Derivatives transactions data and their use in central bank analysis

Prepared by Lena Boneva, Benjamin Böninghausen, Linda Fache Rousová and Elisa Letizia

Published as part of the ECB Economic Bulletin, Issue 6/2019.

Data on derivatives transactions have recently become available at a number of central banks, including the ECB, and have opened up new avenues for analysis. Collected as a result of reforms of the over-the-counter (OTC) derivatives market, which were primarily designed to counter systemic risk, the data have numerous applications beyond the domain of financial stability.

This article presents two such applications. It demonstrates how data gathered under the European Market Infrastructure Regulation (EMIR) can be used to better understand two types of derivatives market that are of particular importance for central bank analysis, namely the interest rate derivatives and inflation-linked swap markets.

For the interest rate derivatives market, the article shows how investor expectations for interest rates may be inferred through “positioning indicators” that track how a set of “informed investors” take positions in the market in anticipation of future interest rate movements. Such quantity-based indicators can complement other, more established indicators of interest rate expectations, such as forward rates or survey-based measures.

For euro area inflation-linked swap markets, the article exploits the fact that EMIR data allow a first systematic look at trading activity in these markets, which can provide valuable and timely information on investors’ inflation expectations. It highlights a number of structural features of activity in these markets and discusses their possible implications for the monitoring of market-based measures of inflation compensation.

1 Introduction

Since the collapse of Lehman Brothers and near-failure of AIG in 2008, OTC derivatives have been recognised as one of the amplifiers of the global financial crisis. In response, G20 leaders pledged at the Pittsburgh summit in September 2009 to reform OTC derivatives markets to improve their transparency, prevent market abuse and reduce systemic risks. In Europe, this initiative was formalised in 2012 in the European Market Infrastructure Regulation (EMIR). EMIR imposes several requirements on entities that enter into a derivatives contract, such as the implementation of risk management standards, clearing of certain contracts through central counterparties (CCPs) and reporting obligations.^[1]

While the OTC derivative reforms were primarily designed with the aim of reducing systemic risk, data from EMIR have applications in central bank analysis beyond the financial stability domain.^[2] Following a brief introduction to the EMIR data (see Section 2), this article presents two examples of such uses. First, it shows how EMIR data on interest rate derivatives can be used to gauge the expectations of investors regarding the future evolution of key interest rates (see Section 3). This is based on the premise that investors expecting lower interest rates in the future position themselves by buying more contracts (than they sell) that benefit from lower interest rates. “Positioning indicators” calculated on this basis can thus be seen as capturing the strength of informed investors’ expectations and have the potential to complement other indicators of interest rate expectations such as forward rates or survey-based measures. Second, the article looks at structural activity patterns in euro area inflation-linked swap markets (see Section 4). It provides an overview of the most relevant contracts and the counterparties that trade in those markets, and draws some conclusions for the ECB’s monitoring of market-based measures of inflation compensation, in particular regarding the information content at various maturities. Both applications demonstrate the wide potential for the use of EMIR data in central bank analysis.

2 The EMIR data

In February 2014 EMIR introduced mandatory reporting of all individual derivatives contracts. This reporting obligation applies to both OTC and exchange-traded derivatives in all five main asset classes, i.e. commodity, equity, foreign exchange, credit and interest rate derivatives. Trades cleared via CCPs are also included. The reporting covers information on both the counterparties involved and the characteristics of the contract, which may change over the life cycle of a derivative trade and are submitted daily.^[3]

All EU-located entities that enter a derivatives contract are subject to the reporting obligation. They must report to one of the seven trade repositories currently authorised by the European Securities and Markets Authority (ESMA). Daily transaction-by-transaction derivatives data are then made available to over 100 authorities in the EU, depending on their mandate and jurisdiction. For example, the ECB obtains a subset of the data reported by euro area counterparties.^[4] One important implication of this is that transactions between two counterparties domiciled outside the euro area (e.g. between two UK banks or between UK and US banks) are typically not available to the ECB.

Owing to their volume, velocity and variety, the EMIR data can be classified as “big data”, which poses many challenges for using them. In cooperation with the European Systemic Risk Board (ESRB), the ECB has developed an EMIR-dedicated IT infrastructure to store and access the data received from all trade repositories. Despite the significant improvement in data quality since the launch of EMIR reporting in 2014, a careful data cleaning procedure has to be applied before the data can be used for policy analysis; for example, observations are deleted when both the market and notional values are missing or when the notional value is considered an outlier.^[5] This article focuses on data between 2 May 2018 and 12 June 2019, as the cleaned data – even as a time-series – are of sufficiently good quality and easily accessible through the EMIR IT infrastructure.

3 Inferring market expectations for future interest rates from EMIR data

The interest rate derivatives market allows market participants to trade financial products linked to future interest rates. The market value of these contracts changes as interest rates move, and investors can use them to hedge against movements in interest rates or for speculative purposes. By analysing the positioning of participants in the market, some inference can be made about their views on the outlook for interest rates.

The market positioning indicators based on EMIR data help to inform central bank analysis. Information on the positioning of certain groups of investors in interest rate derivatives can complement price-based indicators and surveys, which are both commonly used to infer financial market expectations for monetary policy or the macroeconomic outlook.^[6]

Positioning indicators rely on three main building blocks: (i) the assessment of an investor’s “net long” (or “net short”) position in a certain contract, (ii) the identification of a specific set of “informed investors”, and (iii) the choice of appropriate interest rate derivative contracts.

An investor’s net long (or net short) position captures how and to what extent they may profit from future interest rate movements. In the case of a fixed-income futures contract – say, a bond futures contract – a buyer, or an investor holding a long position, gains from a decline in interest rates owing to the inverse relationship between interest rates and the value of the underlying bond. The opposite is true for a seller, or the investor who holds a short position. Where an investor simultaneously holds long and short positions, exposure to future interest rate movements is determined by netting all positions. As a result, investors with a “dovish” interest rate outlook (i.e., expecting interest rate declines) are likely to be positioned net long, while those with a “hawkish” view would position themselves net short.

Any meaningful positioning indicator needs to single out a particular subset of investors since the market overall is positioned neither net long nor net short. This follows from the fact that, if one investor takes a long position, another investor has to take an equivalent short position in the same derivative. As a consequence, the net long (and net short) position of all investors combined must be equal to zero, barring reporting errors and/or sample limitations. An informative positioning indicator therefore has to focus on a particular, meaningful set of investors.^[7]

The positioning indicator constructed here aims to single out “informed investors” who actively take positions in interest rate derivatives on the basis of their expectations for future interest rates. Their identification is challenging, however. Box 1 explains how EMIR data are enriched to obtain a detailed sector classification which facilitates this task. But even a granular sector classification cannot fully capture the heterogeneity of individual investors’ trading strategies in interest rate derivatives.^[8] To address these challenges, “informed sectors” are chosen according to the following criteria: (i) they form a view on future interest rates on the basis of monetary policy and macroeconomic developments, (ii) they react quickly to a change in the outlook, (iii) they trade actively in derivatives contracts, primarily to generate a profit from them, and (iv) they pursue a strategy that is neither very short-term (e.g. arbitrageurs trading to exploit intraday volatility) nor very long-term (e.g. insurance companies or banks hedging their balance sheet duration gaps). The sector referred to as “hedge funds” can satisfy all these criteria, in particular as it is normally identified as comprising entities which take positions on the basis of their expectations for the future evolution of financial market prices in a relatively unconstrained way. However, there are many difficulties in correctly identifying such funds^[9] and there may be other classes of investors acting in a similar manner.

Therefore, we report a range of positioning indicators based on different investor categories (Table 1). The first sample follows the definition of hedge funds in the ECB’s Manual on investment fund statistics^[10] and includes all non-UCITS funds, as well as UCITS funds^[11] with a hedge fund strategy (see Box 1). The second sample is broader as it includes all investment funds. One rationale for broadening the category is that an asset manager would have only one view on the short-term interest rate outlook, but would typically control several funds, some of them falling into the category of hedge funds and others not. The third sample also includes other financial institutions – which are not banks, insurance companies or pension funds – to control for misclassification and to capture other types of active investor such as systematic trading firms. Finally, to capture only large and active^[12] investors, all previous samples are restricted to the counterparties that hold the largest 100 portfolios in terms of gross notional amount on average over time.

Finally, a class of interest rate derivatives needs to be chosen. A basic choice is between derivatives with linear payoffs (e.g., swaps, forwards or futures) and derivatives with non-linear payoffs (most notably options). Since the positioning indicators are intended to capture exposure to general interest rate movements rather than unusual developments, this suggests a preference for derivatives with linear payoffs. In addition, the market segment has to be sufficiently liquid, which is not always the case for options markets.

The full interest rate derivatives market in the euro area is very large in terms of both volume and the number of instruments it contains (Chart 1). As of June 2019 the total outstanding notional amount in interest rate derivatives was around €200 trillion, which accounted for two-thirds of the total euro area derivatives market.^[13] Interest rate swaps and futures are key instruments in the interest rate derivatives market. Swaps are the most prominent contracts, covering about 54% of the notional value of outstanding contracts. Swaps (including those based on EONIA) are traded “over the counter” and are used for a wide range of purposes, including the hedging of interest rate risks on banks and insurers’ balance sheets (e.g. risks arising from positive and negative duration gaps respectively). The futures market is smaller than the swaps market, but is exchange-traded and hence much more standardised and extremely liquid. Among futures, three-month EURIBOR futures have the largest notional amount outstanding (around €7 trillion out of €15 trillion in June 2019), followed by eurodollar and Bund futures.

The positioning indicators are based on EURIBOR futures contracts, owing to their significant information content as regards euro area interest rate developments. As suggested by market intelligence, informed investors make extensive use of EURIBOR futures, primarily on account of their substantial liquidity and high degree of standardisation. Investors that need to adjust their positions may often prefer futures contracts to interest rate swaps, since it is easier to close out existing positions. Moreover, futures on the three-month EURIBOR are attractive because of their direct link to euro area short-term interest rate developments at specific horizons. The basis risk of tracking EONIA through a EURIBOR futures contract is fairly limited at present given the stable spreads between the two. The focus of the positioning indicators is on EURIBOR futures with a residual maturity of above one year to facilitate comparison with gauges of interest rate expectations commonly used by central banks, for instance the one-year EONIA, one year ahead.^[14]

The positioning measure is the ratio of informed investors’ net long positions to their gross positions.^[15] The net long position (long minus short) of each investor is normalised by their gross position (long plus short). This measure has at least two advantages. First, because the measure is normalised by the gross position, it allows the views expressed by all informed investors to be considered, including smaller investors that may have strong views but are unable to take sizeable absolute positions. A simple sum of net long positions across all informed investors without any normalisation would give significant weight to very large investors and idiosyncrasies of individual players. Second, the sum across all informed investors and the normalisation also make the indicator more robust against misreporting.

The measure reveals that the positioning of investment funds is relatively polarised, suggesting that a focus on this investor category is indeed warranted since investment funds appear more inclined to express a view on future interest rates than other types of investor. Using all investment funds (positioning measure 2) as the category representative of informed investors, Chart 2 shows that around 60% of these investors take an either extreme hawkish or extreme dovish view, with the extreme dovish view clearly predominating on the date in question (12 June 2019). This pattern is different from that for dealer banks, for example, which tend to be positioned in a more neutral way, as they typically act as market makers. This does not imply that dealer banks do not have views on monetary policy or the macroeconomic outlook, but their dealing activity generally outweighs the proprietary risk-taking motive. Since dealing activity also implies that many of their positions offset each other, their portfolios tend to be large in terms of gross notional amount (as indicated by the size of the bubbles) but less so in terms of the net notional amount.

Net long positioning has trended upwards since the start of 2019, consistent with market expectations of a more accommodative monetary policy (Chart 3). The one-year EONIA forward rate one year ahead provides another approximation of how interest rate expectations have evolved over the period under consideration. It shows a downward trend starting in late 2018 as investors started pricing in a more accommodative monetary policy and became less sanguine about the global economic outlook. Consistent with these developments, informed investors have increased their net long positions over the same period. The results shown here thus suggest that the positioning indicators – as a quantity, or volume-based, proxy for expectations about monetary policy and the general economic outlook – can provide signals comparable to price, or rate-based, proxies. Further data analysis may also help identify sectors whose positioning, on average, appears to be the most indicative of the market’s price formation mechanism. Ideally, such analysis would also shed new light on the information embedded in forward interest rates, in particular in situations where the signals from the positioning and price-based indicators are not entirely consistent.

4 Examining euro area inflation-linked swap markets

Another promising application of the EMIR data lies in providing a more thorough understanding of euro area inflation-linked derivatives markets, which contain important information on the inflation expectations of investors. Inflation expectations play a central role for the ECB, since its primary objective is to maintain price stability in the euro area. In the conduct of monetary policy, such expectations are relevant in their own right, since they influence economic decisions in areas such as consumption and investment, as well as wage and price setting, and thus inflation. Moreover, they serve as a cross-check on the inflation outlook in the Eurosystem/ECB staff macroeconomic projections, which in turn inform the ECB’s monetary policy decisions. In addition to survey-based measures, which capture inflation expectations as expressed directly in regular expert surveys, there are market-based measures of inflation compensation, reflecting the information derivable from the prices of financial instruments. These include inflation-linked swaps, inflation-linked bonds and inflation options, all of which are linked to future inflation outcomes. Since these financial instruments are traded continuously, market-based measures not only provide additional valuable information on the inflation expectations of investors, but can also give more timely indications of potential shifts in the inflation outlook.^[20]

EMIR data allow a first quantitative look at the structure of the euro area inflation-linked swap (ILS) market. To date the ECB has relied heavily on market intelligence regarding the activity underlying developments in, for instance, ILS rates. Such market intelligence – while useful – is generally qualitative in nature, and challenging to gather in a consistent fashion across counterparties in practice. The EMIR data complement this type of information and allow it to be cross-checked by offering a quantitative, more systematic look at trading activity in euro area ILS markets. This section uses the EMIR data to demonstrate some structural features of these markets.^[21]

The data suggest that activity in the euro area ILS market is dominated by swaps linked to aggregate euro area inflation rather than national consumer price indices. Chart 4 shows that, on average, swaps linked to the euro area Harmonised Index of Consumer Prices excluding tobacco (HICPxT) account for more than 80% of both the number of transactions and the notional amount involved. The remaining euro area ILS market is almost exclusively linked to the French consumer price index (CPI). Activity in swaps linked to other countries’ CPIs is very limited, even Italian CPI-linked swaps, despite the existence of a sizeable Italian CPI-linked bond market.^[22] Since the monitoring of investors’ inflation expectations relies on market quotes (as ILSs are traded “over the counter”), it appears reasonable to assign a higher information content to those ILSs for which quotes are more firmly supported by underlying activity.^[23] On that basis and in light of the above observations, monitoring aggregate euro area inflation expectations in ILS markets seems most reliable. However, this does not preclude the monitoring of individual countries’ CPI-linked ILS rates to detect expectations of possible deviations from the aggregate at the national level.

EMIR data also show that activity is relatively concentrated in the ten-year, five-year, two-year and one-year maturity segments. These results relate to spot rates of zero coupon swaps – that is, swaps that exchange fixed rate payments for variable payments on the basis of realised inflation between now and a given future date. Chart 5 shows that the four most active points on the curve account for around 50% of all activity in euro area HICPxT-linked swaps. The fact that almost a quarter of activity is clustered at the ten-year spot point, with the second-largest share at the five-year spot point, has an interesting corollary. It suggests that among forward ILS rates, the five-year rate five years ahead – which commands considerable attention in the marketplace – is also the rate most supported by underlying activity. Moreover, rather than declining mechanically with maturity, activity is still notable at a number of longer-dated points along the spot curve, for example at the 15, 20, and 30-year maturities. In the context of central bank analysis, this is reassuring since longer-term ILS rates are less affected by short-term transitory shocks and may thus provide a cleaner guide to investors’ “steady state” inflation expectations.

There are important differences in sectoral activity across maturities: hedge funds are quite active at the very short end of the curve, while pension funds show above-average activity in the long to ultra-long segments. Chart 6 sorts transactions into different maturity buckets instead of focusing on individual maturity points. It further shows sector pairs involving banks on at least one side of the transaction. This is due to the dominant role played by banks in the ILS market and because activity accounted for by other sector pairs is negligible. Apart from highlighting the dominance of bank-bank and bank-investment fund transactions across maturity buckets, Chart 6 shows notable activity of hedge funds at short maturities. This observation is consistent with market intelligence, according to which some hedge funds have in recent years stepped up their efforts to forecast near-term inflation and then trade on the basis of those forecasts in ILS markets. Moreover, the fact that pension funds are over-proportionally represented in maturities of 20 years and above is in line with the notion that these actors use the ILS market to hedge inflation-linked liabilities, in particular those incurred as part of defined-benefit plans.

The results show that it is important for the ECB, in assessing investors’ inflation expectations, to consider not only overall activity patterns across the ILS curve but also the sectoral composition of activity in different segments of the curve. More precisely, while the article has shown that activity in longer-dated euro area ILSs of 15 years and beyond is not negligible compared with shorter-dated maturities, the sectoral analysis indicates that a relatively large share of that activity stems from pension funds. Since the latter often use the ILS market to hedge against developments in inflation, they tend to act more as price takers, certainly when compared with hedge funds active at the short end of the ILS curve, which are more likely to express particular views on future inflation. Thus, when price sensitivity is also factored in, the information content of longer-dated ILS rates may be lower than suggested by overall activity in that maturity bucket.

Overall, EMIR data help uncover a number of interesting structural features of euro area ILS markets, suggesting that further EMIR-based analysis can help the ECB better assess future developments in these markets. The findings presented in this section are consistent with market intelligence received. This supports the notion that the EMIR data can indeed serve as a complement to and cross-check other information by offering a quantitative, more systematic view. Natural extensions of the more structural analysis presented here are tracking overall activity or the activity of different investor groups over time as well as across maturities. Moreover, the richness of the data extends beyond the information touched upon in this article, most notably to the prices at which counterparties transact with each other. EMIR data are thus an important addition to the ECB’s toolbox for analysis of euro area ILS markets.

5 Conclusions

This article has shown how EMIR data can be used for analysis beyond the domain of financial stability. This article presents examples based on two classes of derivatives market that are of particular importance for central bank analysis: the interest rate and inflation-linked derivatives markets.

The first example illustrates how EMIR data can help infer investor expectations for future interest rates. The positioning indicators developed track how a group of “informed investors” position themselves in the futures market in anticipation of future interest rate movements. Such quantity-based indicators can act as a complement to other, more established indicators of interest rate expectations, such as forward rates or survey-based measures. While this article provides first insights from such quantity-based indicators, further data analysis may help refine the indicators and also shed new light on the information embedded in forward interest rates, particularly in situations where the signals from the positioning and price-based indicators are not entirely consistent.

The second example shows how EMIR data allow a first systematic look at trading activity in euro area inflation-linked swap markets. This example highlights a number of structural features of these markets, which can provide valuable and timely information on the inflation outlook of investors. Overall, the results support the notion that EMIR data can complement and help to cross-check more qualitative market intelligence on activity in these markets. For example, the data can help assess the information content of inflation-linked swap rates, both across different maturities and on the basis of the relative activity of different types of investors. The data can thus be seen as an important addition to the analytical toolbox of the ECB.

Despite the many challenges in using these “big data”, the use of EMIR data at the ECB and at central banks more generally is on the rise. The increasing scale of analysis based on these data underlines the benefits for policymakers of the reporting of EMIR data as part of the measures to increase transparency in the OTC derivatives market.