Swaps Compression: What is it and why is it important?

This article is written by a guest author.

Swaps Compression reduces the volume of open trades in Swap and other OTC derivatives portfolios. What is it? What are the benefits? Why is it important? The answers to these questions are not well understood outside of narrow groups of people using or depending on compression in market utilities, participants, and regulators. Here, I aim to elucidate for a wider audience.

What is it?

Swaps Compression reduces the number and size of trades in portfolios by terminating many trades in a single bulk transaction, but without a material change in portfolio risk or portfolio value for the parties involved. Termination of a single trade is conceptually straightforward (though manual in practice). Compression operates on whole portfolios and is more complex. However, Clearing Houses and compression vendors have centralized much of that complexity, allowing participants to get the benefits with only medium operational effort and IT investment.

What are the benefits?

The benefits of compression are to materially reduce the portfolios’ operational burden and systemic risk.

The operational burden is the daily and period-end work to settle cash flows as they fall due, and to risk-manage and report at trade- and portfolio levels over each trade’s life.

The operational burden increases because there are inherently many trades compared to other instrument types. First, IR swaps have relatively long maturities – up to 30+ years, averaging 5–7 years – so trades stick around on the books for a long time. Second, a securities or futures trading desk hedges by trading out – directly selling the security or futures position that has a standardized maturity date and other economic terms. By contrast, an IR swap trader cannot trade out of the exact economics of each trade because there is a lack of standardized maturity dates. Each trade is separately traded out with an offsetting swap that may no longer be the most liquid swap.

The operational burden also increases because of macro-hedging. While this is efficient from a risk management perspective, it adds to the trade count and operational burden.

In summary, a typical swaps desk’s open portfolios represent many years of swap trading and macro-hedging activity across many more years of maturity dates in the future. Without compression, all trades will run to maturity.

The systemic risk is that the market cannot effectively manage large swap participant defaults.

Even before the 2008 global financial crisis (GFC), financial regulators globally became concerned about the systemic risk build-up in OTC derivatives portfolios, which had grown from $160.6tn at the end of 1998 to $1,190.6tn at the end of 2008 (source: BIS OTC derivatives statistics). They were concerned about counterparty risk – specifically, the default of one or more cascading series of large swap counterparties. In addition to the market’s ability to absorb the counterparty risk retraded in a default, they felt that higher numbers of trades in a defaulting party’s portfolio threatened participants’ ability to manage the default operationally. They wanted to put downward pressure on portfolio size.

When the 2008 GFC hit, regulators formed the G20 consensus and implemented many measures globally. Two of these strongly promoted compression:

• The GSIB capital surcharge. G20 regulators agreed on the list of global systemically important banks (GSIBs) that were to attract a capital ratio surcharge to their minimum capital ratio based on each bank’s GSIB score. A key ingredient of the GSIB score is the “notional amount of OTC derivatives”, or the gross notional of their OTC derivatives portfolio. This is one of the few components of the GSIB score that can be reduced materially (using compression) without reducing revenue-producing activities.
• Promotion of OTC central clearing. By adopting uncleared margin rules and mandating clearing for the most liquid and linear OTC products, regulators drove a dramatic shift of open OTC trades into CCPs. This made compression a more powerful tool, enabling CCP compression to yield better results.

Why is it important?

The size of the operational burden and systemic risk impacts make compression important, as demonstrated with statistics.

Global OTC derivatives open trades – gross notional (two-sided, $tn)

(Sources: BIS OTC derivatives statistics extrapolated to two-sided basis, SwapClear volume figures, analysis by author).

In the year between end H1 2022 and end H1 2023 we see a $165tn (+13%) global notional increase comprising:

• A non-IR increase of 23tn (+1.8% of the H1 2022 total).
• An IR increase of 142tn (+11%).
• A SwapClear increase of 28tn (+2.3%).
• SwapClear activity of $1,168tn, which was almost as much as all OTC derivatives open notional ($1,264tn), at the start of the period.
• SwapClear compression eliminated about 70% of that activity (other CCPs and uncleared forms of compression have a further reduction effect).

The powerful GSIB capital incentive on OTC derivatives notional makes me doubt whether big banks could absorb most of that $840tn without adding to their GSIB capital surcharge. In other words, I doubt swap trading at the current scale would be possible without compression.

Hence, compression is important.

Summary

Compression reduces OTC derivatives volumes by material amounts, lowering their operational and systemic risk burden.

The scale of the effect means that compression enables swap trading today to operate at the current scale without excessive build-up of capital burden on banks.