The democratisation of OTC derivative indices

The ravages of rapidly rising inflation have been felt acutely in the past year as geopolitical events have caused prices to rocket the world over. 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 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 hedge investors’ exposure to market volatility. OTC derivative indices are an essential source of pricing information for market participants, and the liquidity and price transparency they provide has enabled credit risk to become a traded asset class. However, despite an abundance of trading data, access to consistent and reliable valuations for over-the-counter (OTC) derivatives is a challenge for some market participants, particularly when compared with the transparent and observable pricing of exchange-traded securities. Typically, interest rate and inflation rate indices are provided by investment banks, which are privy to non-public information about their clients, and they are active in credit derivatives markets, both as dealers and in proprietary trading. While these institutions have Chinese walls in place, there are undoubtedly possibilities for a potential of conflict of interest. Further, there are also concerns about the opacity of OTC derivative pricing models and the inability of market participants to interrogate their methodology. It is critical that market participants are able to access robust derivative pricing and risk processes supported by high quality independent data particularly, as regulatory reform and investor demand puts greater emphasis on demonstrable best execution. Market innovation There is no shortage of data on the drivers of rising and falling inflation and interest rates, but access to that information is not always easy. Highly-resourced investors are increasingly using size and financial reach to their advantage by gaining a deeper insight into OTC derivatives through analysis of information not typically available to the wider markets. While this is undoubtedly beneficial on an organisational level, it has the potential to skew OTC derivatives deals in their favour leaving the less well informed at a disadvantage. Working to level that playing field is Parameta Solutions, the data and analytics division of TP ICAP Group, which this August launched a new family of interest rate swap volatility (IRSV) indices to provide 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 will cover the entire range of interest rate products, ranging from exotic options to short and long-term interest rate swaps, to assist market participants with accurate interest rate volatility measures, both when making investment decisions and measuring investment risks. Just as the FTSE100 is a leading benchmark for the performance of the UK’s biggest companies and the MSCI World index is the trusted source for pricing the biggest companies across the globe, the IRSV indices offer market participants the same resource for OTC derivatives. Importantly 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 proven to have superior predictive power over other commonly used volatility forecasting measures. Democratising the OTC derivatives market need not be confined to interest swaps. As the direction of travel for inflation remains uncertain, investors are crying out for data 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. Conclusion The direction of travel for OTC derivatives is 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 should be one where all market participants are armed with the information they need to ensure the best investment outcomes.

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