The Evolution of OTC Derivative Indices.
Evolution of OTC derivative indices The OTC derivatives market is an important tool for investors when hedging risk and generating yield, and has been particularly pertinent in helping investors manage the impact of recent interest and inflation rate volatility. Yet access to relevant, independent indices has been limited. Innovation in the OTC derivative market is changing the landscape.
Explaining the challenge The effects of rapidly rising inflation have been felt acutely in the past year. In response central banks have intervened by hiking interest rates back to levels not seen since before the global financial crisis of 2008. The impact of this on investors is profound, especially large institutions such as pension funds and insurance companies with significant books of inflation-linked liabilities. Increasingly the solution for managing these risks is to purchase inflation and interest rate swaps which help limit investors’ exposure to market volatility.
The latest data from the Bank for International Settlements (BIS) shows the gross market value of OTC derivatives grew by 13% in the second half of 2022 to reach $20.7 trillion at the end of the year. BIS says interest rate derivatives drove this increase amid higher inflation and rising rates1.
The total notional value of OTC derivatives was US$618 trillion at the end of 2022 dwarfing that of the global equity market which stood at US101 trillion2, yet unlike its smaller stock market counterpart, the OTC derivatives market is underserved when it comes to independent indices. Mind the gap
Access to consistent and reliable valuations for swaps has long been a challenge for some market participants, particularly when compared with the transparent and observable pricing of exchange-traded securities. Historically, investment banks have offered proprietary interest rate and inflation rate derivative indices to which they have linked structured products. But while banks have market expertise, they only see a small part of the market liquidity and must also manage conflicts of interest arising from their own trading activity. And since greater regulatory scrutiny of benchmark provision – notably from the International Organization of Securities Commissions3 and under reform of the EU Benchmark Regulation4 - investment banks have started to withdraw from the market, driving participants to seek indices from independent providers.
However, until very recently, it has been a challenge for investors to find suitable OTC derivative indices. This gap in provision existed for several reasons. First unlike, traditional asset classes, there is no standard measure of market returns so while there are a vast range of indices for equity and bond investors, for example, the equivalent is not as straightforward for swaps and other OTC derivatives where no two investors have the same objectives and constraints.
Second, the complexity of the instruments and of market quoting conventions, make the markets opaque to non-specialists.
Third, liquidity for the OTC derivatives markets is provided by inter-dealer brokers (IDBs) and not on exchanges which creates a scarcity of relevant data outside of those providers.
"The future for OTC derivatives markets should be one where all market participants are armed with the information they need to ensure the best investment decisions."
A new solution
Yet it is critical that OTC derivative investors have access to robust, reliable indices if they are to be sure they can make effective investment decisions. Recent market innovation has come from Parameta Solutions, the data and analytics division of TP ICAP Group which is the world’s largest IDB.
Parameta has access to unparalleled levels of high-quality market data over seen by word-class experts and we have used this unique position to create a new family of interest rate swap volatility (IRSV) indices.
This new solution provides market participants with a forward-looking implied volatility measure for some of the most liquid option expiry, swap tenor combinations in the EUR and GBP interest rate swap markets.
The indices, which are informed by input data and analytics from ICAP, use a theoretical foundation for measuring interest rate swap volatility, providing market participants with a model-free measure of spot implied volatility. This approach has been shown to have superior predictive power over other commonly used volatility forecasting measures.5
Importantly for investors with myriad uses of derivatives, our IRSV indices can be tailored to match any strategy over a range of tenors. Meanwhile, investment banks can use the IRSV indices as building blocks for their own risk premium strategies. Future innovation
Evolution of the OTC derivatives indices market need not be confined to interest rate swap volatility. As the direction of travel for inflation remains uncertain, investors need data-driven indices to support their risk management and investment decision making.
There is the potential to use powerful proprietary data and in-depth insights to build new indices that offer robust and daily pricing for the inflation swaps market.
OTC derivatives are moving towards greater transparency and comparability. Reliable, independent indices are essential for all market participants and recent innovation shows just what is possible with access to cutting-edge data and analytics.
The future for OTC derivatives markets should be one where all market participants are armed with the information they need to ensure the best investment decisions.
As the first IDB to be authorised as a Benchmark Administrator by the UK’s Financial Conduct Authority and the European Securities and Markets Authority, Parameta will be at the forefront of future developments in OTC indices.
Our rich market pricing and analytics sourced of from TP ICAP, the leading liquidity provider for OTC derivatives, gives Parameta Solutions a distinct advantage to satisfy the significant gap in the market for independent OTC derivative indices and benchmarks.
1 https://www.bis.org/publ/otc_hy2305.htm 2 https://www.sifma.org/resources/research/fact-book/
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