CFTC Economic Head Say Swaps Market Not Surveyed Properly

The interest rate swap market is not nearly systemically risky as some statistics would suggest.

That was the message from a white paper entitled “Introducing ENNs: A Measure of the Size of Interest Rate Swap Markets,” written by the Economics Department of the Commodities Futures Trading Commission (CFTC).

Bruce Tuckman, CFTC’s Chief Economist also appeared with Andrew Busch, on his podcast.

Busch is CFTC’s Chief Market Strategist who also hosts a weekly podcast.

Here’s part of that white paper.

“Notional amount is not a good measure of the size of the interest rate swap (IRS) market, that is, of the magnitude of risk transfer through IRS. First, since a significant volume of IRS swaps are short term, notional amount exaggerates the extent of risk transfer in this market. Second, since trading conventions leave pairs of counterparties holding risk-offsetting long and short positions, notional amount—which adds longs and shorts—significantly overstates risk transfer between pairs of counterparties.

“This paper introduces Entity-Netted Notionals (ENNs) as a better measure of market size. ENNs for a market are computed as follows: convert the long and short notional amounts of each entity to 5- year risk equivalents; net longs against shorts in a given currency within pairs of legal entities; and sum the resulting net longs (or net shorts) across entities. While any individual entity can easily calculate its own ENNs, the CFTC is uniquely positioned to calculate market ENNs using the detailed data it receives from Swap Data Repositories (SDRs).”

The Chief Economist for the CFTC, Bruce Tuckman, then appeared Andrew Busch’s podcast.

Busch is the Chief Market Strategist at the CFTC who also hosts a weekly podcast.

On the podcast, Tuckman explained further what all this means.

On the broadcast, Tuckman noted that IRS are primarily used by all sorts of financial institutions to hedge: “Market participants use interest swaps, sometimes we say IRS, to hedge against adverse changes in interest rates. So, to take insurance companies and pension funds for example, they use interest rate swaps to hedge against falling interest rates, because when interest rates fall it increases the value of their long-term liabilities relative to the value of their intermediate term assets. To take another example, non-financial corporations that are planning to sell debt in the future will use interest rate swaps to hedge against rising interest which will make their coming debt more expensive.”

Next, Tuckman explained what the notional amount means, the size of the IRS market measured notionally, a better measure, and finally, he compared the IRS markets to other debt markets using this new measure.

“The notional amount of the market is the sum of the notional amount of all of the individual swaps. So, if there are ten trades each with a notional of a hundred dollars, the notional amount of the market would be ten times a hundred or a thousand dollars.”

The notional amount of the global IRS market as of December 31, 2016, said Buckman, was $368 trillion.  Alarmists of swaps will often use this notional amount to raise dire warnings about its threat to the financial system.

Tuckman said the notional amount is not a good measure for the swap market.

“First, the average maturity of most bond markets is between five and ten years but there are a lot of very short-term interest rate swaps. Of course, short term fixed income securities have a lot less risk than long-term securities. So, comparing the notional amounts of swaps where there are a lot of short term stuff with the principle amount of bonds, five to ten years, overstates the amount of risk transfer in the IRS market. The second reason, given the way the IRS market works, market participants often get rid of their IRS exposure not by taking off their old swaps but by putting on new swaps in the opposite direction. So, just going back to a pension fund, it may receive six on a hundred million notional today and pay fixed on a hundred million using a different swap a few months from now. So, it’s canceled its risk, but its notional amount is $200 million.”

In the paper, Tuckman introduced the Entity Netted Notionals (ENN). Tuckman said ENN was calculated using three stesp

  • Convert all the short-term assets to five-year equivalents
  • Net long and short five-year equivalence for each pair of counterparties
  • Net long of all counterparties and add them together to get the market ends

Using this new method, Tuckman said that the interest swap market has the equivalent size of other debt markets: “For all U.S. reporting entities as of December 15, 2017, notional amount across the dominant IRS products, namely, fixed-for-floating swaps, FRAs, OIS, and swaptions, is $179 trillion. Expressed in 5-year risk equivalents, that notional amount falls to $109 trillion.” Tuckman stated in the white paper. “ENNs, however, are only $15 trillion, or just over 8% of notional amount. Therefore, measured with ENNs, the size of the interest rate swap market is comparable to the sizes of other fixed income markets, like corporate bonds at $12 trillion, mortgages at $15 trillion, or U.S. Treasuries at $16 trillion.”