Compressing Over-the-Counter Markets
60 Pages Posted: 4 May 2017 Last revised: 19 May 2018
Date Written: May 15, 2018
This paper studies portfolio compression in over-the-counter (OTC) markets. We show that multilateral netting opportunities can be decentrally exploited in order to reduce excessive notional while preserving individual market risk characteristics. We characterize feasibility and efficiency levels as well as structural features of the resulting compressed markets. Importantly, the results highlight a trade-off between notional elimination and conservation of original counterparty relationships. Applying our framework to transaction-level data on OTC derivatives markets, we find that, on average, 75% of gross notional is eligible for compression. Next, we quantify the efficiency of several benchmark compression approaches and find that even the most conservative approach, which fully preserves original trading relationships, eliminates on average more than 85% of excess notional. Finally, we relate our results to several post-crisis macroprudential initiatives seeking to improve risk management in OTC markets.
Keywords: OTC Markets, Over-The-Counter, Markets, Compression, Intermediation, Derivatives, Networks, Optimization
JEL Classification: C61, D53, D85, G01, G10, G12
Suggested Citation: Suggested Citation