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June 22, 2016

Compressions Shrinking the OTC Space

New regulatory measures start to deliver benefits as efforts to reduce outstanding derivatives have achieved brilliant results in the last 18 months. By June 2015, the derivatives market had shrank to USD 553 trillion from its peak of USD 711 trillion in the first half of 2014. Aggregate compressions over the same period was of USD 265 trillion, three times as much as in the previous 18-months.

New regulatory measures start to deliver benefits as efforts to reduce outstanding derivatives have achieved brilliant results in the last 18 months. By June 2015, the derivatives market had shrank to USD 553 trillion from its peak of USD 711 trillion in the first half of 2014. Aggregate compressions over the same period was of USD 265 trillion, three times as much as in the previous 18-months.

In the last two years, compressions have evolved into more complex products and various market players have joined forces to collaborate in post-trade risk management cycles. The result is the emergence of interesting methodologies that have proved effective in reducing the volumes of derivatives that were so blamed for contributing to the credit crisis.

Portfolio compression is nothing more than a technique to eliminate a number of deals from a portfolio while ensuring that profits and price risk remain the same, or almost the same. Compressions are measured in notional value terms, equivalent to the number of units times the deal price, through all the life of the derivative. Buys and sells, both add up.

Double, Double Troil and Trouble

Figure 1 shows how the aggregate value of global derivatives has increased after the regulatory implementations in 2012, partly because more OTC derivatives have to be cleared. This means that the company enters into a transaction with another company, and then both entities strike the trade through to the clearer. As a result, the number of OTC transactions doubles when the deals are cleared. This is one of the side-kicks of regulation. Clearing OTCs may reduce the risk of losing money in case one of the companies default, but adds operational risk to the financial system from five directions as more operational support is required when considering the companies’ and the clearing house perspectives:

  • When company A does the deal with company B;
  • When company A novates the deal to the clearinghouse;
  • When company B novates the deal to the clearinghouse;
  • When the clearinghouse views the transaction with company A from its own perspective;
  • When the clearinghouse views the transaction with company B from its own perspective.

The good news is that compressions have made their way into the priorities of large and medium financial institutions to manage their regulatory risk. Compressions in the second half of 2013 were of 22 Trillion USD, and jumped to 116 Trillion USD in the first half of 2014. The most recent statistic shows that compressions eliminated 107 Trillion USD notional value in the first half of 2015. 

In Rocket 5, we examined how the Leverage Ratio in Basel III can be improved using compressions even if no capital is injected. This benefit alone has been the main driver behind the steep increase in compressions, which in turn has motivated new vendors to offer this service and design new types of compressions. Furthermore; EMIR, Dodd Frank and FinFrag include mandatory actions related to compressions.

The interest rates swaps (IRS) with central counterparties dominate the compressions landscape. Figures 2 and 3 show how in 2012 these instruments were 86% of the global compressions. In 2015, IRS were an overwhelming 98% of the total. Further details on these statistics can be found in the BIS Quarterly Review from December 2015. The forex market is still active; in the fourth quarter of 2015, Trioptima launched new products to compress FX Forwards and FX Swaps.

Adaptation and Collaboration Efforts Evolving into More Complex Compressions

Compressions are adapting quickly to the needs of the markets. The first compressions in the early 2000s were “Bilateral”, meaning that two companies show each other their portfolios and agree to terminate a set of transactions with no need of arranger or central counterparty.  A similar term “Duo” refers to compressions between two parties, in this case one of them can be a central counterparty. Then in 2003, TriOptima developed a tool to execute “Multilateral” compressions where more than two players submit their portfolios to a central arranger capable of finding opportunities to eliminate transactions across participants.

In 2014 and 2015, different service providers and participants have joined efforts and started to offer complementary services. Central clearers such as CME and LCH SwapClear, in association with Trioptima, have adapted compressions techniques to reduce the number of cleared deals held by its clearing members. For example, “Unilateral” or “Solo” compressions are cycles by which the clearing house sits in the middle, compressing with each participant to reduce their open positions, and therefore reducing their margining requirements. From a participant’s perspective, the compression happens only with the clearinghouse and the participant cannot see what actions are taken by other participants. The clearing house benefits by having to warehouse less “line items” or trades. More important, the clearing house reduces its risk to counterparties by shrinking concentration of margins with any single member which means that less collateral needs to be paid or received by a single member when market prices move.

Swap Execution Facilities or “SEFs” such as Bloomberg, Tradeweb and truEx have developed services by which they match a sometimes large set of trades that offset existing cleared transactions. The clearing house receives the group of trades. As a result, the client’s net position to the clearing house is reduced, and in turn less collateral is required. The client may want to execute a few new trades to get its overall portfolio back to the original position. This additional step is called “Compaction”.

Blended-rate” in IRS compressions enable a participant to replace a group of buys and sells with one transaction that has equivalent economic value. The new transaction would have the net notional value of all the buys and sells. The rate of the new deal is the weighted average rate of the original transactions to ensure that the final cash flows are the same as before the compression.

In early 2015, “Rebalancing” appeared as a technique by which and arranger can find offsetting transactions between two clearing houses and their members. The principle is the same as with other compressions. A member enters into new transactions with a clearing house, and strikes offsetting deals with another clearing house. Another member enters into offsetting transactions with the clearing houses so that the clearing houses keep their original net position. The final result is the elimination of a number of deals with all the participants in the cycle and the clearing houses ending up holding portfolios with less line items, and with the same economic value and open position as before the rebalancing cycle.

Last, but not least in the Fourth Quarter of 2015, BGC Partners and CapitaLabs announced they compressed €800 billion notional Swaptions. These instruments have a more complex risk profile than the vanilla IRS, given their asymmetry. Having had 10 banks including JPMorgan participating in BGC’s cycles shows how portfolio compressions continue to prove useful in reducing risk in OTC Derivatives.

Sources:

  1. Portfolio Compression, Techniques to Manage EMIR and other Regulatory and Trading Risks, by Diana Higgins, Risk Books, 2015. 20% discount for The OTC Space readers on www.riskbooks.com/otcportcomp
  2. BIS Quarterly Review December 2015. Extract by Andreas Schrimpf in pages 24-25. Bank of International Settlements (BIS) http://www.bis.org/publ/qtrpdf/r_qt1512.pdf
  3. The Impact on Compressions on the Interest Rate Derivatives Market, Research note by ISDA, July 2015.

This article was first published in edition 6 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.

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