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November 6, 2014

Portfolio Compression: Win-Win to Avoid Cherry Picking (Part 3/3)

Cherry Picking occurs when a company in default collects money from counterparties but waits to pay them only if there is money left when the administration process is completed. Several reasons may prevent from netting values owed against receivables or profits. For example if the jurisdiction does not allow for netting, if there are no netting agreements in place, or simply because contracts are paid in different currencies making it impractical to net, among other reasons. Compressions can help in the challenging task of reducing counterparty risk when netting is not possible.

The example attached shows how credit risk drops in a bilateral compression by eliminating a transaction in profit and a transaction in loss. The profit and open position remain unchanged. Both My Company and the Counterparty benefit by being left with less trades, each of which contributing to less credit risk. Multilateral compressions may increase the chances of finding offsetting transactions to further reduce counterparty risk.

In summary, compressions can help reducing counterparty risk. Bilateral compressions can benefit both My Company and the Counterparty by reducing the number of trades that contribute to credit risk in a no-netting scenario. The previous article explained how a reduction in an open position can reduce Potential Future Exposure (PFE) for both entities.

The first article explained how a drop in current exposure values may benefit one counterparty but not the other in a bilateral compression, but overall can reduce exposure for several counterparties if the compression is Multilateral.

Sources:

Portfolio Compressions Training Manual, by Diana Higgins

References: Trioptima.com, crediten.co.uk, EMIR Article 14, Crediten's own experience.

Diana Higgins crediten.co.uk

  • Part 1 is here: http://www.theotcspace.com/2014/03/21/portfolio-compressions-winners-and-losers-part-1-3
  • Part 2 is here: http://www.theotcspace.com/2014/09/14/portfolio-compression-win-win-case-part-23

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