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 Friday 20 November 2015

Trade Compression


The semi-annual report published by the Bank for International Settlements (“BIS”) earlier this month estimated that the notional amount of outstanding OTC derivative contracts as at 30 June 2015 was US$553 trillion, a decrease of approximately 14% from the previous half year.

According to the report, it is believed a large part of the decline is due to trade compression.

What is trade compression?

Trade compression is a way to reduce the number of outstanding contracts (and therefore their gross notional amounts) but keep the same economic exposure.

This can be done on a bilateral basis where firms cancel offsetting contracts in their own portfolios or a multilateral basis where a group of market players can tear up offsetting trades with each other within agreed parameters. Compression can be done for all or part of the notional amounts concerned.

Basel III’s new capital rules and leverage ratio are based on gross notional exposures and so trade compression allows banks to reduce the capital needed to cover their OTC derivatives trading book risk. Indeed the International Organization of Securities Commissions has also recently recommended compression as a standard for mitigating risks for non-cleared OTC derivatives trades.

Our first diagram shows how transactions between two parties could be compressed.  The original two contracts are torn up and one new contract with a reduced notional amount takes their place.

Bilateral trade compression example

In standardised contracts (e.g. CDS indices) the compression process is fairly straightforward because the majority of economic details are the same (e.g. spread, scheduled maturity date, underlying index and schedule payment dates) and any difference is reflected in the fee paid by one party to the other following execution of the relevant trades.  It is, of course, easier to tear up trades when there is an exact offsetting match.

Trade compression is not a new idea.  It has been used in the OTC derivatives market for several years. TriOptima and CLS are leading providers of compression services.

In our second example below the 4 original transactions would be replaced with one trade. 

Multilateral trade compression example

Under the European Market Infrastructure Regulation, each financial counterparty or non-financial counterparty with 500 or more OTC derivative contracts outstanding with another counterparty which are not centrally cleared is required regularly to assess their non-cleared positions and determine whether it is possible to undertake a portfolio compression exercise. Where this is not possible they must provide a “reasonable and valid explanation” to the relevant competent authority.

Summary

Trade compression is therefore an important means of reducing gross notional amounts; for achieving regulatory capital savings; and reducing operational and counterparty risk exposures. When used on a multilateral basis, for example, with cleared OTC derivatives trades, it also cuts back on double counting of risk. For when an original bilateral non-cleared trade is accepted for clearing, it becomes two trades between the central clearing counterparty (“CCP”) and Party A and the CCP and Party B which is clearly inefficient from gross notional estimation and capital allocation points of view. ISDA estimates that nearly 70% of OTC interest rate derivatives are now cleared. Therefore the importance of trade compression should not be underestimated.

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Posted by Abigail Harding


Tagged: ISDA negotiation ISDA

Category: ISDA negotiation


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