funds.

Significant interest rate risk reduction is a compelling reason for corporates to initiate interest derivative strategies. Greater awareness, knowledge and confidence in the derivative market, combined with cost effectiveness and advances in technological trading applications make derivatives more accessible to corporates. Ultimately this will underpin the future growth in the interest rate derivative market.

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