Michael J. Fleming, John Jackson*, Ada Li*, Asani Sarkar, and Patricia Zobel*
In recent years, regulators in the United States and abroad have begun to strengthen regulations governing over-the-counter (OTC) derivatives trading, driven by concerns over the decentralized and opaque nature of current trading practices. For example, the Dodd-Frank Act will require U.S.-based market participants to publicly report details of their interest rate derivatives (IRD) trades shortly after those transactions have been executed. Based on an analysis of new and detailed data on the trading activity of major dealers, this post discusses the possible costs and benefits of reporting requirements on the IRD market. In a previous post, we examined the same question for the credit default swap (CDS) market.
Interest Rate Derivatives Defined
An interest rate derivative is an agreement to exchange payments based on different interest rates over a specified period of time. IRD products enable interest rate risks to be hedged, and are thus valuable tools for allowing both financial and industrial firms to manage their risk exposures. For example, the owner of a bond who receives 5 percent annual interest in U.S. dollars could reduce interest rate risk by entering into an interest rate swap (IRS) denominated in U.S. dollars that obliged him to make fixed interest payments that precisely offset those expected on the bond, and entitled him to receive variable payments based on the prevailing market rate of interest at the time each payment was made.
Costs and Benefits of Trade Reporting Rules
The introduction of mandatory trade reporting rules may have costs and benefits for market participants. The vast majority of IRD products are currently traded in the OTC markets where, because of the markets’ decentralized nature, information on traded prices is not widely available. Providing price information may be valuable to investors because it could make it easier for them to evaluate the competitiveness of a price quote. It could also help risk managers more accurately measure the value of their positions. Prices can change rapidly in these markets, so these benefits increase with the timeliness of the price information.
The risk of introducing reporting rules is that, if details of a large trade by a dealer, say, are rapidly made public, participants on the sideline may anticipate the dealer seeking to offset its position and may execute trades to profit from such knowledge. As a consequence of such “front-running,” dealers would be obliged to hedge at worse prices. This risk of being front-run might in turn make dealers reluctant to provide liquidity for large trades or more inclined to widen bid-ask spreads to reflect the increased cost of hedging.
Trading Frequency of Interest Rate Derivatives Is Low and Variable
The frequency of trading in most IRD instruments is low, suggesting that the benefits of price reporting may be limited by the scarcity of activity. Our analysis, which covers approximately 70 percent of all transactions in the global IRD market between June and August 2010, identifies only 2,500 transactions per day spread across eight derivative products and twenty-eight currencies.
At the same time, there is considerable variation in trading frequencies across different products and currencies, so the quantity and timeliness of reported data will vary substantially. The most active product, IRS, accounts for over 1,900 transactions per day, while the least active product, interest rate options known as “Caps/Floors,” account for an average of eleven transactions per day. While 78 percent of all transactions take place in the four most active currencies (U.S. dollar, euro, yen, and sterling), there are several other currencies with less than five transactions per day across all product types.
Product Standardization Is High in Some Features and Low in Others
We find evidence that some important contractual terms are standardized in the IRD market. For example, all U.S. dollar, euro, and sterling IRS transactions reference a single floating rate index in each currency for calculating payments, and a high percentage of transactions have the same frequency of payments. Such standardization likely increases the benefits of transparency because it means that reported prices are more comparable over time for similar IRD transactions.
By contrast, the maturity of IRD contracts varies considerably across transactions. In the IRS market, 57 percent of all activity in the four most active currencies (or 855 transactions per day) is concentrated in the five most commonly traded maturities (that is, two, three, five, ten, and thirty years), but the remaining 43 percent of transactions (or 645 trades per day) are dispersed over numerous different maturities. In the most active maturities, reported data is likely to be sufficiently timely to benefit customers, but for the less actively traded maturities, the benefit may be more limited.
Participation Is Low but Active Customers Have Many Dealer Counterparts
Liquidity in the OTC IRD market is typically provided by dealer firms, which act as market makers by quoting prices and facilitating transactions for their customers. Our data indicate that in the most active sectors of the IRD market the majority of participants have trading relationships with several major dealers. For example, moderately active participants (such as those who trade IRS between two and five times per day on average) trade with ten dealers over the sample period. Only forty-three participants, most of whom are relatively inactive traders, transact with just a single dealer. The opportunity to trade with multiple dealers enhances the ability of participants to compare prices prior to trading, and may limit the additional benefits of post-trade price transparency.
Strong Evidence of Dealer Hedging
In order to make markets and provide liquidity to customers continuously, dealers need to manage the interest rate risk they take on when trading with customers. We find strong evidence in the case of IRS denominated in the most active currencies that dealers are able to offset large risk exposures promptly—in about thirty minutes. Our results mitigate the concern that introducing price reporting would hinder dealers’ ability to hedge their risks, at least for actively traded IRS products.
Implications for Public Reporting
Our findings suggest that the benefits from trade reporting rules are likely to accrue dissimilarly to different segments of the IRD market. The benefits are likely to be limited for segments of the IRD market that have low levels of trading activity and where activity is dispersed across a wide range of products, currencies, and contract maturities. In contrast, trade reporting rules are likely to provide greater benefit to participants in the relatively active segments of the IRD market. For these market segments, timely trade information may broaden the market as firms that currently have limited access to dealers are encouraged to participate. We also show that dealers offset their risks quickly in these more active market segments, alleviating concerns about the potential negative impact on liquidity of reporting requirements.
*Patricia Zobel is an assistant vice president in the Markets Group and Ada Li a senior bank examiner in the Financial Institution Supervision Group (FISG) of the Federal Reserve Bank of New York; John Jackson is on secondment to FISG from the Bank of England.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Thank you for your comment. Our post is a little terse, and we neglected to mention that our findings assume that there are accompanying reporting protections for large trades. Our interpretation is explained more fully in our paper (http://www.newyorkfed.org/research/staff_reports/sr557.pdf) on page 20: “Our findings suggest that introducing a public reporting regime may not disrupt hedging activity in IRS as long as there are meaningful protections that delay reporting or mask trade sizes after the execution of a large trade.” That is, protections that delay reporting or mask trade sizes after the execution of a large trade should typically allow dealers to offset much of the trade before the full details of the trade are reported. We welcome any additional feedback you may have.
You have gathered interesting data but then misinterpreted some of your findings. The fact that dealers try to quickly hedge (although generally it’s done in a much shorter time-frame than 30 minutes) doesn’t LESSEN the possibility that trade reporting will lead to less liquidity, it INCREASES it. In order to make a tight market for size to the customer, the dealer relies on being able to execute size in related markets (e.g., the Treasury market) without other dealers worsening their quotes for that liquidity. If other dealers know the transaction size and direction within moments of execution, then that related liquidity will not be available; knowing this, dealers will widen the primary price quote, “shade” it, or try and get some of the hedge off before the trade is actually consummated – although there is some question whether the latter activity may in the future constitute “proprietary trading.” You can see examples of this trading in the occasional bond market meltdowns associated with mortgage extensions in the early and mid-00s. GSE#1 hits dealer#1 for 1bln IRS (dealer receiving fixed); dealer hits the Treasury market for 1bln 10y Treasuries, but gets weak fills as the market slides; now GSE#2 finds itself needing to hedge and the process repeats. On occasion, the market would drop precipitously simply because all participants knew that GSE#2 was in the market, and dealers would try to “miss” since winning…was losing. The dealer couldn’t hedge.