Portfolio compressions can be useful to manage counterparty risk in derivative transactions. This article is the first of 3 parts and examines how companies can benefit from the mark-to-market credit exposure perspective, and some potential downsides.

This article is part one of my explanation on why new portfolio compression techniques benefit a credit risk manager. As a credit manager I faced being blocked for trading and blocking counterparties because the credit risk exposure was beyond policy limits or being under pressure to come up with ways to accommodate a new attractive long-term deal with a counterparty with little room for more credit risk. Even worse, closing portfolios in an orderly manner because of fearing a default, which is when I came across compressions. There are other benefits, but for now I will focus on credit risk.

Portfolio compression has been brought into the spotlight due to EMIR requirements. However, compression has proved useful to manage other risks. In the following article, I will explain the three ways portfolio compression can help in managing credit risk to counterparties from the following angles:

1. Mark-to-market (MtM) credit exposure
2. Potential future exposure (PFE)
3. Reducing risk with counterparties where netting is not applicable

By the way, what is a portfolio compression?

Imagine having thousands of “buys” and “sells” of the same product with the same counterparty. Ideally those thousands of deals are equivalent to one single “buy” or “sell”. In a compression, some transactions in the portfolio are terminated early, such that the surviving trades deliver the same profits of the original portfolio, with the same economic risk. If not, a company would wish that any reduction in profits or increase in risk falls within acceptable levels. The reward from holding a portfolio with less active trades is to reduce, credit, operational, collateral, regulatory and / or capital requirements risks.

For today, the immediate, Mark-to Market: A win-lose situation

Under normal circumstances, my company will realise the mark-to-market profits over the life of the transactions. If the counterparty defaults before the end date of the deals, then my company will have to claim the expected profits from the administrator or via the applicable default process.

In a compression, some transactions are terminated. If the mark-to-market were in my company’s favour, my credit team would be “happy” about receiving the profits from those transactions “now” straight after the compression, instead of having to wait to realise cash flows over different periods of time in the future. Therefore, my company eliminates the credit risk from those transactions that are terminated, and the credit lines can be re-opened to trading.

On the other hand, the counterparty’s treasurer will have to pay all the mark-to-market value “in one go” and “today” when the compression is completed, instead of spreading cash flows over weeks, months or years; depending on the maturity and payment terms of the deals. From the treasury’s perspective, the counterparty loses out. Nevertheless, counterparties who have to pay-out, enter into compressions due to releasing credit capacity that enables “my company” to re-open trading activity.

A bilateral compression involves a company and its counterparty. From the credit and treasury perspective, there is a win-lose result. In our case, the company benefits from receiving a cash lump sum and reducing the credit risk,  whereas the counterparty had to pay a cash lump sum with no credit risk exposure benefit. From the business potential perspective both benefit by releasing room under the trading lines.

Multilateral compressions aim at redistributing credit exposures across three or more participants. Some may increase and some may reduce their credit risk, so the effect of paying to a counterparty may be offset or at least partially offset by receiving cash flow from another participant. Although not guaranteed, the cash outflow impact may be smoother, resulting in more "winners" from the cash and credit perspective.

In the next post, I will cover compressions where a win-win is possible.

Diana Higgins

www.crediten.co.uk