Initial Impressions on Compression - Q&A with Tradeweb's Michael Furman
The Dodd-Frank Act may just be the best example of unintended consequences in action. It seems like each new rule implementation has created a ripple-effect of reactions in the marketplace, some of which were anticipated and others that took everyone by surprise. Take the central clearing mandate, for example. On the surface, you can imagine how lawmakers envisioned a world in which every swap transaction cleared through a central party would create a more stable derivatives market. What lawmakers likely did not envision was the slew of other technical issues that were raised the moment the idea of a central clearing party was introduced.
One of these is compression. Developed initially at Tradeweb, a leading SEF, as a way to reduce clearing costs, compression allows traders to submit up to 100 line items to market making participants for pricing and execution at one time. Each of these trades can offset existing positions or aggregate other trades at the clearing house. By netting these trades in this manner, traders effectively reduce the number of line items outstanding at the clearinghouse, which reduces overall clearing costs.
That all sounds pragmatic enough, but once market participants started using compression trading on Tradeweb, they also found that the process lent itself very nicely to custom swap lists, essentially making it possible to bunch a large number of unique trades together and for faster, more efficient pricing. To find out more about how market participants are experimenting with compression trading that grew out of Dodd-Frank, DerivAlert sat down with Tradeweb Managing Director Michael Furman.
DerivAlert: Tell us about this new compression functionality; what was your original intent when you launched it?
Michael Furman: The process of consolidating swaps at the clearinghouse is different than that of unwinding a bilateral trade. The clearinghouse requires an exact offset of the original trade to be executed and cleared. We wanted to provide our customers with a tool that allows them to manage their line item exposure, which ultimately aids in the reduction of clearing costs. With the new clearing mandate, you had this situation where a portfolio of swaps would sit at the clearinghouse as a bunch of individual trades each of which would be an outstanding line item on a customer’s book until the underlying swap reached maturity. With our compression tool, offsetting trades can easily be netted to reduce the number of outstanding line items.
DA: Did this concept exist previously or did it grow out of a response to derivatives reform?
MF: As a result of the clearing mandate and procedures implemented by the clearinghouses, customers are now required to execute an equal and offsetting trade in order to collapse a cleared swap position. So yes, this is new. Prior to the launch of the Tradeweb compression tool, the process was highly manual in that it relied on spreadsheets created by customers, each of which could employ varying formats. With our compression tool, we’re automating that process by making it electronic. This process makes it ultra-efficient for a market participant to pull together a large package of trades and shop it to multiple dealers.
DA: What are the initial reactions among customers?
MF: It’s been extremely positive. We are able to compress lists of trades with as many as 100 line items, and we have executed compression trades as large as 85 line items. We are now at the point where we are executing 3-5 of these compression lists every day. In addition, our customers are quickly recognizing that there’s more to compression than just reducing the number of overall line items at the clearinghouse. By making the compression process electronic, we’ve opened up this opportunity for customers to create custom swaps trades with this tool. The framework lends itself to a new form of customization by market participants.
DA: Do you see this kind of functionality inducing more overall swap volume to move onto SEFs
MF: Tradeweb has been supporting electronic derivatives markets since 2005; our proposition has always been that if you make it easier and more efficient to trade electronically, the markets will eventually migrate in your direction. Compression is turning out to be a great example of that theory in practice. We’re seeing both MAT’d and un-MAT’d swaps show up in custom trades that have been built using our compression tool. This is a clear sign that the growth we’ve seen is more than just mandated trading, it is about efficient trading.