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Trade compression is a way to reduce the number of outstanding contracts and therefore their gross notional amounts but keep the same economic exposure. This can be done on a bilateral basis where firms cancel offsetting contracts in their own portfolios or a multilateral basis where a group of market players can tear up offsetting trades with each other within agreed parameters.
Compression can be done for all or part of the notional amounts concerned. Indeed the International Organization of Securities Commissions has also recently recommended compression as a standard for mitigating risks for non-cleared OTC derivatives trades. Our first diagram shows how transactions between two parties could be compressed.
The original two contracts are torn up and one new contract with a reduced notional amount takes their place. In standardised contracts e. CDS indices the compression process is fairly straightforward because the majority of economic details are the same e. It is, of course, easier to tear up trades when there is an exact offsetting match.
Trade compression is not a new idea. It has been used in the OTC derivatives market for several years. TriOptima and CLS are leading providers of compression services. In our second example below the 4 original transactions would be replaced with one trade. Under the European Market Infrastructure Regulation, each financial counterparty or non-financial counterparty with or more OTC derivative contracts outstanding with another counterparty which are not centrally cleared is required regularly to assess their non-cleared positions and determine whether it is possible to undertake a portfolio compression exercise.
Trade compression is therefore an important means of reducing gross notional amounts; for achieving regulatory capital savings; and reducing operational and counterparty risk exposures. When used on a multilateral basis, for example, with cleared OTC derivatives trades, it also cuts back on double counting of risk.
Therefore the importance of trade compression should not be underestimated. We hope you found this article useful.
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Call us today on Blog Suggest a blog topic. What is trade compression? Summary Trade compression is therefore an important means of reducing gross notional amounts; for achieving regulatory capital savings; and reducing operational and counterparty risk exposures. Posted by Abigail Harding Tagged: ISDA negotiation Add comment.
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