Over-the-counter markets are at the centre of the global reform of the financial system. The authors of this paper show how the size and structure of these markets can undergo rapid and extensive changes when participants engage in portfolio compression, which is an optimisation technology that exploits multilateral netting opportunities. They find that tightly knit and concentrated trading structures, as featured by many large over-the-counter markets, are especially susceptible to reductions of notional amounts and network reconfiguration resulting from compression activities.
Using a unique transaction-level dataset on credit-default-swaps markets, they estimate reduction levels suggesting that the adoption of this technology can account for a large share of the historical development observed in these markets since the Global Financial Crisis. Finally, the authors test the effect of a mandate to centrally clear over the counter markets in terms of size and structure. When participants engage in both central clearing and portfolio compression with the clearinghouse, results show large netting failures if clearinghouses proliferate. Allowing for compression across clearinghouses by-and-large offsets this adverse effect.
Marco D’Errico is Senior Financial Stability Expert at the European Systemic Risk Board, and Tarik Roukny is Assistant Professor of Finance at the KU Leuven.
The paper has received the ECMI Best Paper Award at the ECMI Annual Conference 2020, held virtually on 4-5 November.