Compression Has Scope to Expand Across Asset Classes

Shanny Basar

Compression could expand from the interest rate swaps market to more derivative products and more buyside clients as banks continue to face balance sheet pressures from new regulations.

Michael Modlock, head of triReduce North America at TriOptima, told Markets Media: “We are extending both the product class and client base. We also continually refine our compression process so the client experience of triReduce is consistent, irrespective of product or geographic location. This minimizes the resources client need to use the service.”

TriReduce is the multilateral compression service run by TriOptima, Icap’s post-trade infrastructure provider for over-the-counter derivatives, in collaboration with clearinghouses and CLS, bank-owned physical settlement system for foreign exchange.

Compression is a process in which clients can “tear-up” offsetting trades in their portfolios to reduce the notional outstanding and number of line items in their portfolio while maintaining the same risk exposure. Use of compression services has increased following the introduction of stricter capital requirements, such as the Basel III leverage ratio, which has led to banks reducing their balance sheets and capital efficiency becoming increasingly important.

Last month SwapClear, part of the London Stock Exchange’s clearing house LCH, and TriOptima announced the inclusion of the first client-cleared trades in a compression cycle.

“Traditionally only direct clearing members have taken part in our cleared compression cycles but going forward non-member clients can also participate with their portfolios,” added Modlock. “More participants means a larger eligible trade pool for compression, leading to more optimal results and greater benefits for everybody.”

The client-cleared trades were part of an entire Canadian dollar interest rate swaps cycle with 18 participants who eliminated C$1.38 ($1.05) trillion in notional principal. Client-cleared trades are from a clearing broker or futures commission merchant who clears on behalf of market participants who are not direct members of a central clearing counterparty. This allows buyside firms to benefit from compression while maintaining the same risk exposure.

John Naud, chief operating officer of global fixed income for Citadel, said in a statement: “We have long supported buyside access to these solutions and look forward to the benefits that this will bring to the market.”

Modlock said: “We have extended rates compression to more currencies and more products such as cross-currency swaps, inflation swaps, overnight index swaps and FRAs. FX forwards has seen excellent growth in the last year and remains a great opportunity, as does emerging markets.”

The majority of compression takes place in the US dollar interest rate swaps market. Cleared swap volumes were boosted In the US as certain swaps have had to be traded on swap execution facilities since 2013 as a result of the Dodd-Frank Act. Mandatory clearing of interest rate swaps for the largest banks, who are also clearing members, began in June this year in the European Union with the next category of firms following on 21 December and the smallest firms next year.

Amir Khwaja, chief executive of analytics and research firm Clarus Financial Technology, analysed the compression activity last month on US SEFs in a blog.

“October is much lower than the prior two months, but still massively higher than 2015,” Khwaja added. “Overall volume of $63bn in October is 31% of the $204bn of US dollar interest rate swaps.”

However compression volumes are growing in other currencies. In May Eurex Clearing, Deutsche Börse’s central clearer, also  completed its first triReduce compression cycle for euro interest rate swaps.

CME Group has scheduled its first multilateral compression cycle for sterling interest rate swaps with triReduce this year after completing its second euro interest rate swap compression cycle last month.

Jack Callahan, CME Group’s executive director of OTC products, told Markets Media last month: “In total we have done nine multilateral compression cycles – six in US dollars, two in euros and one in Mexican pesos. We have two additional TriOptima compression cycles scheduled this year, including our first in sterling.”

The capital efficiencies from clearing and compression have become more important regulations requiring the exchange of initial margins for uncleared swaps came into force in September in some jurisdictions. The rules affected the largest swap dealers, with gross exposures of more than $3 trillion in the US, Japan and Canada affecting approximately 20 global firms. The rules did not cover transactions between two European institutions but European firms have been required to post margin for uncleared swaps with US, Canadian and Japanese institutions. However the exchange of initial margins for uncleared swaps is likely to be required in the European Union next year.

In addition new variation margin rules for non-cleared OTC derivatives will come into effect on 1 March 2017, likely on a global basis,  They are not being phased in, unlike the initial margin rules, and so will immediately apply to a wide variety of counterparties including a variety of dealers, buyside firms, pension funds and corporates.

Clarus Financial Technology also analysed the swap data to determine the impact of the initial margin rules that came into force in September 1. Tod Skarecky at Clarus said in a blog that there has been an increase in the clearing of non deliverable forwards in the foreign exchange market and in the clearing of inflation swaps.

Inflation-linked swaps are typically used by asset managers and pension funds looking to hedge against rising inflation and interest rates. Skarecky said all cleared inflation swaps are currently via LCH and that US-named business account for roughly one-third of this activity.

“By looking at just US dollar inflation swaps on US swap data repository, and including uncleared, corroborates the notion we raised last time that the majority of the inflation market is now cleared,” he added.

LCH said in a statement today that its SwapClear service has cleared a total of $1 trillion in notional of inflation swaps since the service launched in April 2015. SwapClear has also extended its compression offering to provide solo compression, within their own portfolios, for inflation swaps.

Daniel Maguire, global head of rates & FX derivatives at LCH, said in the statement: “The introduction of bilateral margin rules in September is driving volume growth across our rates and FX services and we’re pleased to be supporting our members and their clients in achieving improved risk management and capital efficiencies.”

In contrast Skarecky said there has only been a smattering of activity in the clearing of swaptions since their launch earlier in the year. He added: “However there has been recent news of more firms onboarding to swaption clearing, so it appears to still be in the infrastructure buildout phase within the industry.”

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