Issue 71

Managing Post-Trade Risk in Precious Metals Portfolios

Portfolio compression, also known as multilateral early termination, of OTC derivative portfolios has arrived in the precious metals derivatives market and is gaining traction. In March 2013, TriOptima completed the first portfolio compression cycle for precious metals forwards and swaps, terminating $7.2 billion in notional principal outstandings. Six institutions were able to reduce their gross positions in gold and silver, unlocking regulatory capital and reducing collateral requirements. Additional precious metals cycles are scheduled for later this year.

Managing capital and collateral resources efficiently is especially important in the new regulatory environment, and the commodities market has responded with interest to the expansion of portfolio compression to precious metals trades. The incentive to achieve greater reductions in precious metals forwards and swaps is strong, especially as new capital rules and margin requirements are implemented.

In a portfolio compression exercise, participants are able to tear up their existing trades at their own mid mark-to-market valuations and avoid the difficult negotiation process of bilateral termination. Multilateral terminations leverage the expanded number of participants and result in increased numbers of terminated trades. While individual institutions benefit from a more efficient use of capital and collateral, reducing outstanding notional also contributes to the overall stability of the financial markets.

Since its introduction in 2003, first for interest rate swaps (IRS), then for credit default swaps (CDS), and finally for commodity trades in energy and precious metals, portfolio compression has contributed significantly to reducing the number of transactions and the notional outstandings in the OTC derivatives markets. In 2008 alone, compression in the CDS market eliminated 50% of the notional outstandings globally after regulators focused on inefficiencies in the CDS market. Since then, the expansion of portfolio compression to cleared IRS trades in LCH.Clearnet’s SwapClear service has dramatically reduced the IRS swaps outstanding.

Through June 2013, $353 trillion has been eliminated from swap portfolios globally since compression was first introduced 10 years ago. The ISDA (International Swaps and Derivatives Association) recently analysed the contribution that portfolio compression has made to controlling the growth of notional outstandings, one of the goals of global regulators. In its OTC Derivatives Market Analysis Year End 2012, ISDA noted that, over the last five years, “…portfolio compression has significantly reduced notional amounts outstanding by 25% or more”. The ISDA concluded that “the industry has worked very hard using tools such as netting, collateralization, portfolio compression, and central clearing to reduce risks in the system in accordance with G-20 goals.”

The graph below indicates the growth of portfolio compression from 2003 through 2012. The ISDA Year End Market Analysis reports that the total notional compressed across all transaction types in 2012 was $48.7 trillion and that $214.3 trillion notional has been compressed in the five-year period through 2012.

How Portfolio Compression/ Multilateral Termination

Works Portfolio compression is a powerful tool for eliminating risk that amplifies results beyond the bilateral relationship. It is much more effective than bilateral attempts at termination because it has access to a greater pool of trades that can be eliminated while still respecting the constraints preferred by participants. More trades and more participants yield proportionately better results.

Market participants that a significant two-way flow of OTC derivative trades build up an inventory of trades that are not necessary to maintain the firm’s net risk position. By joining a portfolio compression cycle, firms can eliminate trades they don’t need for accounting, regulatory or risk purposes, and achieve significant benefits. Without compression, a firm will have a portfolio of transactions against a series of counterparties as shown in Figure 2 below.

“Market participants that have a significant two-way flow of OTC derivative trades build up proposal is legally binding for all parties, and transactions are terminated and eliminated from an inventory of trades that are not necessary to maintain the firm’s net risk position.

While there is some potential to reduce the number of trades outstanding while maintaining the net position through bilateral early termination, this is very time-consuming and very difficult to achieve in scale. By participating in a multilateral compression cycle, significant numbers of trades can be eliminated while the net risk position does not change.

Each participant in a compression cycle identifies and submits the trades they are willing to terminate at their own mark-to-market values. Once these trades have been matched against the other side of the original transaction, a proposal of transactions that can be terminated while maintaining a firm’s predefined tolerances for changes in counterparty credit exposure, market risk and cash payments is generated. Each institution reviews the proposal and submits its acceptance. When all cycle participants have accepted the proposal, the proposal is legally binding for all parties, and transactions are terminated and eliminated from the books. As a result, the terminated trades will no longer incur costs, risks and capital charges. This process typically includes both a ‘dress rehearsal’ and then a ‘live run’ a few days later.

One of the key tolerances that a firm sets is the delta tolerance. It can be defined on up to four different levels as illustrated below, where each level protects against different kinds of yield curve movements in the time buckets defined by each participant as designated by X. The tolerance is symmetrical, it will allow for the delta to either increase or decrease within the defined tolerance value by the same amount. Another important tolerance is the counterparty exposure tolerance, which can be set asymmetrically to constrain or allow positive or negative movements in mark-to-market exposure versus each counterparty participating in the cycle. So, for example, you might be willing to allow counterparty credit exposure to increase by $5 million or decrease by $5 million versus counterparty A, but only be willing to see a decrease by $5 million and no increase versus counterparty B.

With the renewed focus on credit risk management, firms and regulators have underscored the importance of improving exposure management. Regular participation in compression cycles reduces counterparty exposures overall; but by utilising the counterparty tolerances, participants can also smooth out the peaks and troughs in remaining exposures, resulting in a more efficient distribution among counterparties, as illustrated below. This capability is another contributing factor to reducing systemic risk as well.

The Benefits of Portfolio Compression

Getting rid of unnecessary transaction inventory that does not contribute to the desired market risk position can yield many benefits, especially for trades where the underlying prices are high, credit lines are constrained, collateral demands have escalated or capital is in demand as is the case in precious metals trading.

  • Capital Benefits: Terminating trades reduces regulatory and economic capital charges. For firms under IFRS accounting rules, which require gross positive and negative mark-to-market values on the balance sheet, reducing trade inventory will reduce the balance sheet consumption.
  • Credit Exposure Management: With reduced credit exposures, credit lines can be freed up to support new business opportunities. In addition, collateral volatility will be reduced by managing down counterparty exposures that cause collateral calls to be triggered and incur capital costs under Basel III. Internal charges for capital will also be reduced to the benefit of individual, well-managed businesses. Shrinking portfolios will show a reduction in potential future exposure (PFE) over time, and bilateral risk can be managed effectively using asymmetric counterparty exposure tolerances.
  • Reduced Operational Risk and Costs: The operational costs and risk associated with maintaining an OTC derivatives portfolio are directly proportional to the number of trades in the portfolio. If there are fewer trades, there are fewer payment and fixing events, fewer nostro breaks, fewer processing errors and less time spent on resolving errors or erroneous payments. With fewer trades, there is also more control over the portfolio. Participating in a portfolio compression cycle will involve a data scrub for all submitted trades so that existing errors can be identified before they grow into major losses.
  • More Efficient IT Processing: In a business environment where cost containment is a key consideration, smaller trade portfolios require less system resources and postpone the need to increase or upgrade capacity. Moreover, IT processes can run quicker batch processes; and system response times are reduced.

Portfolio Compression for Precious Metals

While some benefits are particularly relevant to a financial institution, most of the advantages of reducing portfolios in precious metals can be enjoyed by any firm. In the current economic and regulatory environment, managing counterparty risk, reducing operational risk and costs, deploying capital efficiently and maximising IT processes are important goals for everyone.

Although portfolio compression is just beginning to gain traction in the precious metals market, its potential is appreciated by market participants. TriOptima has scheduled the next precious metals compression cycle for October this year, and TriOptima anticipates executing three to four precious metals cycles per year going forward. As the new US and European regulations come into effect, there is a greater need to capture the benefits of compression, especially the reduction in counterparty credit risk, the more efficient deployment of capital and the reduced operational risk and costs that compression delivers.

Mattias Palm, Business Manager, TriOptima

Mattias Palm is responsible for managing TriOptima’s business in the commodities markets, which includes the portfolio compression service triReduce Commodities, as well as the portfolio reconciliation service triResolve.

Prior to joining TriOptima in 2011, Mattias was EVP, Head of Markets & Sales, at Navita Systems (now part of Brady plc.). This role included executive responsibility for sales, marketing, and product strategy, as well as hands-on responsibility for product management.

During his 17 years in the commodity trading and risk management sector, he has also worked at NASDAQ OMX as product manager, and in principal consultant roles at PA Consulting Group and Capgemini.

Mattias holds a MSc in Electrical Engineering & Computer Science from the Royal Institute of Technology in Stockholm, Sweden.

Susan Hinko, Head of Industry Relations, TriOptima.

Susan is responsible for TriOptima’s corporate communications and industry relations globally.

Prior to joining TriOptima, she worked at the International Swaps and Derivatives Association (ISDA) as head of policy for the Americas. Susan also served as the administrative officer of several investment banking departments at Lodestar, Merrill Lynch M&A, and Goldman Sachs Real Estate. She started her career on Wall Street in the cash management area at Chase Bank and Merrill Lynch treasury.

Susan holds a BA from Skidmore College, an MA from the University of Michigan and an MBA from Columbia University.