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Compressing over-the-counter markets


D'Errico, Marco; Roukny, Tarik (2017). Compressing over-the-counter markets. European Systemic Risk Board Working Paper Series (ESRB) 44, University of Zurich.

Abstract

In this paper, we show both theoretically and empirically that the size of over-the-counter (OTC) markets can be reduced without affecting individual net positions. First, we find that the networked nature of these markets generates an excess of notional obligations between the aggregate gross amount and the minimum amount required to satisfy each individual net position. Second, we show conditions under which such excess can be removed. We refer to this netting operation as compression and identify feasibility and effciency criteria, highlighting intermediation as the key element for excess levels. We show that a trade-off exists between the amount of notional that can be eliminated from the system and the conservation of original trading relationships. Third, we apply our framework to a unique and comprehensive transaction-level dataset on OTC derivatives including all firms based in the European Union. On average, we find that around 75% of market gross notional relates to excess. While around 50% can in general be removed via bilateral compression, more sophisticated multilateral compression approaches are substantially more effcient. In particular, we find that even the most conservative multilateral approach which satisfies relationship constraints can eliminate up to 98% of excess in the markets.

Abstract

In this paper, we show both theoretically and empirically that the size of over-the-counter (OTC) markets can be reduced without affecting individual net positions. First, we find that the networked nature of these markets generates an excess of notional obligations between the aggregate gross amount and the minimum amount required to satisfy each individual net position. Second, we show conditions under which such excess can be removed. We refer to this netting operation as compression and identify feasibility and effciency criteria, highlighting intermediation as the key element for excess levels. We show that a trade-off exists between the amount of notional that can be eliminated from the system and the conservation of original trading relationships. Third, we apply our framework to a unique and comprehensive transaction-level dataset on OTC derivatives including all firms based in the European Union. On average, we find that around 75% of market gross notional relates to excess. While around 50% can in general be removed via bilateral compression, more sophisticated multilateral compression approaches are substantially more effcient. In particular, we find that even the most conservative multilateral approach which satisfies relationship constraints can eliminate up to 98% of excess in the markets.

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Additional indexing

Item Type:Working Paper
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Language:English
Date:8 January 2017
Deposited On:16 Jan 2017 13:51
Last Modified:29 Aug 2017 21:23
Publisher:American Economic Association
Series Name:European Systemic Risk Board Working Paper Series (ESRB)
Number of Pages:75
Free access at:Official URL. An embargo period may apply.
Official URL:https://www.esrb.europa.eu/pub/pdf/wp/esrbwp44.en.pdf?bb4aa408e3d69f6b2e6b54151c9483aa
Other Identification Number:merlin-id:14479

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