IFSL research Derivatives 2009

In partnership with: IFSL RESEARCH JUNE 2009 DERIVATIVES 2009 OVERVIEW Rapid growth in the derivatives industry seen over a long period was checked in 2008 This overview summarises developments in both OTC and exchange-traded derivatives and reviews the influence of derivatives on the financial crisis OTC Derivatives Markets The notional outstanding value of OTC derivatives contracts fell by 13% from the peak of $684 trillion in June to $592 trillion at end-2008: the first fall since BIS started collecting figures in 1998 (Chart 1) Key contributor to this decline was the move to central counterparty clearing of some contracts following concern over systemic risks posed by OTC derivatives In addition, voluntary terminations of contracts reduced the total value of credit default swaps (CDS) contracts Gross market value more than doubled from $16 trillion to $34 trillion during 2008, as a result of volatility of prices associated with greater risks in many derivatives contracts (Table 1) Higher market value was reflected in a rise in gross credit exposure, up over a half to $5.0 trillion Interest rate instruments remain the mainstay, accounting for 71% of global notional value Derivatives based on foreign exchange contracts make up a further 8% The balance consists of foreign exchange, CDS, commodities and equity linked derivatives, all of which declined in 2008 The euro and the US dollar are the most widely traded currencies in single currency interest rate derivatives, with 37% and 35% shares respectively in 2008 UK was the leading derivatives centre for trading OTC derivatives worldwide in April 2007 with its share of turnover stable at 43% The US was the only other major location with 24% of trading Exchange-traded derivatives Notional outstanding value of exchangetraded derivatives fell by 29% in the second half of 2008 (Chart 1), while value of turnover dropped by 47% in the 12 months to Q1 2009 (Chart 2) Strong trading in the first half meant that annual turnover fell by only 3% in 2008 to $2,214 trillion, having risen by about a quarter annually in each of the four previous years BIS notes that the decline in trading during the second half of 2008 reflects a combination of significantly reduced risk appetite, expectations of stable low interest rates in major markets and lower hedge fund activity The decline in turnover slowed to 3% in the first quarter of 2009, although over the whole of 2009 turnover could be 25% down on 2008 Exchanges have seen considerable consolidation in recent years Based on notional value of trading, the biggest exchange groups worldwide are CME Group, NYSE Euronext (largely based on NYSE Liffe) and Eurex These three exchanges account for over a half of turnover value London has a prominent role in global exchange-traded derivatives NYSE Liffe is the leading exchange in the trading of short-term euro interest rate contracts: 98% of NYSE Liffe turnover by value takes place on the London exchange At least 45% of Eurex trades have originated in the UK since 2003 More than 90% of international business in non-ferrous metal futures is transacted at the London Metals Exchange ICE Futures Europe is the WWW.IFSL.ORG.UK Chart International derivatives markets $ trillion, notional amounts outstanding, June & December 700 Over-the-counter 600 500 400 300 200 Exchange-traded 100 1998 2000 2002 2004 2006 *Exchange-traded March 2009 Source: Bank for International Settlements 2008 2009* Table Measures of activity in international derivatives markets $ trillion (except contracts traded) OTC market 2006 2007 Notional value 414.8 595.3 Gross market value 9.8 15.8 Gross credit exposure 2.0 3.3 2008 592.0 33.9 5.0 % change -2007 2008 44 -1 62 114 60 54 Exchange-traded derivatives Notional value 79.1 69.4 57.9 Turnover 1807.7 2288.0 2213.3 Contracts traded (bn)12.0 15.6 17.8 14 27 30 -27 -3 14 Source: Bank for International Settlements, Futures Industry Association Chart International exchange-traded quarterly turnover by value $ trillion, quarterly value of turnover 700 600 500 400 300 200 100 2005 2006 2007 2008 2009 Source: Bank for International Settlements IFSL leading electronic global exchange for energy products European Climate Exchange, part of ICE Futures Europe, is the leading carbon markets exchange in Europe for futures and options trading Derivatives account for the majority of UK banking sector spread earnings on derivatives, foreign exchange trading and other securities transactions, which combined totalled £9.5bn in 2007 and an estimated £10bn in 2008 Derivatives and the financial crisis While there are differing views on the role of OTC derivatives as a contributory cause to the crisis, the drive for regulatory repair will include much closer oversight of these markets, the imposition of comprehensive trade reporting to the regulatory authorities and widespread use of central clearing Although the regulatory authorities are concentrating on collateralised debt obligations (CDOs) and the central clearing of CDS, it is clearly the intention in both the EU and the US to propose tighter regulation for OTC markets in general The underlying issue for market users is whether closer regulatory oversight and the pressure to standardise contracts will result in a reduction in product diversity and a scaling back of the capability of customers to manage their diverse and often complicated underlying risks The position is further complicated by strong indications in the US that standardised OTC contracts will be required to be executed on (and not just cleared through) an exchange or by a regulated trading system Other measures under consideration include the application of higher capital requirements to cover the proprietary trading of banks and other institutions, particularly in high-risk products and the imposition of leveraged ratios This could impact on market liquidity in both OTC and exchange-traded contracts The emerging focus on development of “safety first” regulation could also reduce innovation, which has always been at the forefront of the OTC and derivative markets in general The aim of US authorities is to facilitate expansion of exchange-traded products and downplay OTC contracts While exchanges would benefit from such a move, some major exchanges have said that OTC derivatives should not be forced onto clearing houses which are not equipped to deal with the associated risks The exchanges said that market participants should have a role in determining the extent to which OTC products are standardised Whatever the eventual outcome the regulatory climate needs to preserve the widespread availability of derivatives products, both OTC and exchangetraded, as important risk management tools The derivatives industry is also concerned about any moves that disadvantage London, as the leading global centre for OTC derivatives, relative to other centres OVER THE COUNTER DERIVATIVES MARKETS Data on global OTC derivatives markets is generated mainly from statistics compiled by the Bank for International Settlements (BIS): the six-monthly survey of major market participants and the triennial central bank surveys Five triennial surveys have been undertaken, the most recent in April 2007 I Six monthly BIS survey of major market participants Size Indicators of activity in OTC markets have shown divergent trends in the past year Notional value fell in the second half of 2008, while gross market Derivatives 2009 Measures used in BIS survey Nominal or notional amounts outstanding provide a measure of market size, and can also provide a rough proxy for the potential transfer of price risk in derivatives markets They are also comparable to measures of market size in related underlying cash markets Gross market value supplies information about the scale of gross transfer of price risks in the derivatives markets Essentially it represents of the cost of replacing all existing contracts It provides a measure of market size and economic significance that is readily comparable across derivatives markets and products Gross credit exposure represents the current value of contracts that have a positive market value after taking account of legally enforceable bilateral netting agreements, i.e it measures netted credit exposures between counterparties Turnover data collected in the triennial survey provide a measure of market activity, and can also provide a rough proxy for market liquidity Turnover is defined as the absolute gross value of all new deals entered into during the month of the surveys, and is measured in terms of nominal or notional amount of the contracts Chart OTC derivatives markets $ trillion, June & December Gross market value 40 Gross credit exposure Gross credit exposure 35 30 25 20 15 10 Gross market value 1998 2000 2002 2004 Source: Bank for International Settlements 2006 2008 IFSL Derivatives 2009 value and gross credit exposure both rose: - - - Notional value Moves to greater centralised clearing have contributed to a 13% fall in the notional value of OTC derivatives from $684 trillion in June to $592 trillion in December 2008 (Chart 1) This is the first such fall to be recorded by BIS since it started compiling the statistics in 1998 Notional value of exchange-traded derivatives declined by 27% in the second half of 2008, and was only one tenth the value of OTC derivatives at the year end Gross market value more than doubled from $15.8 trillion to $33.9 trillion between the end of 2007 and 2008 (Chart 3) This was a result of volatility of prices associated with increasing risk in many derivatives contracts Gross credit exposure reflected the rise in gross market value although the rise was less, up by 53% from $3.3 trillion to $5.0 trillion (Chart 3) Risk instruments Interest rates are the main instrument in the OTC derivatives market, having accounted for around 70% of contracts in recent years (Table 2) The share of derivatives based on foreign exchange contracts has fallen from 11.3% to 8.4% since 2004 Declining prices in equity markets have contributed to a lower share of equity derivatives over the past two years More recently the slump in commodity prices in 2008 halved commodities share from 1.4% to 0.7% CDS share fell from 9.7% to 7.1% (see paragraph on CDS on page 4) Currency composition The euro and the US dollar are the most widely traded currencies in single currency interest rate derivatives, with 37% and 35% shares respectively in 2008 (Table 3) They were followed by the Japanese yen with over 13% and pound sterling 7% Swedish krona and Swiss franc each made up just over 1% and other currencies 5% Table Risk instruments in global OTC markets Notional amounts outstanding in December $ trillion 2002 2004 2006 2007 Interest rates 102 191 393 292 Foreign exchange 18 29 56 40 Credit default swaps 58 29 Equity-linked Commodity 1 Unallocated 18 27 71 43 Total contracts 142 259 595 418 2008 419 50 42 71 592 % share Interest rates 71.8 Foreign exchange 13.0 Credit default swaps Equity-linked 1.6 Commodity 0.7 Unallocated 12.9 Total contracts 100.0 70.7 8.4 7.1 1.1 0.7 12.0 100.0 73.7 11.3 2.5 1.7 0.6 10.3 100.0 69.7 9.6 6.9 1.8 1.7 10.3 100.0 66.0 9.4 9.7 1.4 1.4 12.0 100.0 Source: Bank for International Settlements Table Currency breakdown of single currency interest rate derivatives Notional amounts outstanding $ trillion, by currency, end-year Euro US dollar Japanese yen £ sterling Swedish krona Swiss franc Others All currencies 2007 146 130 53 28 27 393 2008 155 146 56 30 5 22 419 -% share 2007 37.2 33.0 13.5 7.2 1.3 1.0 6.7 100.0 2008 37.0 34.9 13.5 7.1 1.2 1.2 5.2 100.0 Source: Bank for International Settlements II BIS coordinated triennial central bank survey (April 2007) Location International OTC derivatives trading is heavily concentrated in the UK and US (Table 4) The share of global turnover of the UK and US remained stable at 43% and 24%, respectively, in the April 2007 survey Over the longer period the UK’s share has risen from 36% in 2001, while the US share has grown from 18% Germany’s market share dropped from 13% in 2001 to 4% in 2007 and France from 10% to 7% Ireland showed the largest gain with its share rising from less than 1% in previous Table Location of OTC derivatives turnover surveys to over 3% in 2007 Japan’s share also edged up to just Average daily turnover in April over 3% Counterparties The major feature of the global counterparty breakdown was a further rise in the share of other financial institutions to 44%, close to the 46% share of reporting dealers The global share of non-financial customers also edged up to 10% Distribution of trading by counterparty in the UK was more closely aligned with global shares in 2007 than previously Concentration The OTC derivatives market in the UK became even more concentrated between 2004 and 2007, with the share -$bn 1998 2001 2004 2007 UK 275 171 643 1081 US 135 90 607 355 France 67 46 183 154 Germany 97 34 93 46 Japan 22 42 85 39 Ireland 85 13 Switzerland 15 16 73 18 Singapore 11 69 17 Italy 24 32 41 Others 141 62 268 223 Total 764 1508 2544 475 -% share -2004 2007 1998 2001 42.6 42.5 36.0 36.0 23.5 23.9 18.9 17.7 10.2 7.2 9.7 8.8 3.1 3.7 7.2 12.7 2.6 3.3 8.8 2.9 0.9 3.3 0.6 0.8 1.2 2.9 3.4 2.0 1.1 2.7 2.3 0.8 2.7 1.3 1.1 3.1 14.8 10.5 13.1 18.5 100.0 100.0 100.0 100.0 Source: Bank for International Settlements IFSL of the largest 10 institutions rising from 79% to 81% In 1995 the share of the top ten had been 52% In the US, the other major location, survey data indicates that in 2007 the share of the largest ten institutions was even higher than in the UK at over 90% of turnover III Other developments in OTC derivatives markets Centralised clearing Concerns about the systemic risk posed by some OTC derivatives contracts were raised in the wake of the credit crunch These focused on the potential impact of the collapse of Lehman Brothers on other brokers; and the potential threat posed by the huge volume of toxic securities As a result some classes of standardised OTC derivatives contracts, including interest rate swaps, commodities and CDS have been brought into centralised clearing Derivatives 2009 Chart Credit default swaps $ trillion, notional amounts outstanding, end-year ISDA 60 50 40 30 BIS 20 10 Credit default swaps (CDS) In CDS one party promises to pay another party 2000 2001 2002 2003 2004 2005 2006 2007 2008 a fixed fee in exchange for a guarantee that if a bond defaults it will be Source: International Swaps and Derivatives Association (ISDA), Bank for International Settlements (BIS) redeemed Centralised clearing and voluntary termination of contracts has contributed to a 39% drop in notional amounts outstanding of CDS from $62 trillion at end-2007 to $38 trillion at end-2008, according to the Table Gas & power derivatives International Swaps and Derivatives Association (ISDA) (Chart 4) This Contracts transacted by brokers in the UK, decline is slightly larger than the 28% fall in the BIS data, although Twelve months ending July % change previously the two series have moved closely in parallel ISDA’s longer Size of market, TWH* 2004 2005 2006 2007 2008 2008 12 1311 688 646 985 1104 UK power time series show that notional value of CDS had mushroomed over the -23 4206 5089 6131 12810 9919 UK gas previous four years from less than $4 trillion at end-2003 -41 2879 2525 3127 6337 3758 Euro power Energy derivatives There are a range of participants actively trading energy-related financial instruments including oil and gas producers, utilities, refiners and other industrial consumers, investment banks and hedge funds Following several years of strong growth in the energy OTC derivatives markets covering power and gas forward contracts, trends in the year to end-July 2008 were more mixed The FSA’s annual survey of energy market brokers showed that volumes in 2008 in the UK gas and European power were down by 23% and 41% respectively having both doubled in 2007 (Table 5) These two markets remain the largest by volume By contrast the other four markets all saw growth in trading in 2008, particularly emissions trading Applied prices rose by between 50% and 100% in the markets covered in the survey This is consistent with the strong rise in global commodity prices that was in evidence across the survey period As a result, the notional value of four of the six markets - UK power, Euro gas, coal and emissions - more than doubled in 2008 Notional value of gas contracts also rose, by 31% to £176bn, as the jump in prices more than offset the 23% fall in volume In the case of European power notional market value fell by 9% as the 54% rise in price was insufficient to counter the drop in volume Between a half and three quarters of business in the various markets was traded through screen-based electronic platforms Freight derivatives A number of the large broking houses are using freight derivatives to hedge or take a position on the future movement of freight rates According to Baltic Exchange estimates, the notional value of trading in Forward Freight Agreements (FFAs) in the OTC derivatives market rose from $142bn in 2007 to $163bn in 2008, although the steep decline in 895 Euro gas 576 Coal (m tonnes) Emissions (m tonnes) 689 415 121 673 1110 1509 926 1305 1595 379 780 1956 36 22 151 Notional value of market, £bn 35 UK power 40 UK gas 45 Euro power 3.5 Euro gas Coal Emissions 25 54 77 45 1.5 30 108 147 11 107 5.5 30 134 193 11 46 8.8 110 31 -9 145 143 302 63 176 178 27 111 36 *TWH: terawatt hours Source: FSA survey of energy derivatives markets Chart Freight derivatives $bn, notional freight value of Forward Freight Agreements traded each year 160 140 120 100 80 60 40 20 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: Baltic Exchange, Forward Freight Agreement Brokers' Association IFSL shipping markets is likely to result in a much smaller market in 2009 (Chart 5) Previously the market expanded rapidly from $7bn in 2002 to $61bn in 2006 Up until the drop in the market in autumn 2008, FFAs were being increasingly used by larger charterers, shipowners and also by financial institutions such as investment banks The dry bulk market, such as grain and coal, accounted for 95% of the total value of contracts in 2007 and 2008 with wet cargoes, such as oil, making up the remaining 5% The predominance of dry bulk is due to the much higher share of freight costs in the dry market EXCHANGE-TRADED DERIVATIVES MARKETS Derivatives 2009 Chart International exchange-traded derivatives turnover by region $ trillion, annual value of turnover 2250 2000 Europe 1750 8% North America 1500 7% 1250 7% 9% 750 International trading on the exchanges is most easily compared on the basis of the number of contracts traded, although these comparisons are heavily influenced by the contract sizes selected by individual exchanges Small contract sizes raise the number of contracts traded, a particular feature of the Korean, Mexican and Brazilian exchanges, where trading is dominated by individual rather than institutional investors Comparisons based on the nominal value of turnover therefore provide a better indicator of the relative size of the exchanges Value of turnover Notional outstanding value of exchange-traded derivatives fell by 29% in the second half of 2008 (Chart 1), while value of turnover dropped by 47% in the 12 months to Q1 2009 (Chart 2) Strong trading in the first half of 2008 meant that annual turnover fell by only 3% to $2,213 trillion, having risen by about a quarter annually in each of the four previous years (Chart 6) BIS notes that the decline in trading during the second half of 2008 reflects a combination of significantly reduced risk appetite, expectations of stable low interest rates in major markets and lower hedge fund activity The decline in turnover slowed to 3% between Q4 2008 and Q1 2009 (Chart 2) 500 15% 9% 32% 250 34% 59% Number of contracts traded The number of contracts transacted through derivatives exchanges worldwide has continued to rise in 2008 to 17.8bn CME Group, with 3.3bn contracts, is the largest 10 11 12 13 14 21 35% 39% 51% 8% 33% 41% 56% 53% 59% 50% 32% 35% 38% 60% 54% 58% 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: Bank for International Settlements Chart Largest derivatives exchanges Value of derivatives turnover, $ trillion 1200 CME 1000 800 NYSE Liffe 600 400 Eurex 200 Turnover of exchange-traded derivatives is heavily concentrated on the Source: CME Group, NYSE Liffe & Eurex exchanges of North America and Europe, which have accounted for over 90% of trading by value in recent years According to BIS data, 53% of turnover by value in 2008 was based in the North American Table Largest derivatives exchange groups exchanges, 39% in Europe, 7% in Asia/Pacific and 1% in other Annual number of contracts traded, millions regions of the world (Chart 6) Europe’s share has picked up from Exchange 2005 2006 2007 1940 2443 3158 CME Group 32% in 2006, while North America’s has fallen back from 60% Mergers and acquisitions in recent years have produced a number of exchange groups that each own several subsidiary exchanges The largest such exchange group is CME Group, which includes the Chicago Mercantile Exchange, the Chicago Board of Trade and New York Mercantile Exchange NYSE Euronext, which incorporates the NYSE Liffe, is the second largest on value of trading, followed by Eurex (Chart 7) Over a half of the value of turnover on financial exchanges is concentrated amongst these three exchange groups 8% Other regions 1000 International exchange trading 9% 2000 2001 2002 2003 2004 2005 2006 2007 2008 Eurex 1697 Korea Futures Exchange 2593 NYSE Euronext1 1106 CBOE Holdings 468 BM & F Bovespa 466 Nasdaq OMX Group 266 National Stock Exchange of India 132 SAFEX Securities Exchange 51 Dalian Commodity Exchange 198 Russian Trading Systems Stock Exch 53 Intercontinental Exchange2 82 Zhengzhou Commodity Exchange 28 Boston Options Exchange 78 London Metal Exchange 79 2119 2475 1124 675 571 396 194 105 120 80 140 46 94 87 2704 2777 1525 946 794 551 380 330 186 144 196 93 130 93 2008 3278 3173 2865 1674 1195 742 722 590 514 313 238 237 223 179 113 1Includes NYSE Liffe markets in London, Amsterdam, Paris, Brussels & Lisbon ICE Europe basd in London Source: Futures Industry Association 2Includes IFSL exchange based on the number of contracts traded (Table 6), followed by Eurex 3.2bn, the Korea Futures Exchange 2.9bn, and NYSE Euronext 1.7bn Looking at other UK-based exchanges, ICE Futures Europe accounts for the majority of trading in Intercontinental Exchange, the 12th exchange listed, while the London Metal Exchange is 21st Based on the location of the subsidiary exchanges, the US accounted for 39% of the number of contracts traded in 2008 followed by South Korea 16%, Germany 12% and the UK 6% (Table 7) Electronic trading European financial exchanges have been electronic since the late 1990s, and electronic trading on the US derivatives exchanges has become predominant On CME Group, the share of electronic trading has risen from 20% in 2001 to 83% in 2008 Exchange traded derivatives in the UK There are four derivatives exchanges operating in the UK, all of which had a record year in 2008 for number of contracts traded: NYSE Liffe Following the merger of Liffe’s parent Euronext with NYSE, it was renamed NYSE Liffe Turnover at NYSE Liffe rose by 11% in 2008 to 1.05bn contracts (Table 8) Trading in short term euro interest rate contracts, for which NYSE Liffe is the leading exchange, has accounted for 97% of the exchange’s annual turnover by value in recent years Trading on the London platform accounted for 98% of the value of all Liffe turnover in 2008 London Metal Exchange Turnover of LME contracts rose by 23% in 2008 to reach 113m contracts Primary aluminium has been the most widely traded metal in recent years It accounted for 46% of trading in 2008, followed by copper 25% and zinc 15%: these shares are much in line with previous years ICE Futures Europe ICE Futures Europe turnover rose by 10% to 153m contracts in 2008, but had risen much more rapidly in the previous two years partly due to the introduction of the West Texas Intermediate launched in 2006 Brent Crude futures remains the biggest contract with 45% of turnover in 2008 Trading in the two key oil contracts rose by over 50% to 111m European Climate Exchange (ECX), which is part of ICE Futures Europe, is the dominant exchange for futures and options trading in the EU Emissions Trading Scheme ECX accounted for 91% of futures and options contracts traded in the EU ETS in 2008 and 98% in the first five months of 2009 (Table 9) EDX London Trading in the exchange’s indices and single stock products totalled 60m contracts in 2008 up from 43m in 2007 Remote trading from the UK The UK is an important source of remote trading for the increasing volume of derivatives business globally that is transacted electronically A geographic breakdown for the origination of Eurex derivatives contracts data shows that, since the move from floor to remote electronic trading in the mid-1990s, UK-based traders have become increasingly prominent The share of Eurex contracts sourced from the UK has been at least 45% each year since 2003 (Chart 8) Liffe estimates that 60% of its business originates in London Derivatives 2009 Table Exchange-traded derivatives turnover, based on location of subsidiary exchanges Annual number of contracts traded, millions 2006 US 4573 Korea 2475 Germany 1527 UK 724 Brazil 571 India 293 China 225 South Africa 105 Russia 120 Japan 218 Other countries 1180 Total 12011 % share 2006 2007 38.1 39.1 20.6 17.8 12.7 12.2 6.2 6.0 5.1 4.8 3.1 2.4 2.3 1.9 2.1 0.9 1.5 1.0 1.9 1.8 8.6 9.8 100.0 100.0 2008 39.1 16.1 12.2 6.4 4.2 4.0 3.8 2.9 2.1 1.8 7.5 100.0 Source: Futures Industry Association Table Turnover of London-based derivatives exchanges Millions of contracts traded each year NYSE EDX ICE Futures Liffe2 LME London3 Europe1 1990 34.3 13.4 6.9 1995 136.4 47.2 15.0 2000 131.1 66.4 25.5 2005 759.3 78.6 20.3 42.1 2006 730.3 86.9 28.8 92.9 2007 949.0 92.1 43.1 138.5 2008 113.2 59.9 153.0 1049.7 20094 439.4 44.8 26.0 64.6 Total 54.6 198.6 223.0 900.3 939.0 1222.8 1375.7 574.7 1IPE before 2005 2Includes other NYSE Liffe exchanges after 2000 3EDX London was created in 2003 4First months of 2009 Source: Exchanges Table EU ETS futures & options exchange trading Volume of emissions transacted through futures & options, million tonnes CO2 (mtCO2) Nord Other Pool exchanges Total ECX/ICE 2005 28 123 94 2006 59 517 453 2007 95 1159 1038 26 2008 107 2441 2234 101 2009* 15 1922 1892 15 Source: Thomson Reuters *First five months of 2009 Chart Turnover of Eurex participants by country of origin Millions of derivatives contracts traded each year 2200 2000 Other countries 1800 Germany 1600 UK 35% 38% 1400 35% 1200 35% 800 600 17% 20% 400 19% 16% 1000 200 2007 2008 6091 6952 2777 2865 1900 2165 970 1135 794 742 484 709 364 676 330 514 229 370 292 316 1338 1266 15570 17771 38% 12% 81% 7% 1997 Source: Eurex 46% 46% 2007 2008 48% 32% 30% 45% 2000 2003 2006 IFSL CONTRIBUTION OF DERIVATIVES TO THE UK ECONOMY Derivatives provide a set of risk management tools for a wide range of organisations, so the wider economic contribution of derivatives is seen in the benefits they bring to individuals and businesses - access to finance at lower costs, achieving more stable commodity prices and controlling foreign exchange risk for importers and exporters The estimation of derivatives' contribution to the economy in terms of shares of GDP, employment and overseas earnings is not straightforward In other financial markets the value of activity is related to revenue and profits of the firms involved With derivatives the measures of market activity cannot be so easily ascertained, partly because the value of a derivative is related to the shifting value of the underlying asset Available data for the UK is set out below Employment related to the derivatives markets is widely spread across trading floors in investment banks, derivatives exchanges, other dealers of futures, options and commodities, and various support and back office functions It is estimated that there are about 10,000 people employed in derivatives in central London Derivatives 2009 Chart UK banks' net exports from spread earnings £bn, spread earnings on derivatives, foreign exchange trading & other securities' transactions 10 1997 1999 2001 2003 2005 2007 Source: Office for National Statistics, Bank of England Overseas service earnings include banks’ spread earnings and net fee income on derivatives contracts; fee income of futures and options dealers; and fees and commissions on exchange contracts of UK-based derivatives exchanges Banks’ spread earnings and fee income Banks generate substantial earnings from spread earnings on derivatives, foreign exchange trading and other securities transactions These net exports, currently published as an aggregate, have grown rapidly since 2000, reaching £9.5bn for 2007, the latest available year, and 35% up on £7.0bn in 2006 (Chart 9) Overall figures for UK financial sector exports showed surprising buoyancy in 2008, so spread earnings are likely to have remained in the region of £10bn in 2008 Derivatives are estimated to account for the majority of banks’ spread earnings Separate data on banks’ net fee income is based on gross derivative fees receivable from foreign residents for derivatives services, netted off against fees payable Because of the move to inclusion of the commission in the spread, data reported by banks’ to the Bank of England on their net overseas service earnings from derivatives is modest, although a surplus of £218m in 2007 reversed a deficit of £118m in 2006 Fee income of futures and options dealers Net exports of futures and options dealers have not been separately identified in balance of payments statistics since 2002 when they totalled around £250m Fees and commissions on exchange contracts and clearing These are significant as a majority of customers of UK exchanges and clearing organisations are based overseas or owned by overseas companies, three-quarters in the case of Liffe and over 90% at the LME International investment position Growing derivatives business of the UK financial sector is also reflected in the rising value of financial derivatives in the international asset position of UK financial institutions Data shows that financial derivatives assets rose by 62% between end-2006 and end-2007 to Chart 10 Financial derivatives: international assets of UK financial institutions Financial derivatives, assets valued at end-year, £bn 1800 1600 Securities dealers etc Banks 1400 1200 1000 800 600 400 200 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: Office for National Statistics, Bank of England IFSL Derivatives 2009 reach £1,824bn (Chart 10) Data published by the ONS, based on Bank of England data, is at present experimental, and so is not yet included in the financial account of the UK balance of payments Banks account for around three quarters of financial derivatives assets - 76% in 2006 and 2007 - with securities dealers making up nearly all of the remainder Insurance companies and pension funds contribute less than 1% of the total The share of securities dealers has doubled from around 12% between 1999 and 2002 to about 24% in 2006 and 2007 OTHER SOURCES OF INFORMATION Alternative Investment Management Association www.aima.org Association of Corporate Treasurers www.treasurers.org Bank for International Settlements Triennial surveys of OTC derivatives markets International Banking and Financial Market Developments (quarterly) www.bis.org Eurex www.eurexchange.com Futures and Options Association www.foa.co.uk Futures Industry Association www.futuresindustry.org ICE Futures Europe www.theice.com International Swaps and Derivatives Association www.isda.org Bank of England www.bankofengland.co.uk LCH.Clearnet www.lchclearnet.com Bourse Consult Current issues affecting the OTC derivatives market and its importance to London, April 2009 www.bourse-consult.com London Metal Exchange www.lme.co.uk NYSE Liffe www.euronext.com/derivatives Financial Services Authority Analysis of activity in the energy markets 2008 www.fsa.gov.uk Thomson Reuters Carbon Market Community http://communities.thomsonreuters.com /Carbon EDX London www.londonstockexchange.com/edx/ IFSL Research: Report author: Duncan McKenzie Director of Economics, Duncan McKenzie d.mckenzie@ifsl.org.uk +44 (0)20 7213 9124 Senior Economist: Marko Maslakovic m.maslakovic@ifsl.org.uk +44 (0)20 7213 9123 International Financial Services London 29-30 Cornhill, London, EC3V 3NF This report on Derivatives is one of 15 financial sector reports published by IFSL All IFSL’s reports can be downloaded at: www.ifsl.org.uk © Copyright June 2009, IFSL Data files Datafiles in 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EC3V 3NF This report on Derivatives is one of 15 financial sector reports published by IFSL All IFSL s reports can be downloaded at: www .ifsl. org.uk © Copyright June 2009, IFSL Data files Datafiles... higher share of freight costs in the dry market EXCHANGE-TRADED DERIVATIVES MARKETS Derivatives 2009 Chart International exchange-traded derivatives turnover by region $ trillion, annual value of... 2003 2006 IFSL CONTRIBUTION OF DERIVATIVES TO THE UK ECONOMY Derivatives provide a set of risk management tools for a wide range of organisations, so the wider economic contribution of derivatives