Incentivizing Post-trade Risk Reduction

Post-trade risk reduction has become increasingly common as a means to reduce risks in the derivatives market. Portfolio compression is a case in point: offsetting trades between multiple parties are torn up, which reduces the size of gross exposures, in turn reducing systemic risk. Over  €1,000 trillion in derivatives exposures has been eliminated in this manner.

Regulators recognize the value of compression. Under the European Market Infrastructure Regulation (EMIR), market participants with more than 500 over-the-counter (OTC) trades on their books are required to examine the possibility of performing portfolio compression twice a year.

However, EMIR simultaneously disincentivizes use of this service by requiring administrative trades that result from compression, and which fall under the clearing mandate, to be cleared. This limits the ability of participants to perform compression and reduce risk.

The same is true of other post-trade risk reduction services like counterparty rebalancing. This  involves inserting new, market-risk neutral transactions into netting sets to reduce risk exposures between counterparties. This decreases counterparty credit risk and therefore reduces systemic risk. However, those new transactions are required to be cleared if they are subject to the clearing obligation, preventing counterparty rebalancing risk reduction from taking place. As a result, counterparty rebalancing today is only limited to FX derivatives, which are not subject to the clearing obligation. Over €100 billion in counterparty credit risk has been reduced in this manner.

ISDA, the EBF, ICMA and ISLA believe EMIR should be amended as part of the Regulatory Fitness and Performance program (REFIT) to allow non-price forming, market-risk neutral transactions that result from post-trade risk reduction services to be exempted from the clearing obligation.

To read the full whitepaper, click on the link below.

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