Compressing Over-the-Counter Markets

60 Pages Posted: 4 May 2017 Last revised: 19 May 2018

Marco D'Errico

University of Zurich; European Systemic Risk Board

Tarik Roukny

Massachusetts Institute of Technology (MIT)

Date Written: May 15, 2018

Abstract

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

D'Errico, Marco and Roukny, Tarik, Compressing Over-the-Counter Markets (May 15, 2018). Available at SSRN: https://ssrn.com/abstract=2962575 or http://dx.doi.org/10.2139/ssrn.2962575

Marco D'Errico

University of Zurich

Andreasstrasse 15
Zurich, 8050
Switzerland

European Systemic Risk Board ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Tarik Roukny (Contact Author)

Massachusetts Institute of Technology (MIT) ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

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