Banks are hiking their usage of swaps compression in order to reduce their amount of notional OTC derivatives outstanding as new Basel III requirements kick in.

Starting in the first quarter of 2015, banks will have to report what their leverage ratios and supplementary leverage ratios.

So-called blended compression is the process by which swap market participants reduce the number of individual positions and overall notional value of a portfolio by combining or offsetting trades with comparable characteristics.

“Compression is when you look at a portfolio of swaps and you replace the cash flows with fewer line items and lower overall notionals,” Sunil Hirani, CEO of swap execution facility trueEx, told Markets Media. “A simple example: let’s say you’re paying fixed for $1 billion for 30 years, and you’re receiving fixed for $900 million for 30 years. You can replace the swap by paying fixed for $100 million for 30 years.”

According to semiannual OTC derivatives statistics from the Bank for International Settlements, interest rate derivatives notional outstanding reached $584.4 trillion at the end of 2013.

A significant amount of activity can be attributed to so-called administrative trades –transactions meant to risk-manage, consolidate or reduce derivatives books, according to a report by the International Swaps and Derivatives Association, citing a study by the Federal Reserve Bank of New York of OTC interest rates derivatives activity during three months in 2010.

“Administrative activity to manage and tidy dealer derivatives books accounts for a large
proportion of derivatives turnover,” said the Isda report.

The data covers all electronically matched interest rate derivatives transactions between June and August 2010, where one of 14 large global dealers (G-14) was on at least one side of the trade.

Administrative trades accounted for approximately $66 trillion worth of activity over the three-month period versus $45 trillion in notional in price-forming trades. The $66 trillion included $5.6 trillion in compressions.

LCH.Clearnet earlier this year expanded its compression offering to include multilateral compression via SwapClear, its interest rate derivatives clearing service. Multi-compression is in addition to SwapClear’s existing Solo and Duo compression capabilities, and enables multiple members to simultaneously compress their trades with each other.

Compression reduces the number of trades and notional outstanding by terminating contracts with offsetting positions. In 2013, SwapClear compressed over $83 trillion through its proprietary and TriOptima’s compression offering.

There are three drivers for compression, according to Hirani: capital requirements, as measured by supplementary leverage ratio, gross notionals, and line items reductions. In July, trueEx launched a compression service called trueBlend, which banks, hedge funds and asset managers, use to perform one-way blended compression.

“This service that we offer is completely self-initiated, and you don’t need to coordinate with other market participants,’ Hirani said. “This is something that you, as a dealer or a buy-side firm, can do on your own and you don’t need the cooperation of any other counterparty.”

trueEx offers another product called truePorter which enables a portfolio to be moved from one clearinghouse to another. One regulatory regime may contain a certain set of rules, and from time to time banks may feel like they want to move it to another regime.

Another reason for porting is concentration risk. “For whatever reason, in a particular currency or product, your concentration limits may have been exceeded with one clearing house,” Hirani said. “So you can use truePorter and move your positions around.”

Six months after U.S.-based SEFs began executing mandated OTC transactions, the take-up for SEFs has been less than spectacular, according to Hirani. “It’s a very, very challenging, difficult environment,” he said. “We have historically low levels of volatility and historically low levels of interest rates which, combined with increased costs for regulation compliance, doesn’t make for a great environment. Having said that, if you have differentiated products and service, and if you can create efficiencies for clients, we find there’s a lot of opportunities in that space.”

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