In the world of over-the-counter (OTC) derivatives, "all things are not created equal". Let's briefly discuss why one, in particular, reigns supreme.

Preface

Today's article begins with the Office of the Comptroller of the Currency (OCC) and their Quarterly Report on Bank Trading and Derivatives Activities?for Q3 2022. Published in December, this 108th edition of the report is a culmination of analyzing credit, market, operational, reputation, and compliance risks of bank trading and derivatives activities at the largest banks. The information in the report is derived from call report data from 1,211 insured U.S. national and state commercial banks and savings associations.

The Big Four. A Quick Segue into Some Fun Facts

Fun Fact # 1: Of the 1,211 insured US entities that report this data, The OCC identifies their top 25 holding companies, in terms of "Notional Amounts of Derivative Contracts Held for Trading". These 25 holding companies account for nearly 100% of all bank derivatives held.

Fun Fact # 2: Of the top 25 holding companies that account for nearly all derivatives contracts, four banks stand alone at the top and account for nearly 87% of derivatives contracts.

So, "Who are these four banks?", you may be asking yourselves. Reasonable question. JP Morgan Chase, Goldman Sachs, Citibank, and Bank of America held a collective $172,836,703,000,000 of the $193,941,227,000,000 in derivative contracts in the third quarter of 2022.

Even Funner Fact (yes, I said "funner") # 3: When looking at this information for the top four banks, we can make some interesting observations. Based on the total derivatives, relative to their total assets, there is some serious leverage going on, and not just from these top four banks.. but we'll keep our focus there.

So, let's revisit the table above and analyze this information and see how leveraged these banks were in the third quarter of 2022; rounded to the nearest whole number. (Using the formula Total Derivatives / Total Assets)

JPMorgan - $54,304,061 / $3,308,575 = 16X Leverage

Goldman Sachs - $50,966,723 / $513,905 = 99X Leverage

Citibank - $45,968,848 / $1,714,474 = 27X Leverage

Bank of America - $21,597,071?/ $2,407,902 = 9X Leverage

Back to our topic at hand..

Interest Rate Derivatives (IRD)

The OCC makes quick work of presenting some eye-watering numbers in their executive summary, as it relates to derivatives, and are as follows:

• Insured U.S. commercial banks and savings associations (collectively, banks) reported trading revenue of $12.7 billion in the third quarter of 2022, $2.4 billion more (22.9 percent) than in the previous quarter and $5.8 billion more (84.1 percent) than a year earlier
• Credit exposure from derivatives increased in the third quarter of 2022 compared with the second quarter of 2022
• Derivative notional amounts increased in the third quarter of 2022 by $231.0 billion, or 0.1 percent, to $195.1 trillion
• Derivative contracts remained concentrated in interest rate products, which totaled $142.0 trillion or 72.8 percent of total derivative notional amounts.

Before moving on, I would like to point out the timing of the increase in both credit exposure and derivative notional amounts in the third quarter of 2022. This is not a coincidence. Recall from my previous article on UMR PHASE 6 Initial Margin went into effect on September 1,2022. These new requirements for the tracking and posting of margin brought new process, structure, expectations, and more money to nearly 800 counterparties. So, to see derivatives exposure and overall derivatives amounts increase in the third quarter is of no surprise, to me. In my opinion, this just means that more banks/entities/counterparties are rolling the [proverbial] dice, doubling down on what are likely losing bets, hoping the tide will turn...but I will digress.

If we zoom out and look at the European derivatives market, we see a similar trend with IRDs leading the way. International Swaps and Derivatives Association (ISDA) informs us that in their Interest Rate Derivatives Trading Activity Reported in EU, UK and US Markets report that IRD trading was $43.8T in the third quarter of 2022, over 27% higher than derivative trading in the same period of 2021. Moreover, we see that Euro-denominated IRD accounted for over 50% of all IRS traded in Europe in 2022.

The Bank of International Settlements (BIS)--the bank for central banks that facilitates central bank cooperation and coordination--provides us with a visualization of the over-the-counter OTC derivatives notional amount outstanding by risk category which illustrates the disparity between IRD and IRD/FOREX.

Additionally, BIS provides us with another visualization of OTC derivatives outstanding on a semi-annual basis that looks at activity for all countries, counterparties, & risk sectors followed by BIS. Again, IRD accounts for the majority of derivatives.

So, we have established that interest rate derivatives are big business, and in fact, account for the lion's share of global derivatives activity, but is this something new?

Derivatives History 101

I wanted to quickly present some information I came across in my research that shows the reign of IRDs go back at least 30 years, and likely much further.

In 1999, the Economic Analysis Division of the Commodity Futures Trading Commission (CFTC) published a report, The Global Competitiveness of U.S. Futures Markets Revisited. In this report, which was an update of a 1994 "study of the competitiveness of organized U.S. futures exchanges relative to their counterparts abroad", tells us that interest rates were the most important commodity group & futures/option contracts accounted for 52 percent of total annual volume in 1993.

In 2011, The Technical Committee of the International Organization of Securities Commissions (IOSCO) published a report, Report on Trading of OTC Derivatives. In this report, we are informed that in 2005 "the total notional OTC derivatives outstanding was $283 trillion, of which 72.5% was interest rate derivatives".

In this same report, we learn that in Q2 of 2010, BIS estimated interest rate derivatives turnover accounted for 86.5% of all turnover across global ETFs & options, or $479,729,000,000,000.

Hedging and Hedge Funds

Now that we have identified that interest rate derivatives account for the largest amount of (notional) derivative activity, and that interest rate derivatives use go back decades, let's look at some reasons why. "Why are IRDs so popular"? "Why have they been in such heavy use for so long"?

Based on Form PF data, we see that when looking at investment exposure, Aggregate Qualifying Hedge Fund Gross Notional Exposure by Asset Type has been steadily rising since at least 2019.

The Journal of Risk & Financial Management tells that interest rate derivatives are the primary source of high valuations for banks & that hedging derivatives contribute to US bank market values.

Further, Choi et al "concluded that the effect of derivatives holdings for hedging purposes had an active role in adding value to the US banking holding companies between 2000–2010".

BIS' Quarterly Review on International Banking & Financial Market Developments informs us that As interest rates fluctuated in Europe, Dutch pension funds quickly raised liquidity to mitigate the falling value of IRD positions in Q2 of 2022. We also learn in this review that reform of benchmark rates for IRD caused a shift in markets.

““The reform altered the risk landscape & brought a new mix of traded instruments to the fore. Some instruments now redundant, global turnover of IRDs dropped by some 20% since 2019.”

6° of Ken Griffin, or "Griffin’s Law"

In a December 2021 10-K filing, we learn that BCG Partners—a global financial brokerage & tech company servicing the global financial markets—offers in its products & services, an electronic platform called Fenics GO. Fenics GO is the only anonymous multilateral electronic platform for block-sized equity index options and offers global options electronic trading platform, providing 2way electronic liquidity for exchange-listed futures & options.

This gets more interesting when we learn that Citadel & Susquehanna are liquidity providers for Fenics GO.

Fenics GO offers electronic trading of OTC & listed financial products like govt bonds, IRDs, spot FOREX, FOREX derivatives, bonds, & credit deriv.

Fenics GO was also named OTC Trading Platform of the Year by Risk.net & Risk Magazine at the Risk Awards 2021.

As seen below, Fenics GO brokers interest rate derivatives--along with a host of other products--has their liquidity provided by Citadel Securities.

Looking at LinkedIn, we see there are a number of connections between Citadel Securities and BGC Partners.

In one of these cases, an individual was Director/Software Development Manager at Citadel for over 9 years, and is now Software Development Manager at BGC. In five other cases, we see individuals who worked at BGC now employed with Citadel. Two of these individuals I find interesting: one was previously Regional Head of Compliance, Asia at BCG, and currently Chief Compliance Officer at Citadel. The other individual was previously employed with BGC as Global Head of Algorithmic Business Development and is currently Global Head of Derivatives and FICC Development with Citadel.

Approximately 6 months after BCG Partners announced their partnership with Citadel as a liquidity provider, we see the The Depository Trust & Clearing Corporation (DTCC) publishing an important notice for a "New Participant in the Netting System of the Government Securities".

A February 14, 2023 PR Newswire article lets us know that Fenics Repo--the same new participants in repo netting services we see above--is a subsidiary of BCG Parters. This, the same BCG Partners that spun off Fenics GO, with Citadel Securities as a liquidity provider.

For anyone unfamiliar with the repo and reverse repo market, I wrote previously on the repo market:

• The Repo Market is surging. Let's look at why this could be, and the impact that this market has on the economy, and
• The Antithesis: Reverse Repurchase Agreements and Government Treasuries

A Quick Recap/TL;DR

For at least 30 years--and likely many more--interest rate derivates have played an integral role in financial markets. These derivative vehicles, who derive their value in the underlying fluctuations in interest rates, have long been the most used/sold/purchased derivative, as well as holding the most notional value.

These interest rate derivatives, or IRDs have many uses; be it to hedge a position, mitigate credit exposure, or more. Banks, funds, counterparties, and other entities utilize derivatives so much that in some cases, the leverage of what a derivative position is worth far exceeds the value of the bank, fund, etc. In all situations that I have come across in my research, where derivatives were heavily used, interest rate derivatives outweigh all other derivatives.

In terms of IRD's as a use to hedge, as well as their relation to institutions such as hedge funds, we can see that brokerages have created new business to further engage in derivative trading, providing liquidity through market makers like Citadel Securities. As a natural result of heavily engaging in derivatives, we see brokers and their subsidiaries branching out into the repo market, which to many, is nothing more than a money washing operation that temporarily reduces risk by making balance sheet appear to be something they are not, and provides a quick buck to those on the receiving end of the profit in the transaction of treasuries for cash.