Ali Curi: [00:00:00] Hi everyone, and welcome to ION Markets Quick Takes. I'm Ali Curi, and every week, along with my guests, Amir Khwaja and Chris Barnes, we take a quick dive into the headlines on the Clara's blog. Let's get started.

Hi Amir. Hi Chris. It's great to have you back on Quick Takes. 

Amir Khwaja: Hi Ali. 

Chris Barnes: Hey Ali, how you doing?

Ali Curi: I'm doing great. Chris, Amir, the boys are back in town. 

Amir Khwaja: Thank you. 

Chris Barnes: Maybe we should ask Amir how his holiday was, Ali. 

Ali Curi: That's right, Amir, you've been on holiday. We're gonna have to do a separate podcast on all your adventures. 

Amir Khwaja: All I can say is, Sri Lanka was pretty impressive. Food, safari, temples, beaches, has everything.

But it's nice to be back. 

Chris Barnes: Very, very jealous. I've also just hot footed it back from the mountains for this recording. I'm looking forward to a good one, Ali. 

Ali Curi: Thank you. Well, Amir, since you're all rested up, let's start with you. What's your Quick Take for this week? 

Amir Khwaja: Sure, Ali, yeah. So I'm going to talk about the blog we called "Swaps Compression: What it is and why is it important?"

[00:01:00] Now, this was first published on the Iron Markets Blog and for Clarus we referred to it. It was done by a, not by myself, by a guest author. And really it's a topic that I wanted to talk about. For folks that are familiar with trading in futures or equities, it's a very different concept, Swaps Compression.

So if you trade in equity or a future and you're a market maker that throughout the day is making prices in these contracts, you're buying and selling the same contract. At the end of day, all those trades that you've done could be hundreds, could be thousands at the clearing house, and they can be netted together to one open position for the next day.

So I may have done a thousand trades today in the same contract. Tomorrow, that's one position, essentially. So essentially the trades are fungible. They can be netted and distinguished. That's very different to swaps, right? So in swaps trading, a market maker is buying and selling or paying, receiving on swaps with clients.

So in their account, these are all individual trades. So they can't really be [00:02:00] extinguished by netting together. So what that would mean is over time, you would have lots and lots of trades in your portfolios. And so the market came up with a solution called Compression, where post trade end of day, a firm submit their trades for Compression.

So what that means is that you set some risk tolerances. And on a multilateral basis, the clearinghouses and vendors like Troptima and Quantile will work out which of the swaps can be terminated, which can be partially terminated, and new trades to replace the ones that have been terminated to give you the same amount of risk.

So your risk hasn't changed, but you have far less trades. And far less gross notional. It's a very important process. The swap market runs daily, weekly, monthly in different currencies. And it really keeps the trade count down, which is super important for many reasons. Firstly, operationally, if you have lots of trades in your systems, you have more operational costs, IT costs, and they can really build up over time as these trades can last five years, 10 years, 20 years, 30 years, right?

So it [00:03:00] really reduces the volume or line items of trades. But even more importantly many measures that market makers of banks are constrained by, depend on the gross notional of your derivative portfolio. By gross notional, we mean we sum up the absolute values of all trades with the buys and sells, right?

So the more trades you have, even though they offset, from risk point of view, they could be risk neutral. They have a large gross notional and that gross notional inputs into measures like leverage ratio, the GCIP complexity scores, which really increases the capital that firms are required to hold.

And really a business is all about return on capital. So if you hold more capital, then you have less return on capital for given amount of profit, right? So hence, Compression really tears up all those trades, and it's super important. So in that blog, we explain why it's important, not how it works, but why it's important and the figures are phenomenal.

I think the author showed some BIS stats and some swap clear stats where I think, was it $840 trillion dollars of gross national wealth compressed last year, right? And in fact, the [00:04:00] SwapClear site has quite a nice stat that I like, which shows that since SwapClear started showing Compression, which I guess was 20 years ago possibly, right?

They have compressed $6 Quadrillion Dollars gross notional swaps. Yeah, so that's a quite nice number, from a marketing point of view. But I guess the point is, the swap market would not be where it is now, the capacity, without Compression. And yeah, so I think that's really the aim of the blog, what it is, why it's important.

It's something that is alien to folks that are familiar with futures or equities trading, right? Because that, because every equity trade is fungible or netable, that doesn't really happen in exchange-traded markets, but it happens in over the counter markets. So Interest rate swaps, Inflation swaps, other sort of products, et cetera. Okay. So I think that's a quick intro into that blog. 

Chris Barnes: Amir, a question that comes immediately to mind is that MAC swaps were introduced to the market back in, let's say 2012 now, right? A MAC swap is an IMM starting swap with a market agreed coupon. So in theory, [00:05:00] everybody could trade the same standardized swap for standardized maturities, two year, five year, 10 year, 15 year, and they could go in and out of these swaps all day long. My question to you is, do we really understand why Compression is so important if MAC swaps never really took off? 

Amir Khwaja: Yeah, good question, Chris.

Yeah, so I would say the analogy there, some MAC swaps are listed with a standard coupons, right? And I think, [they] haven't been that successful. Clearly, if you have swaps with the same IMM dates, it makes compression much more efficient, right? An allege there is, if you remember, when the credit default swap market first started, people were trading those like swaps, right?

And there was a CDS Big Bang change driven to always roll coupons on the 20th of the day, right? Quarterly, and that had a massive impact on CDS compression. So clearly at that point, I think the market drove a big change from trading CDS-like swaps on any sort [00:06:00] of coupon date, to only rolling coupons on the 20th.

So the market changed, it made Compression more efficient for CDS. It was done pretty early in the CDS lifecycle market where swaps had been around for more than 20 years. , So I think MAC swaps are a bit late in that process. And then I think having these fixed coupons is not ideal. 

Chris Barnes: And fixed coupons are not ideal because of convexity versus client trades or just because it's forcing you to trade on an MPV?

Amir Khwaja: I think all those reasons and you're forced to trade in MPV with an upfront amount, right? So I think those sort of reasons, clearly, if you're doing standard IMM swaps, your conversion is much more efficient because your coupons match on those dates, right? Same with MAC swaps. I think just for that reason, and possibly because too much like features in some sense, right?

You have the features product, right? Rather than a MAC swap. 

Chris Barnes: If I talk anecdotally a little bit about MAC swaps, and this is a reason of us reading each other's blogs and doing this podcast, is that when I remember they were introduced, it must've been in 2012, I think. There was [00:07:00] lots of pushback because they were based on LIBOR.

And so if you had standardized dates, you would push all of your fixings risk onto a single LIBOR fixing. I do honestly think that we could see a new wave of life in MAC swaps as a result of the transition to RFRs. Of course, you've got rid of that fixing risk element associated with a single date of fixing.

So now all of your daily compounded fixings are fungible. And so I could see a potential for a relaunch of MAC trading basically. But I think from a compression perspective, leads us on to a second question. And the second question is more to do with the data. Do we know from the compression data that is out there what the split is between risky compression and riskless compression?

So CCPs are able to net exactly the same as futures, that would be "riskless" compression, whereas a third party provider can provide "risky" compression where you're [00:08:00] basically saying a five and a half year swap is identical to a five year, a blended amount of five year and six year swap. 

Amir Khwaja: Yes, good question, Chris.

So I don't have it to hand. It may be possible to glean some of that, it may not in the market, but clearly, having a slightly wider risk tolerance will make compression more efficient, with more compression, right? And people can set those tolerances. And the stock market, yeah, I think really there should be, some tolerance in your risk and your value.

But I haven't seen those stats that show the breakup of that compression. I think there's data out there. So compression volumes are made public, but I think they don't distinguish, unless you can assume that a particular compression venue is only doing x, right? Not y. 

So it's about that might be possible. And as you can say, so most clearing houses have their own very simple compression, right? That like features just nets and then they rely on dropped in a quantile or all the other vendors to do true multilateral compression where you can set some tolerance.

So you're willing to accept [00:09:00] in your new portfolio to replace the ones that are torn up. 

Chris Barnes: Makes sense. 

Amir Khwaja: But given these things are driven by cash flows, it's pretty efficient, right? I would say to find optimizations, replacements.

So Ali so that was the blog; "Swaps Compression, What it is and why it's important."

Ali Curi: Thank you, Amir, that works. Amir Khwaja, Chris Barnes, thank you both for sharing your Quick Takes. Let's do it again next week. 

Amir Khwaja: Thanks, Ali. 

Chris Barnes: Looking forward to it, Ali. Thanks very much. 

Ali Curi: And that's our episode for today. You can read more about these topics on the Clarus blog, and you can follow ION Markets on X and on LinkedIn.

Thank you for joining us.