The BIS Quarterly Review for December 2010, released today, discusses how the focus of market participants has shifted to renewed worries about sovereign risk in the euro area from the global impact of further monetary policy easing in the United States.
In addition, it features four articles on FX and OTC derivatives drawing on the Triennial Central Bank Survey released at the beginning of December (more detailed abstracts follow):
- Turnover in FX markets has risen to $4 trillion since the 2007 survey. Growth owed largely to the increased trading activity by high-frequency traders, banks trading through the biggest dealers, and online trading by retail investors.
- Turnover of derivatives in emerging markets has grown more rapidly than in developed countries. FX derivatives are the most commonly traded instruments.
- The volume of outstanding credit default swaps has nearly halved since the end of 2007, as market participants have intensified efforts to reduce counterparty risk.
- A user's guide to the Triennial Central Bank Survey of foreign exchange market activity highlights key dimensions of this dataset and methodological issues that are important to interpret it correctly .
Monetary policy and sovereign debt concerns drive markets
In the period from late August to the beginning of December, two themes dominated global financial markets. Through early November, the perceived slow pace of economic recovery in the major advanced economies helped intensify investor expectations that central banks would introduce further accommodative measures. Since early November, concerns about sovereign risk in several euro area economies have resurfaced and become the dominant theme.
Much of the focus during the initial period was on the US Federal Reserve and its early November announcement of a second round of large-scale Treasury bond purchases. The Fed's ultimate announcement followed a prolonged period during which senior officials gave speeches combined with other public statements in an effort to prepare markets. As a consequence, US real and nominal bond yields dropped significantly while equity prices rose strongly between August and early November as investors increasingly priced in the expected actions. At the same time, market indicators suggested that bond investors were revising upwards their US inflation expectations.
The Fed's anticipated monetary easing had a visible impact on market prices well beyond the United States as well. The US dollar depreciated against most other major currencies. Together with even lower US interest rates, this made the dollar the funding currency of choice for FX carry trades and intensified capital flows to emerging markets. The result, which was reflected in higher equity and bond prices in the faster-growing emerging market economies, prompted a number of these countries to introduce policy measures aimed at dampening the rate of capital inflows.
Since early November, attention has shifted to the euro area, with market participants becoming increasingly concerned about exposures to Ireland and other economies. Once again, credit spreads increased significantly on government bonds issued by affected countries. This time concerns were driven by two factors: the deteriorating fiscal situation in Ireland that resulted from continued government support for troubled banks; and consideration of EU treaty changes that would make it possible to impose losses on holders of bonds issued by governments in financial distress. Even as an EU support package for Ireland was agreed in late November, the stress persisted, with attention turning first to Portugal and Spain and later to Belgium and Italy. The situation did, however, stabilise in early December in anticipation of possible ECB support.
Highlights from the BIS statistics
The balance sheets of BIS reporting banks, which in the first three months of this year had expanded for the first time since the start of the crisis, ceased to grow during the second quarter of 2010. That said, at a more disaggregated level, several trends that had characterised international bank lending over the past few quarters remained in place. Banks continued to direct funds towards the faster-growing emerging markets at the expense of the slower-growing advanced economies. Just as in the previous couple of quarters, lending patterns diverged considerably across the four emerging market regions. In particular, banks continued to increase their exposures to the buoyant economies of Asia-Pacific and Latin America-Caribbean, but cut cross-border lending to residents of the somewhat slower-growing emerging Europe and Africa-Middle East regions. Amidst the turmoil in global financial markets triggered by concerns about the fiscal situation in Greece, Ireland, Portugal and Spain, foreign claims on these countries decreased during the second quarter.
Activity in the primary market for international debt securities rebounded in the third quarter of 2010, reversing most of the sharp drop that occurred during the European sovereign debt turbulence in the second quarter. Completed gross issuance increased to $1,934 billion in the third quarter, 15% higher than in the previous three months but short of the $2,175 billion recorded in the first quarter. With repayments down 7%, net issuance rose to $475 billion, from $111 billion in the second quarter. Between January and March, issuers had raised $603 billion in the international debt securities market.
Both sharp movements in asset prices and ongoing efforts to mitigate counterparty risk had a strong influence on over-the-counter (OTC) derivatives markets in the first half of 2010. The notional amount of OTC derivatives outstanding fell by 3% in US dollar terms during this period. However, partly as a result of the growing concern over sovereign risk, substantial movements in asset prices drove up the gross market value of these contracts by 15% and the gross credit exposures associated with them by 2%. Consistent with the increased use of central counterparties (CCPs) in some segments of the market, there was a smaller rise in gross credit exposures than in gross market values, reflecting increased netting. The ratio of gross credit exposures to gross market values consequently fell to 14.5% at the end of the first half of 2010, down from 16.3% at the end of 2009 and 24.0% at the end of the first half of 2007.
Trading on international derivatives exchanges, as measured by turnover volume, declined in the third quarter of 2010. Turnover measured by notional amounts fell by 21% to $438 trillion between July and September. The decline in volumes affected all major risk categories. Trading in interest rate contracts receded by 23% to $371 trillion, primarily as a result of lower activity in contracts on short-term interest rates (-24%, to $328 trillion). Turnover in futures and options on stock indices fell by 12% to $57 trillion, and that in contracts on exchange rates by 22% to $9 trillion.
The $4 trillion question: what explains FX growth since the 2007 survey?
Daily average foreign exchange market turnover reached $4 trillion in April 2010, 20% higher than in 2007. The article by Michael King (BIS) and Dagfinn Rime (Central Bank of Norway) shows that this growth is largely due to the increased trading activity of financial institutions other than reporting dealers. Within this rather heterogeneous category, which contributed 85% of the higher turnover, the authors identify high-frequency trading, banks trading through the biggest dealers, and online trading by retail investors as the main factors behind the rise in activity. They argue that electronic trading, particularly algorithmic trading, was instrumental in this increase.
Derivatives in emerging markets
Turnover of derivatives has grown more rapidly in emerging markets than in developed countries. Dubravko Mihaljek and Frank Packer (BIS) point out that FX derivatives are the most commonly traded instruments, with increasingly frequent turnover in emerging market currencies, as well as a growing share of cross-border transactions. As the global reach of the financial centres in emerging Asia has expanded, the offshore trading of many emerging market currency derivatives has risen. The authors show that the growth in derivatives turnover in emerging markets is positively related to trade, financial activity and per capita income.
Counterparty risk and contract volumes in the credit default swap market
After more than a decade of rapid growth, the volume of outstanding credit default swaps peaked at almost $60 trillion at the end of 2007. Since then it has nearly halved, while turnover has continued to rise. The article by Nicholas Vause (BIS) ascribes the decline in volumes outstanding to intensified efforts to reduce counterparty risk, which have eliminated more than $65 trillion of offsetting positions.
A user's guide to the Triennial Central Bank Survey of foreign exchange market activity
This article by Michael King and Carlos Mallo (BIS) provides an overview of the foreign exchange components of the Triennial Central Bank Survey. It highlights key dimensions of this dataset, as well as methodological issues that are important in correctly interpreting the information it contains. The authors also compare the methodology of the Triennial to that of more frequent surveys from regional foreign exchange committees.