Collaboration provides risk mitigation services with an exciting compression tool

Sponsored feature: triReduce CLS FX

Collaboration provides risk mitigation services with an exciting compression tool

Established less than two years ago, triReduce CLS FX has already eliminated nearly $3 trillion in gross notional value from participants’ outstanding FX forward and swap portfolios – of which $2 trillion was eliminated in the last six months alone

The triReduce CLS FX service is a collaboration between the settlement, processing and data solutions provider CLS, and triReduce, the post-trade compression service that is part of NEX Optimisation. 

Compression is of course nothing new to other asset classes. In FX, the novelty is also wearing off and is being replaced by confident uptake, resulting in a 15-fold year-on-year increase in compressed notional eliminated, and a 100% increase in the number of clients joining the service. The rapidly accelerating growth is a result of the network effect of increased interest by participants in terms of both participation and submission rates. 

But it’s not just numbers that are driving growth. As early adopters became more confident, behaviours changed too. 

Moving from neutral to constrained 

Adam Levine
Adam Levine, head of product management, CLS

There are three approaches participating members can take when compressing trades: the risk-neutral approach, where the risk profile of the portfolio doesn’t change; the risk-constrained method, where small changes to the risk profile can occur within the set parameters; and finally, offsetting. 

“Typically, new users start with the risk-neutral approach and gradually move on to the risk-constrained method as their confidence in the service builds. This is a significantly more efficient way to do compression,” says Michael Modlock, global head of sales and relationship management at triReduce.

“We also provide a level of confidence from an operational perspective as well as from a technology point of view. It’s really about becoming comfortable with the process more than anything else,” he adds.

This evolution of confidence was one of the reasons for the stellar growth in eliminated notionals. While early adopters experimented with risk-neutral compression during 2016, today’s participating members are mining the risk-constrained method for a wider reach and greater efficiency.

“Much of last year’s growth in notional compressed was a result of clients moving from risk-neutral to risk-constrained approaches,” says Adam Levine, head of product management at CLS. “This has translated into significant growth in activity, with volumes tripling during 2017.” 

Levine notes that this change in behaviour was made possible not just by the evolving confidence of participating members, but also by the track record established by CLS and triReduce.

“Both of the organisations involved in this collaboration are market leaders in their fields and have demonstrated their value to the market already. CLS standardised the market for FX settlement. Meanwhile, NEX Optimisation’s triReduce has been conducting compression in other asset classes since 2003,” Levine says.

Offset, expand and multiply

Michael Modlock
Michael Modlock, global head of sales and relationship management, triReduce

The prime brokerage space is also a big focus, Modlock and Levine say. An enhancement to the compression service now allows participating members to generate new, offsetting trades in addition to compressing them.

This is a big step for FX prime brokers, who had previously faced substantial hurdles in entering compression. By introducing the ability to reduce net exposures by adding new, offsetting trades, FX prime brokers will be able to manage their leverage ratios more effectively, as well as enjoy a significant risk reduction. 

With both the compress and replace option running simultaneously with the offsetting process, participation widens and the network effect of the service accelerates.

“It’s important to note that the service does not sell software or hardware, but instead provides a seamless process for participants,” Levine says.

In the months ahead, the continued automation of post-trade processes will also offer opportunities. The service will connect to the Thomson Reuters Trade Notification Service in the fourth quarter of this year, not just translating into a more seamless operational process for clients, but also ensuring scalability for firms that want to bulk-process compression volumes.

“Helping prime brokers is the next step, enabling them to compress the prime broker versus executing broker leg without creating downstream challenges for the prime broker versus client leg of the trade,” Modlock says.

“Automation is also a big opportunity. CLS and NEX already have excellent connectivity to the market and that’s something we will continue to build on. Our connectivity is really the backbone for making this process seamless,” he adds.

But, as well as planning for the future, changes and feedback from customers need to be taken into account. When regulators changed how the leverage ratio for FX products is determined, the service also mirrored the shift by providing offsetting swap positions per maturity date, per counterparty and per currency pair. 

There are further plans to expand the service beyond CLSSettlement members, a blueprint of which has been in the works since the service’s conception. 

“The next focus is extending the service to CLS third parties, which incorporates rolling out the offering to the buy side as well,” Levine adds. “Once this happens, I think we will see exponential growth yet again.” 

Compression made simple

The idea of compression is simple: the goal is to reduce risks and costs by replacing trades with ones that don’t materially change the risk profile, but where the combined notional value of new transactions is less than that of the terminated trades.

As leverage ratio requirements, uncleared margin rules and rising capital costs hit the industry, it was no longer sufficient to simply settle forwards and swaps on the outstanding notional basis.

Instead, under triReduce CLS FX compression, FX forwards and swaps among multiple counterparties are terminated and replaced with new transactions, the combined notional value of which is less than the original combined notional value of the terminated trades. All of this happens without materially changing the risk profile of the portfolio.

“Compression has significant benefits for members, including reduced operational risks, reduced counterparty exposure and credit risk, an improvement in leverage ratios, enhanced capital efficiency and also regulatory compliance,” says Michael Modlock, global head of sales and relationship management at triReduce.

The process, which occurs monthly, is voluntary, with compression members having discretion over participating in each cycle or not. At the beginning of the cycle, CLS provides NEX Optimisation’s triReduce with all eligible forward-dated data for participating settlement members, after which triReduce publishes trades that are eligible for compression to members on the triReduce website. The existing connectivity CLS has in place with participating settlement members limits the need for additional infrastructure development to participate in
triReduce CLS FX.

During the subsequent ‘dress rehearsal’, participating members agree on the set of trades eligible for compression and provide the necessary risk parameters to run the compression cycle. Once triReduce has run its compression algorithm on the agreed set of trades using the risk parameters submitted by members, it recommends a set of termination and replacement dates for agreement.

At this point, and following mutual agreement, participating members rescind their original trades in CLSSettlement and submit new instructions for settlement.

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