When Does Portfolio Compression Reduce Systemic Risk?

Abstract

We analyse the consequences of portfolio compression on systemic risk. Portfolio compression is a post-trading netting mechanism that reduces gross positions while keeping net positions unchanged and it is part of the financial legislation in the US (Dodd-Frank Act) and in Europe (European Market Infrastructure Regulation). We derive necessary structural conditions for portfolio compression to be harmful and discuss policy implications. In particular, we show that the potential danger of portfolio compression comes from defaults of firms that conduct portfolio compression. If no such defaults occur, then portfolio compression weakly reduces systemic risk.

Keywords: systemic risk, portfolio compression, financial networks, cycles, netting

JEL Classification: D85, G01, G28, G33