Trade Compression

Trade compression is a post-trade process in which two or more parties replace a large set of outstanding derivatives contracts with a smaller set, or cancel them outright, in such a way that each party's net exposure to the market stays broadly the same. It reduces the number of trades and the gross notional amount on firms' books without changing their economic positions. The practice is also called portfolio compression.

Compression exists because derivatives positions are rarely closed by cancelling the original trade. A dealer that wants to reduce an interest rate swap position typically enters an offsetting swap, often with a different counterparty, so both contracts remain open until they mature. Over time, dealers accumulate thousands of contracts whose risks largely cancel out but which still have to be valued, margined, reconciled and backed by capital. Compression removes this build-up. It is used mainly for OTC derivatives, both cleared and uncleared.

In the simplest case, one party holds two contracts with the same counterparty and identical terms but in opposite directions. The two can be terminated against each other, or netted into a single contract for the difference. Bilateral compression of this kind needs only the agreement of the two parties.

Multilateral compression achieves much larger reductions by finding chains of offsetting trades across many participants. If bank A has paid fixed to bank B, B to C and C to A on similar swaps, all three trades can be removed with little or no change to anyone's position. A compression service runs the process in cycles:

1. Participants submit the trades they are willing to compress, with their valuations and their tolerances for changes in market risk, counterparty exposure and cash payments.
2. The service's algorithm searches for a set of terminations, partial reductions and, where needed, replacement trades that satisfies every participant's constraints at once.
3. Each participant receives a proposal showing the effect on its own portfolio and accepts or rejects it.
4. If all accept, the proposal becomes legally binding at a set time. Old trades are terminated, any replacement trades are booked, and small balancing payments settle differences in value.

Because the trades being removed are rarely identical, a small residual change in risk is normal, and participants set limits on how much they will tolerate.

When trades are cleared, every contract faces the central counterparty, which makes compression easier because all of a member's trades are with the same legal entity. Clearing houses offer netting of trades with matching terms within a member's account, and techniques such as coupon blending, in which swaps with the same remaining dates but different fixed rates are combined into fewer trades with an averaged rate. Multilateral cycles across clearing members are also run for cleared swaps. Compression has become a routine feature of cleared derivatives markets and is a major reason why reported gross notional outstanding in interest rate swaps has at times fallen even as trading volumes grew.

The benefits are operational, financial and regulatory:

• Capital. The Basel III leverage ratio and the assessment of global systemic importance both use measures linked to gross derivatives notional, so removing redundant trades lowers requirements without reducing business.
• Counterparty exposure. Fewer bilateral trades mean lower gross exposures and less counterparty risk, and can reduce initial margin on uncleared portfolios.
• Operations. Each open trade carries costs for payments, resets, valuation, portfolio reconciliation and reporting throughout derivative lifecycle management.
• Default management. A smaller, cleaner portfolio is easier to value, hedge and auction if a member fails.

Authorities have encouraged compression as part of the reform of derivatives markets after the 2008 crisis. Under the risk mitigation rules made under the European Market Infrastructure Regulation (EMIR), counterparties with 500 or more uncleared OTC derivative contracts outstanding with one another must have procedures to assess, at least twice a year, whether to carry out a compression exercise, and must be able to explain a decision not to. The EU's markets regulation, MiFIR, defines portfolio compression and exempts it from best execution and trading venue obligations, while requiring the volumes compressed to be made public. In the United States, swap dealers are subject to comparable Commodity Futures Trading Commission rules on periodic compression. Terminations and replacement trades must be reflected in trade repository reporting.

Compression works best for standardised products with many offsetting positions, such as interest rate swaps and index credit default swaps, and less well for bespoke or directional portfolios. Its effectiveness depends on participation: the more firms and trades in a cycle, the more chains can be found. Tolerances set too tightly limit the result, while loose ones leave participants with unwanted residual risk. Replacement trades can also complicate hedge accounting and the tracking of a trade's history. Finally, a lower gross notional figure does not by itself mean that a market has become safer, since net risk is unchanged by design.

• European Securities and Markets Authority
• International Swaps and Derivatives Association (ISDA)