ISDA highlights a selection of research papers on derivatives and risk management         

The Anatomy of the Euro Area Interest Rate Swap Market

European Central Bank Working Paper Series
By Silvia Dalla Fontana, Marco Holz auf der Heide, Loriana Pelizzon, Martin Scheicher

The paper analyzes the structure of the over-the-counter (OTC) interest rate swaps (IRS) market and the dynamics of IRS trading in the euro area. The analysis is done based on the regulatory dataset of 1.7 million bilateral OTC IRS transactions reported in the euro area under the European Market Infrastructure Regulation (EMIR). EMIR requires EU entities to report their derivatives transactions to trade repositories authorized by the European Securities and Markets Authority.

The study demonstrates that IRS trading in the euro area is focused on standardized products and is concentrated around the G-16 dealers (four from the euro area) and 10 intermediaries (six from the euro area). The analysis shows that dealers are active in all segments of the IRS euro market, while intermediaries are more specialized in the euro currency. The study identifies the leverage ratio as a factor that may restrict bank participation in the OTC derivatives markets, and offers some evidence that banks tend to transfer the larger costs of capital from their IRS transactions on to their counterparties. In particular, banks with potential leverage ratio constraints tend to charge a higher price or banks with lower leverage constraints might offer a better price to their counterparties.

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ENNs for Corporate and Sovereign CDS and FX Swaps

CFTC Office of the Chief Economist
By Lee Baker, Richard Haynes, Madison Lau, John Roberts, Rajiv Sharma, and Bruce Tuckman

This paper proposes and calculates entity-netted notionals (ENNs) for corporate and sovereign credit default swaps (CDS) and for foreign exchange (FX) swaps. In January 2018, the Office of the Chief Economist at the Commodity Futures Trading Commission introduced ENNs as a metric of size in the IRS market. Measured using ENNs, the IRS market transfers the same amount of interest rate risk as a market of $15.4 trillion principal amount of five-year bonds.

This paper proposes that ENNs for CDS should be expressed in terms of the risk of a five-year corporate or sovereign CDS that trades at a spread of 100 basis points. Since shorter-term and lower-spread CDS are less risky than this benchmark, the notional amount of these swaps contributes less than one-to-one toward ENNs. As of September 2018, the notional amount of the global corporate and sovereign CDS markets was $5.5 trillion. In terms of ENNs, the CDS market transfers credit risk to the same extent as a market of about $2 trillion of five-year bonds that trade at a spread of 100 basis points. For FX swaps, the paper proposes to express the notional amount of FX options in delta equivalents. As of September 2018, the notional amount of FX swaps was about $57 trillion across US reporting entities. However, the size of the market in terms of ENNs was significantly lower at $17 trillion.

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Financial Innovation and Financial Intermediation: Evidence from Credit Default Swaps

By Alexander W. Butler, Rice University; Xiang Gao, Binghamton University; and Cihan Uzmanoglu, Binghamton University

The paper examines the effects of CDS on bond underwriting fees. The authors use the sample of corporate bond issuers from the Mergent Fixed Income Securities database and a dataset of CDS transactions from the Bloomberg, Credit Market Analysis and Depository Trust and Clearing Corporation databases. The paper analyzes the changes in underwriting fees of new bond issues from the pre- to post-CDS initiation period, and finds that CDS initiation results in a 17% decline in bond underwriting fees on average due to the hedging opportunities that CDS provide to investors. The reduction in underwriting fees is more significant for riskier firms and less liquid bonds, but not for more informationally opaque issuers. The paper points out that the participation of insurance companies and banks in bond offerings increases with the initiation of CDS trading relative to that of other investors. Although underwriting fees decline, the quality of underwriting services, as proxied by bond underpricing, offering yield spread, and underwriter reputation, is not affected by CDS initiation.

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