Portfolio Compression

Staff who manage derivatives balances, or who calculate the leverage ratio, look to compression as a way to reduce the number of trades and the total notional amount.

Why compression exists

Derivatives trades accumulate, and you can end up holding trades whose positions offset each other. If you hold one trade that pays a fixed rate and another that receives it, the gains and losses from a move in rates almost cancel. Even so, there are still two contracts, each with its own notional amount, so the total notional amount is larger than the net position. Compression terminates such trades and makes the balance measured by total notional amount smaller, while leaving the amount of risk roughly unchanged¹.

As a motive for reducing notional amounts, a 2017 Bank of Japan paper cites meeting the leverage ratio requirement. The requirement at the time called for Tier 1 capital in proportion to total exposure, including securities, loans, and derivatives. Derivatives exposure was the sum of the replacement cost, which reflects market value, and an add-on obtained by multiplying the notional amount by a risk weight. Netting agreements and cash margin could reduce the replacement cost, but reducing the add-on required reducing the notional amount itself².

That is the calculation as of June 2017. The Basel Committee on Banking Supervision then published its final document in December 2017. The final document changed the measurement of derivatives exposure in the leverage ratio to a modified form of SA-CCR. Under the modified approach, the exposure is 1.4 times the sum of the replacement cost and the potential future exposure (PFE)³. The current calculation is covered in The Leverage Ratio.

The same paper also notes that the global outstanding amount of OTC derivatives fell sharply from 2014, and that the BIS pointed to financial institutions' growing use of compression as a background factor⁴.

A numerical example

Consider a hypothetical example in which a participant holds two interest rate swaps with the same central counterparty. Both have a fixed rate of 2% per year, and the same maturity and floating-rate index. Real compression exercises include bilateral ones between two parties and ones that cover the trades of many participants at the same time. This example is simplified to the trades of one participant facing a central counterparty.

• Trade A pays fixed and receives floating, with a notional amount of 10 billion yen.
• Trade B receives fixed and pays floating, with a notional amount of 6 billion yen.

The combined position is a pay-fixed position of 4 billion yen (10 billion yen minus 6 billion yen). In compression, trade B is terminated in full, and trade A is terminated in part, for 6 billion yen.

Before and after termination, the position looks like this.

Check it with one year of interest payments. Trade A receives "notional amount × (floating rate − 2%)", and trade B receives "notional amount × (2% − floating rate)". Amounts are in units of 100 million yen, and a negative number is a payment.

With a floating rate of 3% per year, the participant receives 40 million yen; with 1%, it pays 40 million yen. The amounts are the same before and after termination.

Types and who runs it

Compression can be carried out bilaterally with a counterparty, or as a bulk exercise in which many financial institutions take part (bulk compression)⁵.

A central counterparty can also run a bulk compression on the trades it clears. The Japan Securities Clearing Corporation (JSCC) does so in its clearing of yen-denominated interest rate swaps. It carries out the exercise with services from external providers. The 16th cycle in September 2017 used TriOptima's triReduce, and the exercise in March 2025 used a service from Quantile Technologies⁶⁷.

In compression of trades that are not cleared, if one party wanted to terminate a trade but the counterparty had no need to, the trade could not be terminated. In cleared trades, the counterparty has been replaced by the central counterparty. The central counterparty agrees to terminations to the extent that its own payments and receipts stay balanced, so it can terminate trades regardless of whether the original counterparty agrees, which made compression more efficient. The Bank of Japan paper calls this approach the Unlink type⁸.

The Unlink type was begun by LCH, the world's largest central counterparty for OTC derivatives as of 2017, after the start of 2014, and by JSCC in September 2015⁸.

JSCC has announced the results of its bulk compressions. The announcements split the number of terminated trades into full terminations and partial terminations⁶.

The 16th cycle in 2017 had 18 major domestic and overseas financial institutions taking part, including clearing clients. The numbers of trades and the notional amount are on a round-trip basis, and the one-way figure is half the round-trip figure. JSCC's statistics are on a one-way basis⁶. The 2025 announcement does not say whether its figure is round-trip or one-way, so the notional amounts of the two exercises cannot be compared⁷.

In the compression process, participants pool information on their own trades, and several trades are terminated at once in a way that leaves the amount of risk roughly unchanged¹. The scope and operators of the services that provide compression are covered in Post-Trade Efficiency Services.

What changes and what does not

What changes is the number of trades and the total notional amount. The terminations are chosen so that the amount of risk stays roughly the same¹. In the numerical example, trades fell from two to one and the total notional amount from 16 billion yen to 4 billion yen, while the net notional amount stayed at 4 billion yen.

Relationship to regulation

US and EU rules include requirements for procedures to reduce trades. Neither is a Japanese regulation.

In the United States, a CFTC rule (17 CFR 23.503) requires swap dealers and major swap participants to establish, and follow, written policies and procedures that provide for the following.

• Where the counterparty is another swap dealer or major swap participant, the policies must provide for timely termination of fully offsetting swaps, periodic bilateral compression exercises with the counterparty at appropriate times, and procedures for multilateral compression exercises.
• Where the counterparty is anyone else, the policies must provide for periodic termination of fully offsetting swaps and compression exercises, to the extent the counterparty requests.

A "fully offsetting swap" is defined in 23.500(f) of the same rule as swaps whose terms are the same and whose payments, once offset, leave no net payment to either counterparty. The rule does not apply to swaps cleared by a derivatives clearing organization⁹.

Article 14 of delegated regulation 149/2013 under the EU's over-the-counter derivatives regulation (EMIR), in the revised version of January 3, 2018, requires procedures to be established. They apply to financial counterparties and non-financial counterparties that have 500 or more uncleared OTC derivatives contracts with a single counterparty. Under those procedures, they must analyze the possibility of compression exercises with their counterparties at least twice a year and carry them out where appropriate. The purpose is to reduce the counterparty credit risk of the counterparties. If they judge that carrying out compression is not appropriate, they must be able to give the authorities a reasonable explanation¹¹.

Notes

Notes

1. Bank of Japan, "（日銀レビュー）最近のOTCデリバティブ市場の動向 ： OTCデリバティブ統計からみた特徴点" (Bank of Japan Review 2017-J-8, June 2017; recent trends in the OTC derivatives market: characteristics seen in OTC derivatives statistics, our translation), section "コンプレッションの普及" (The spread of compression), page 5, under "コンプレッションによる残高の削減" (Reducing outstanding amounts through compression) (in Japanese). ↩ ↩² ↩³

2. The same paper, "レバレッジ比率規制への対応" (Response to the leverage ratio requirement), pages 5 to 6, and Figure 10. The explanation of the calculation at the time. The need to reduce the add-on is on page 6. ↩

3. Financial Services Agency and Bank of Japan, "「レバレッジ比率の枠組みの見直し」の概要" (Outline of "Revisions to the Leverage Ratio Framework", our translation) (February 2018), page 3, "スケジュール" (Schedule) (finalization of the leverage ratio framework in December 2017), and page 5, "デリバティブ・エクスポージャー（修正 SA-CCR の採用）" (Derivative exposure (adoption of the modified SA-CCR)) (in Japanese). Exposure = 1.4 × (RC + PFE), where RC is the replacement cost and PFE is the potential future exposure. ↩

4. The same paper, "コンプレッションによる残高の削減" (page 5), and note 14. ↩

5. The same paper, "コンプレッションの普及" (page 5). ↩

6. Japan Securities Clearing Corporation, "金利スワップ取引において一括コンプレッションを実施いたしました。" (Announcement that a bulk compression of interest rate swaps was carried out, our translation) (September 15, 2017) (in Japanese). The 16th cycle's numbers of trades, notional amount, number of participants, and the note on the round-trip basis. ↩ ↩² ↩³

7. Japan Securities Clearing Corporation, "金利スワップ取引において一括コンプレッションを実施いたしました。" (March 27, 2025) (in Japanese). Numbers of trades and notional amount as in the table. A note (※) says the figures exclude terminations of euroyen TIBOR-OIS basis swaps. ↩ ↩²

8. Bank of Japan, same paper, "Unlink型コンプレッションの導入" (Introduction of Unlink-type compression), page 6, and note 16 (in Japanese). ↩ ↩²

9. 17 CFR 23.500(f) (Definitions; fully offsetting swaps), 23.503(a)(1) (Bilateral offset), (a)(2), (a)(3), (b) (where the counterparty is other than a swap dealer or major swap participant; to the extent the counterparty requests), and (c) (Portfolio compression of cleared swaps). ↩

10. 17 CFR 23.503(d)(1) and (d)(2). ↩

11. Commission Delegated Regulation (EU) No 149/2013, Article 14 (Portfolio compression). Text of the revised version of January 3, 2018 (Revised 03/01/2018), published on legislation.gov.uk. ↩