Compression 101: How a Humble Efficiency Tool Became a Major Factor in SEF Trading
Compression has become a topic du jour for the financial technology trade press. Wall Street & Technology recently reported that compression-style trades have “skyrocketed,” while GlobalCapital inked a headline citing “compression usage spikes,” and Markets Media reported that “swap compressions hit $500 trillion.” Clearly, there’s a trend here.
But what is compression, really? Until recently, this relatively benign method of back-office number-crunching was an efficiency tool that market participants would use to reduce the number of trades that were sitting on their books at the clearinghouse. As the clearing mandate under the Dodd- Frank Act has taken effect, compression is becoming an important part of derivatives trading on Swap Execution Facilities (SEFs).
Despite its newfound popularity, many people still wrestle with the definition of compression and its cousin compaction. To help get a handle on the basics, we’ve developed a Q&A to explain the tool that is becoming more and more a part of the derivatives trading process:
Q: What is compression? How does it work?
A: Compression is essentially a process through which market participants can reduce the number of line items they have outstanding at the clearinghouse by netting offsetting positions in a single trade. Using Tradeweb, traders can submit up to 120 line items to market making participants for pricing and execution at one time. All of the trades that represent swap positions in opposite directions are offset. By netting these trades together in this manner, firms reduce the number of line items outstanding at the clearinghouse, which reduces overall trading costs in an efficient way.
Q: Is this a new concept?
A: Buyside compression existed prior to electronic trading, but it was less common as participants would net or tear up trades as necessary. For cleared trades, buyside customers sent spreadsheets with all of the trades they wanted to compress to dealers who would review each swap and provide pricing for the list of trades. The process took a fairly long time as participants weren’t able to easily shop these types of trades to multiple dealers and then had to manually book all the offsetting positions. The implication was that if the dealer was going to spend the time pricing the compression list, it would be executed with them.
While the original forms of compression had their roots in position management and trading efficiency, the genesis of the current demand for compression is rooted in the clearing mandate, which requires swaps to be centrally cleared, doing away with the traditional way swaps were unwound and settled in the past.
Clearinghouses set forth guidelines through which swaps can be netted out or removed from the clearinghouse. To meet these guidelines, participants have to execute an exact offsetting swap – which is not the same as just offsetting risk – that accounts for every attribute of the original swap. That need opened the door for platforms like Tradeweb, which launched compression trading in November 2013, to enhance the compression workflow with electronic execution. When a compression trade is initiated electronically through a SEF, each part of the trade – from pre-trade credit check to trade execution to clearing to reporting – is done via straight-through processing, and becomes a seamless process to the end-user.
Q: Recent articles in the press have said that Tradeweb’s compression volume grew significantly between June and July; what’s driving that demand?
A: Clearing costs are a new issue for the OTC derivatives marketplace. Under current clearinghouse fee schedules, market participants are charged for each line item that sits at the clearinghouse and those costs can add up. Compression cleans up their books, improves overall portfolio position management and cuts down on clearing costs by eliminating the number of line items that live in the clearing house. All of those are driving factors in the adoption of the tool.
Q: What are the current volumes of compression-style trades that we’re seeing on Tradeweb?
A: Since June, when compression trades really started to pick up, we’ve seen more than $265 billion in notional volume pass through our compression tool. That’s from about 66 different clients trading globally.
Q: How does the tool work; what are customers actually doing when they compress a trade?
A: On Tradeweb, a buyside customer will load up a compression ticket with the details of the trade(s) they are looking to compress. They can do this by uploading a list through an order management system, pulling historical details from the Tradeweb blotter, adding swaps directly on the Tradeweb screens or entering the trades through a spreadsheet. Once they have a list of up to 120 trades, they can initiate a pre-trade credit check, select dealers, run a validation to see if the swaps are made-available-to trade and RFQ to one dealer if there are no MAT swaps below block level, and two or more dealers if there are. The minimum RFQ requirement will increase to three market makers on October 2, 2014 based on Dodd-Frank mandates. Market makers then price the entire list and send it back to the customer who can execute the all-or-none list on the aggregate price of the total list of swaps. Once both parties agree, the trade is executed and behaves like any other swap traded on Tradeweb; it is sent to the Swap Data Repository (SDR) for reporting and the clearinghouse for clearing.
Q: There is sometimes confusion between the term compression and compaction; can you differentiate between the two?
A: They are very similar in principle, but while a compression trade nets the full group of trades a compaction trade reduces the total number of trades but stops short of netting all trades in a portfolio. For example, if a buyside customer has 50 trades at the clearing house today, they can net that portfolio of 50 items while putting on new positions, similar to a roll trade. That is what we refer to as a compaction trade. The customer can essentially build new, custom trade lists that reduce their line item exposure but do not offset everything. In a compression trade there is a one-to-one netting relationship between every trade in the portfolio.
Q: What are your projections for the future; do you see compression continuing to grow?
A: We’re hearing very positive feedback from customers. Since June 2014, when SEF trading really began to pick up momentum, we’ve seen more than a 600% growth in compression trades executed on the Tradeweb platform from Q2 to Q3 and we only see that number going up as more and more volume moves onto SEFs. As more market participants become comfortable with trading on SEFs and executing electronically, compression volume will continue to increase.