16 Jun Offsetting Swaps Using Compression
This article speaks about reducing notional by offsetting swaps by using compression. The success we’ve seen and expect to see as counterparties phase-in to CCP clearing has been a testament to firms working together to get things done.
Collapsing Swaps Positions
Compression has proven an enormously successful process. By year-end 2016, Notional outstanding of OTC swaps fell to US$483 trillion down from a US$707trn peak in 2011, according to the Bank for International Settlements.
Using compression, collapsing swaps positions, resulting in One-Third less outstanding swaps.
At MHDS, we use a three-step process to organize clients’ positions and prepare a report for Risk Management. So here’s what we did.
Compression is the first step to offsetting bilateral swap positions. The first task to prepare an offset list including swaps which can be compressed
The typical Swap Book will have several primary buckets into which swaps will be placed.
- 1) payor or fixed Interest type
- 2) currency
- 3) maturity
Using maturity as the backbone of the analysis makes it easier to price,
Next, we isolate and report the type of swap and the reason the swap was traded (i.e., corporate counterparty versus bond issuance, market convention swaps with hedge fund clients, etc.)
COMPRESSION OF SINGLE CURRENCY MARKET CONVENTION INTEREST RATE SWAPS
- Market Convention Swaps will be the first to be offset (compressed).
- Denominated in the USD:
- FIXED = semi-annual with 30/360 day count;
- FLOATING – 3 month LIBOR with an ACT/360-day count
- Record the economic terms, counterparty, and other documentation and legal information on the swap
- Denominated in the USD:
- Single Currency Market Convention Swaps in a currency other than the firm’s functional currency will likely be the next easiest to compress.
- Their currency, economic terms, counterparty, other documentation and legal information on the swap are recorded
MATURITY, PAYMENT DATE DIFFERENCES
The second step is to take all non-market convention swaps and evaluate the difference(s) between the swaps tenors for each maturity bucket.
- A monthly pay fixed swap vs. 3 mo LIBOR with 5 yr maturity vs.
- An annual receive fixed swap vs 3 mo LIBOR with a 5 1/4 year maturity
- is first analyzed for each counterparty to see if the different tenors gave the client(s) a collateral posting advantage.
- If so, this
OFFSETTING SWAPS WITH EMBEDDED OPTIONS
The third step is to bucket all swaps with embedded caps/floors or swaptions and identify the maturity of the embedded options and the swap.
Embedded options will be Caps/floors versus 3 month USD LIBOR or swaptions which will be the same maturity as the swap. Swaptions with Bermudan style exercise features are submitted to the compression process using the exercise dates.
NON-BULLET SWAPS FALL INTO TWO PRIMARY RISK BUCKETS:
- Where the relationship between non-bullet swaps and the related bonds narrowed to a point where keeping the trades on the books, was no longer profitable relative to the cost of funding; and
- Where the relationship between swaps and bonds were too wide to take off, creating realized losses.
The positions would be closed “by hand” or kept bilateral as clearinghouses are not yet taking callable swaps. Buy-side and Corporations will implement CCP and collateral processes by 2020. May as well get a workflow in place to track those positions now.
USING CREDIT DEFAULT SWAPS
Swaps traded against a corporate debt issuance will benefit from knowing the counterparties CDS spread.
- The CDS (or calculating the implied CDS) indicate whether the bonds are trading
- at a relatively low spread to LIBOR (Positive Basis)
- or a relatively high spread to LIBOR (Negative Basis).
By using CDS, Risk Management will know which way collateral will flow and determine whether the swap should remain bilateral or hand compressed with another counterparty. N.B.: Corporations are exempt from CCPs for the moment.
SUMMARY & CONCLUSION
The Offset Report will clarify which positions can be
- Offset easily (in USD & other single currencies)
- Offset, albeit less easily (USD & other single currencies)
- Positions not offset on this first round of compressions.
The next step is for the risk manager to review the first tun & prepare a report detailing the possibility of offset, the residual risks as well as their greatest cost of collateral. They’ll make the decision as to which swaps should go to CCP and compression & which swaps should remain Uncleared can be made with more confidence with the right information.
- As of this writing, TriOptima’s TriReduce product has been the compression product of choice.
- Learn more about compression by reading “Three Vital Steps To Maximise Capital Savings“
- And “Optimizing Leverage Ratios and Reducing Risk.”
- The CME has also provided this useful compression resource.
- View Emily Perryman’s excellent piece written for HedgeWeek »