Compression of excess over-the-counter swaps notional can play a major role in mitigating systemic risks, according to a new study, and further analysis of swaps data could help firms and regulators to improve the efficiency of their derivatives elimination activities to further those aims.
An analysis of compression in OTC derivatives markets, in association with the European Systemic Risk Board, showed 75% of gross notional in credit default swap contracts traded by EU institutions between 2014 and 2016 represented excess that could be eliminated without impacting net positions.
The reduction in counterparty risk exposure achieved through compression could limit the effects of contagion that saw liquidity issues at Lehman Brothers quickly morph into an insolvency event, said report authors Marco D’Errico, a researcher at the University of Zurich, and Tarik Roukny, a research associate at the Massachusetts Institute of Technology.
“A potential way to reduce stress in the market failed because counterparties were not able to reconcile contracts and identify other counterparties,” said Roukny. “With those tools now available, this major issue is not so limiting anymore and we want to understand the full role that compression plays in this augmented set-up.”
Roukny said around 50% of swaps excess can be removed via bilateral compression in which counterparties agree to collapse redundant contracts. That jumps to as much as 98% with the most conservative forms of multilateral compression, which bring a pool of counterparties together without creating new trades between parties with no pre-existing relationship.
Non-conservative approaches that allow new trades to be created with any counterparty can further enhance efficiency, but Roukny said participants face a trade-off between the fraction that can be eliminated and other constraints, including pre-existing trade exposures.
“If the need to compress is high, you might be willing to make new trades with a subset of participants, such as OECD dealers, to improve the efficiency,” said Roukny. “When you move from a conservative to a hybrid approach, you are able to eliminate almost all excessive notional without the need to go all the way towards non-conservative compression. If properly monitored, the hybrid approach provides a good trade-off.”
Banks have made progress in scrubbing down their bloated derivatives books to reduce hefty capital charges on derivatives portfolios. Swaps compression provider TriOptima has presided over more than US$1 quadrillion in eliminated derivatives notional since its triReduce service went live in 2003.
Hundreds of billions of dollars in redundant swaps are still outstanding, however, and the addition of non-bank participants could accelerate efficiency in some markets.
“While banks are incentivised to compress due to the high capital requirements, other institutions that may help to increase the efficiency of compression might not be willing to compress given the lack of incentives,” said Roukny.
“I don’t think we should aim to always compress everything, but at times it is more important, and counterparties might need those incentives.”
Having created a framework for analysing swaps trading data, the authors hope to quantify the impact of compression on systemic risk, helping regulators to form a position on the activities and potentially consider appropriate incentives.