CLS Group, which provides risk mitigation and operation services for the global foreign-exchange market, and TriOptima, a technology company providing OTC derivatives post-trade and risk reduction services, are making improvements to the triReduce CLS FX Forward Compression Service.
The improvements coincide with the service breaching the $1 trillion figure for the gross notional value of compressed trades from the outstanding FX forward and swap portfolios of its users since launch in October 2015.
The additions to the service will enable greater compression levels overall for prime brokers and dealers. Counterparties will be able to reduce their market risk exposure and leverage ratios without fundamentally changing their market positions.
Alan Marquard, CLS
“The new functionality expands the service to capture trades that could not previously be eliminated, but still incurred a capital charge,” says Alan Marquard, chief strategy and development officer at CLS Group. “The trade is netted down, maintaining risk neutrality.”
Peter Weibel, CEO of triReduce, says: “With the traditional compression method, participants submit all their eligible trades for compression. As these trades will be eliminated and replaced by a smaller number of new trades, participants will not only reduce their outstanding notional amounts but also their number of remaining line items.
“There are some instances where trades cannot be eliminated, but continue to represent exposure risk. By injecting new trades offsetting that risk, banks and the wider industry are further enabled to reduce their exposures, which results in lower capital requirements.”
The big difference, says CLS’s Marquard, is that with the traditional method the trade was eliminated, reducing the notional exposure. “With the new method, customers are not reducing the notional value of the trade, but their risk exposure is being reduced,” he says.
CLS and TriOptima say it is too early to estimate the value of additional trades the new functionality will allow their customers to compress. However, they note that the change came in response to requests made by some of the biggest FX trading banks, meaning the numbers involved are likely to prove significant.
FX was relatively late to the compression party: TriOptima was offering compression services for OTC derivatives outside of FX before the triReduce service was launched, but it is playing a more pioneering role now, with the new method for compression not yet available elsewhere.
|Peter Weibel, triReduce|
Weibel says: “Combining traditional compression with the injection of new risk offsetting trades is new for triReduce that offers compression in a whole range of asset classes. So here, FX is taking the lead.”
The expansion of the service marks the start of a new stage in its development.
Of the $1 trillion-worth of trades compressed, $400 billion has come from the last two cycles. The numbers demonstrate the service that started as a trickle has become a markedly more abundant flow as it becomes more efficient. And that effect is self-perpetuating as new customers come on board, creating more opportunities to find matching trades.
The hope and expectation is that the flow will become a deluge. Marquard would not be pinned down to a specific growth target going forward, but says its recent growth demonstrates the momentum it has built up, along with a critical mass of users.
“We expect to see growth continue to accelerate, and for the $1 trillion figure to double quickly,” he says.
However, further growth is no longer the principal focus. Having reached a critical mass of users, and with a healthy pipeline of new institutions waiting to be added in future compression cycles, the emphasis is now on maturing the service with these kinds of improvements.
Part of the reason for the success of the service is the fact it has received tacit regulatory endorsement. The International Organization of Securities Commissions has called on market participants to engage in portfolio compression where appropriate, suggesting the practice offered “wide-ranging benefits for market participants as well as the market as a whole”.
The Basel III leverage ratio measures capital coverage against exposures, including for derivatives, and there is an add-on element of the exposure that is calculated as a percentage of notional, based on the duration of contracts. Banks, therefore, have a considerable incentive to reduce their notionals.
CLS and TriOptima argue that the principal driver behind banks and others using the service is not regulatory but the ability to substantially improve their capital leverage ratios. Banks are struggling to mitigate the capital impact of their positions and are, therefore, keen to compress trades that reduce both their risk exposure and notionals.
Marquard says: “Compression was cited as one of the risk-management standards by international regulators, so it’s great that there is regulatory support. But what we know is that the capital impact of compression is a driver; the desire to reduce both exposures and notional value is probably the stronger driver.”
CLS operates the world’s largest multicurrency cash-settlement service, settling payments relating to FX trades across 18 currencies.