Doug Ashburn, editor-at-large of John Lothian News and lead project manager for MarketsReformWiki, talked with Peter Weibel, CEO, triReduce division of TriOptima, about how the regulatory environment encourages compressions and how about 75 percent of trades on a typical bank’s portfolio are dead wood.

Q. How is the Dodd-Frank mandate toward central counterparty clearing affecting the business of portfolio compression?

A: As far as Dodd-Frank is concerned, the regulatory environment actually encourages compressions to take place. More and more trades will be going into CCPs, which means that the number of compression services to be provided in the cleared environment will increase. Nevertheless, we still do quite a bit of bilaterals at well. That is something that has been going on ever since LCH has offered its services in the early 2000s. So from that perspective there’s no change at all as far as our services are concerned.

Q. How exactly do compression services work, and why do banks desire to compress their trades?

A: An active trading bank trades in and out everyday, meaning that in its portfolio, there’s an accumulation of trades of very similar risk profile. From experience, we can say that probably about 75 percent of all those trades on a typical bank’s portfolio are exactly that – the part we can call “dead wood.” In order to represent the position that the banks actually want to have, probably 25 percent of all its trades will be sufficient to replicate or to have that risk value in their portfolio. Everything else has been bought, sold over the time and really just bears risk and cost. That’s the rational reason why terminations are actually very much in demand.

What we do is that we invite banks to sign up on our website, to signal that they want to take part in a compression or terminal exercise All the banks participating in triReduce compression service know that they should submit or extract the trades versus, let’s say, all other 19 counterparties if there was a cycle of 20 participants. They all extract the data and submit it to TriOptima, and we make sure that we have the opposite trades for each. That subset of what we call “linked” or “matched” trades will then go through the actual compression process, with the aim that at the end of this exercise, you and I will have hundreds if not thousands of fewer trades on our portfolio without having changed our market risk profile.

Q: How much are you able to compress right now versus how much you should theoretically be able to, if you had full participation?

A: That’s the big “if.” It’s a figure that’s very difficult to find out but I think we can say banks will never be able to submit all trades because some will have to remain on the book because they may be hedged, such as in liability management for instance. Such trades will never be eligible for early termination. But if a bank can submit, say, 80 percent of all their trades, we could link another 80 percent from their other participants, and assume a termination ratio of about 75 percent. So if you multiply those three parameters, we could say that from the existing portfolio to the end product, that we could halve the outstanding volume amongst that group that has participated. To give you an idea of what we have done in 2011: TriReduce helped the industry to get rid of $62 trillion U.S. worth. In LCH alone, since 2008, we have now exceeded $110 trillion.

Q: Can you give us an overview of triBalance?

A: You can describe the functionality as a bridge. The landscape within the new regulatory framework means that there will be a number of different CCPs and these CCPs will all have counterparty exposure risk, meaning that we have different sets of risk in different silos. What triBalance does is find new trades that will offset that potential future risk. By bringing down these open risk positions to a minimum, between one CCP and another CCP, and also between CCPs and the bilateral trades, that I think is a very strong argument to say that this is a reduction of systemic risk overall and also it will help banks to more efficiently use the available collateral that they will have to put up against each other, but also in terms of initial margins and variation margins to the CCPs. TriBalance [is designed to] rebalance the potential future exposure and minimize the need to put up collateral with each other or put initial margin with the clearing houses.

Q: So the service provides recommendations on how to best net out exposure?

A: Banks will deliver us with the necessary risk profile that they have, and also a risk profile with the bilateral counterparties that they still have, expressed as potential future exposure. This potential future exposure has been securitized by the CCPs, by requiring you to put up a certain amount of initial margin. In the bilateral world, it’s the amount that needs to change on a daily basis for collateral because we can just collateralize the static amount of counterparty exposure risk but if the market moves, and my trades come more profitable, then I will ask you to submit more collateral. And the smaller that position is, the less impact it will have should the market move. If there are offsetting positions between the CCPs and the bilateral world, it’s make sense to de-risk that situation by putting on trades that will bring down [total future exposure].

Once TriOptima receives the necessary parameters of the risk profile from each participant versus their other counterparties and their CCPs, then we can propose a set of trades that can bring down the potential future exposures. That is a proposal that TriOptima will find that is suitable for all counterparties, let’s say all 20 participants. The aim is to always reduce counterparty exposure risk and it will have to be a proposal that fits all 20 banks’ criteria. It is very much a multi-lateral construct, with [the end result being] to make the whole risk profile smaller.

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