Counterparty Risk Reduction by the Optimal Netting of OTC Derivatives

Abstract

The netting of OTC derivatives trades, known as 'compression', reduces systemic risk in financial markets by minimising counterparty exposures between large financial institutions, in particular the large dealer banks. We present here a framework for compression in the OTC derivatives market for interest rate swaps. We minimise the total net counterparty exposure by partially or fully unwinding existing swap trades and determine the degree of compression obtained as a function of the number of trades, the number of participating parties and the number of risk constraints. We do this using both linear programming (LP) and quadratic programming (QP) approaches. We are able to separately quantify the benefit of bilateral and multilateral netting. We also compare the tendency of both LP and QP approaches to favour full unwinds of existing trades versus partial unwinds. We calculate the performance of both optimisation approaches by calculating their average reduction in counterparty risk by simulating over large numbers of randomly generated trade sets. We show that significant compression can be achieved, and find that LP approaches are preferable as they are generally computationally faster and produce solutions with more full unwinds than QP approaches.

Keywords: Counterparty Risk, Netting, Derivatives, Linear Programming, Quadratic Programming

JEL Classification: C44, C61, D40, G01, G28