Derivatives Compression Takes Hold01.29.2015 By Terry Flanagan
There has been a recent surge in compression volumes for over-the-counter derivatives which looks set to continue as the International Organization of Securities Commissions has recommended compression as a standard for mitigating risks for non-cleared OTC trades.
A research paper from the International Swaps and Derivatives Association today estimated that 69.3% ($230.6 trillion) of the interest rate derivatives market is now cleared and that 35.7% of the market has been reduced through portfolio compression.
Scott O’Malia, chief executive of ISDA said in a statement: “Close to 70% of the total interest rate derivatives market is now cleared, and compression activity is catching up fast following a big increase in volumes last year. We expect both these trends to continue as clearing services and mandates expand and compression technology continues to develop.”
Compression allows firms to either cancel offsetting trades in their own portfolios, or can take place multilaterally where market participants can tear up offsetting trades with each other, within defined risk parameters.
The new capital rules and the leverage ratio under Basel III are based on gross notional exposures, so compression allows firms to use less capital in their derivatives businesses. In addition by cutting notional values and the number of individual transactions, firms can also reduce operational and counterparty credit risk exposures.
Isda estimated that total outstanding compressed volume nearly doubled from $94.7 trillion in December 2011 to $184.9 trillion in June 2014. “We observe a steady uptick in compressed CCP trades throughout the series, with the largest jump – an increase of 60% – occurring in the most recent six-month period,” said the report.
This week IOSCO included portfolio compression as one of its nine recommendations in its final report on Risk Mitigation Standards for Non-centrally Cleared OTC Derivatives.
The report said: “Covered entities should establish and implement policies and procedures to regularly assess and, to the extent appropriate, engage in portfolio compression.”
However, IOSCO also warned that portfolio compression may carry some disadvantages specific to a party’s legal, tax, accounting and/or operational status and may not be appropriate in all circumstances.
Last year SwapClear, part of London Stock Exchange’s LCH.Clearnet, achieved an annual reduction in notional outstanding through compression for the first time. SwapClear reduced notional outstanding from $426 trillion to $362 trillion in 2014.
Analysts at Barclays Capital said in a report that 2015 will be an opportunity for Swapclear to further extend its compression services as banks are under significant pressure to reduce leverage and comply with harsher capital requirements.
This year SwapClear has increased the the number of trades available for compression by broadening the range of currencies. It further intends to increase the capacity of trades that can be compressed and the frequency of some compression cycles.
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