Portfolio compression takes the spotlight

Innovation, creativity and adaptability have characterised the over-the-counter derivatives industry since the first interest rate swap was executed between IBM and the World Bank in 1981. As the market for OTC derivatives grew, the need for better post-trade management also emerged, and TriOptima’s multilateral early termination service, triReduce was an early leader in addressing that need.

Compression is in the news these days, fuelled by the impending Basel III leverage ratios and by steep capital charges and margin requirements for OTC derivative transactions. Since the enactment of Dodd-Frank legislation in the US and the European Market Infrastructure Regulation in Europe, the regulatory authorities have emphasised the importance of compression in reducing notional principal exposure for individual institutions and for the clearing houses. And they have required periodic assessments of compression opportunities, putting the industry on notice that compression is a critical risk management activity.

CFTC (DFA)

• Swap Dealers (SDs) and major Swap Participants (MSPs) are required to establish policies and procedures for periodically engaging in portfolio compression evercises with couterparties that are also SDs or MSPs
• SDs and MSPs must engage in portfolio compression exercises with non-SDs/MSPs upon request 

ESMA (EMIR)

• Art 13: “ Financial counterparties and non-financial couterparties (“CP”) with 500 or more OTC derivative contracts outstanding with a counterparty which are not centrally cleared shall have procedures to regularly, and at least twice a year, analyse and possibility to conduct a portfolio compression exercise (..)”
• Alternative to participation: Provide a reasonable and valid explanation that a portfolio compression exercise is not appropriate

As sellside institutions look to gain the capital, credit and leverage ratio benefits of compression, buyside firms are examining the new regulatory and operational environment and their own opportunities to reduce their portfolios. Usually much leaner organisations and often with mandated customer/
investor reporting requirements, the buyside focuses on reducing line items to minimise operational risk and on implementing ‘good housekeeping’ measures that relieve pressure on systems capabilities and reporting requirements. In addition, they are eager to neutralise the effect of increased
trading costs as their counterparties pass on the financial impact of new regulatory requirements.

TriOptima’s launch of triReduce, its multilateral riskconstrained compression service in 2003, signaled that there were opportunities in post-trade to reduce credit risk, operational costs and capital charges. Today, these opportunities have increased substantially as the execution and clearing environment shaped by new regulation realigns and increases the benefits of reducing outstanding portfolios.

The Clearing House Effect

Mandated clearing has dramatically impacted the OTC derivatives market in general and has opened up new portfolio compression possibilities.

As reported by the International Swaps and Derivatives Association (ISDA) in their December 5th SwapsInfo Weekly Analysis, about 70% of interest rate notionals and 75% of credit notionals are being cleared. The same report indicated that approximately 50% of interest rate notionals and 66% of credit notionals are executed on swap execution facilities (SEFs) with growth in both clearing and electronic execution projected.

TriOptima currently supports clearinghouses offering opportunities to reduce notionals to the buyside, either directly if they are clients, or through futures commission merchants (FCMs) in the US or clearing brokers in Europe. TriOptima also continues to work with any CCP, like LCH SwapClear and JSCC, that offers multilateral compression to its members.

An important liberating factor in cleared trade compression is the practice now implemented by most CCPs to represent their portfolios as “unlinked” where the link between the two original counterparties to the swap is no longer maintained as part of the CCP record. Removing the need for the original counterparty to participate in the compression exercise in order to terminate the trade dramatically expands the pool of compression eligible trades.

Understanding the Compression Landscape

Compression is now shorthand for many new initiatives that seek to reduce notionals concurrent with execution on a SEF or after execution, in the clearinghouse. The tendency to identify all these recent activities as compression has created confusion in the market, in the regulatory community and in the press. While many of these new approaches are effective, multilateral risk-free compression is the most comprehensive compression solution with the most flexibility and the broadest reach. The characteristics of each approach are discussed below.

• Execution driven, cleared (compaction),
• Post-trade bilaterally uncleared,
• Post-trade in a clearinghouse (netting, coupon blending, multilateral risk-constrained compression), or
• Post-trade uncleared multilateral risk-constrained compression.

Compaction: Execution Driven Cleared

Clearing eliminated the popular buyside custom of novating/ assigning away trades to sellside institutions in order to reduce their portfolios. In place of novation, compaction developed. Compaction is offered on execution platforms enabling the buyside to enter into new swaps that mirror existing cleared trades. The process facilitates the execution of trades that are equal and offsetting for netting recognition by the CCP. The new mirrored trade is tagged to the existing one, which the CCP nets at the end of the day.

Bilateral Negotiated Compression: Post-trade Uncleared

Counterparties have always been able to negotiate early termination of transactions bilaterally. Two institutions identify a trade that they both want to exit and then negotiate and agree a close-out valuation of that trade. One counterparty pays the other based on the agreed valuation and the trade is terminated. While this allows for ad hoc scheduling and some flexibility, it can be time-consuming and it can be difficult to achieve consensus on valuations and risk neutrality.

Risk Free Netting/Coupon Blending: Post-trade Cleared

CCPs offer a simple netting process available to all members/clients. This netting process enables individual members to offset perfectly matched trades in their own portfolios – trades with the same coupon and payment dates. Each institution can cull its cleared trades in the CCP by selecting their cleared trades for CCP netting. This type of netting only applies to one member’s portfolio and does not involve any other firm.

Coupon blending is a recent extension of the netting process. Offered by the CCPs it enables individual clearing members to combine trades with the same end date but different coupons and reduce notional by putting on a replacement trade with a smaller notional that captures any residual cashflow or mark-to-market differences of the original trades. While more effective than simple netting, coupon blending opportunities remain limited by the need for full cash flow neutrality.

Multilateral Risk-Constrained Compression: Post-trade Cleared and Uncleared

Multilateral risk-constrained compression differs from the other offerings in several respects.

First, it includes the participation of multiple institutions submitting as many trades as possible in compression cycles. This increases the pool of trades available for termination.

Second, by including the ability to set risk-based constraints that limit changes in risk profile, trades can be compressed that have similar but not identical payment dates. When executed within a CCP, the results leave the CCP fully cashflow neutral. Without the constraint of perfectly matched cashflows and payment dates for each participating entity, a multilateral risk constrained exercise results in significantly increased compression efficiency.

Reflecting this increased efficiency, participants automatically compress both:

• trades with different coupons but ending on the same maturity date AND
• trades across different maturity dates within a predefined time bucket constrained by a market risk tolerance.

Third, each participant can terminate its trades at its own midmarket valuation rather than having to agree the valuation of each compressed trade with the counterparty.

Multilateral compression cycles run according to a schedule. Currently TriOptima offers at least two cycles in various products and locations a week and modifies or adds to the schedule as requested by its clients.

As summarised in the chart below, the total notional eliminated by TriOptima through November 2014 reached $524 trillion. TriOptima’s triReduce compression cycles cover all OTC derivative trades including credit, interest rate, cross currency, and commodity products both cleared and uncleared.

While the notionals compressed in the cleared environment are substantial, eliminating notionals in uncleared interest rate swap currencies also contributes to achieving Basel III leverage ratios and reduces capital charges, credit risk and country risk. The same is true for commodity transactions and for uncleared credit default single name and index swaps.

Getting the Most Bang for Your Compression Buck

The increase in opportunities to reduce notional by any of the methods now offered to both sellside and buyside market participants is a positive development. However, as illustrated below in the table of TriOptima’s offerings, multilateral riskconstrained compression can also reduce notionals in some of the more exotic currencies or products that typically carry higher capital charges, credit risk or country risk.

Always working closely with clients to introduce new services that meet their evolving needs, in 2014 TriOptima inaugurated compression in precious metals and cross currency swaps, as well as an on-demand bespoke compression service with a new focus on compressing buyside cleared trades. In 2015, inflation swaps and FX forwards compression as well as additional CCP relationships are planned in a bid to continue to reduce notionals and line items; and enhance best practice risk management.