What is portfolio compression and why do dealers use it?

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AcadiFi · Accepted Answer

Compression terminates economically-offsetting swaps between multiple counterparties, reducing gross notional without changing net risk profile. It's run periodically by vendors like TriOptima (triReduce) or LCH SwapClear.

Mechanic: each participant submits their swap population to the compression cycle. The algorithm finds trades whose risk offsets across parties and tears them up, often introducing new small 'wedge' swaps to preserve each participant's exact risk vector.

Example: Three banks each have 5-year USD IRS trades among each other. Bank Aldermont pays fixed $2B to Bank Cressidale and receives fixed $1.9B from Bank Wharnby. Compression eliminates $1.9B of gross notional on each side by netting, leaving Aldermont net pay-fixed $100M. Gross notional drops from $3.9B to $100M across the trio; risk unchanged.

Why compress: (1) Leverage Ratio — SLR penalizes gross notional; (2) Capital — CVA capital scales with EAD; (3) Operational — fewer trades, less confirmation risk; (4) Default Management — simpler auction on counterparty default.

LCH compressed $1.1 quadrillion cumulative notional since 2003. TriOptima removed $220T in 2024 alone. Most dealers report 60-75% gross notional reduction across IRS books. Compression explains why headline swap notionals ($600T global) are much smaller than they would be organically.

What is portfolio compression and why do dealers use it?

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