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Michael Riddle

Eris Exchange

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Michael Riddle

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Spotlight-blackOTC Derivatives Reform (more stories)

12 April 2011

Re-thinking Compression in a Cleared Swaps World

The migration to a cleared swap environment provides opportunities to re-think and improve the traditional methods for compression of swaps contracts, Riddle says.

With new cleared swap instruments being created for each new day and each unique coupon traded, and tenors that can extend 20 or 30 years, one easy-to-predict consequence of the migration to centralized clearing of swap derivatives is that trading and clearing firms must prepare to support a proliferation of open position line items for each customer.

The natural reaction to this realization is to call for increased use of compression within the industry. What we shouldn’t miss, however, is that the migration to a cleared swap environment provides opportunities to re-think and improve the traditional methods for compression of swaps contracts, in light of the important structural differences between the OTC and CCP environments. Legacy compression techniques have evolved from a world characterized by factors that are increasingly irrelevant in the cleared swap paradigm: Bi-lateral credit relationships, inconsistent collateral exchange terms and non-centralized pricing calculations.

Trading swaps as freely tradable, centrally-cleared futures, on the other hand, offers compelling advantages to these legacy constraints, without the inflexible product specifications traditionally associated with futures contracts. Realizing the full potential of the CCP model calls for a reevaluation of compression methods to take full advantage of the standardization of terms for contracts, collateral, pricing and counterparty risk. With all participants on a swap execution venue eligible to participate on equal terms, the reduced complexity of compression may even lead to an integration of compression into the trading routines, rather than requiring manual, time-consuming, complex back-office processes.

What’s also important to keep in mind is that compression evolved as a method to allow an institution to consolidate its portfolio of bi-lateral swaps without needing to negotiate individual tear-ups with multiple bi-lateral counterparties.

Traditional compression achieves this goal by reducing the total number of swaps in existence, which in the cleared world equates to a reduction of open interest. The cleared swaps world, however, offers other options for a party to reduce its portfolio of open positions without the need to find another counterparty who has similar positions against which its position can be offset.

The most successful swap execution venues and clearinghouses will be the ones that harness the full potential of the CCP model and allow swap derivative positions to be freely tradable among all eligible counterparties, thus increasing substantially the opportunities for institutions to consolidate portfolios in a straightforward manner, with or without the need to compress open interest to achieve this goal.

Eris Exchange’s innovative contract construction allows for free tradability among parties by embedding the total economics of an OTC interest rate swap – including NPV, historical coupon payments, and daily interest on collateral – into an instrument that trades according to traditional OTC market protocols and clears as a future at CME Clearing.

Whereas historical interest rate swap futures contracts have required participants to trade one specific, fixed coupon and roll positions upon quarterly expiration, Eris Exchange interest rate swap futures offer OTC interest rate swap characteristics never previously offered in futures form: the flexibility of trading any fixed coupon for any maturity date out for 30 years.

Dedicated liquidity providers on Eris Exchange embrace the opportunity to step into aged swap future positions as a means of allowing customers to consolidate their portfolios and the exchange is partnering with market participants to develop additional tools to facilitate simplified consolidation of multiple positions, which is traditionally achieved through compression.

We look forward to joining with the rest of the industry in continuing to reassess the most effective methods for trading swap derivatives, and suspect that we have all only begun to scratch the surface of how the CCP model will create new opportunities for improving the efficiency and effectiveness of financial risk management.

Spotlight-white-trans For more stories in the OTC Derivatives Reform Spotlight Series click here.

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