Compressing Over-The-Counter Markets

Tarik Roukny¹

In this paper, we show that the networked nature of decentralized markets where trading takes place over-the-counter generates excess of notional, i.e., a positive difference between the aggregate gross notional of the market and the minimum aggregate amount satisfying every participants’ net position in the market. In turn, the existence of this excess makes those markets “compressible”, i.e., the web of outstanding trades can be modified in order to reduce notional excess. We proceed by identifying the different classes of compression and analysing the conditions under which each approach can be applied. We show that a trade-off exists between the amount of excess that can be removed from the market and the conservation of trading relationships. Furthermore, our results highlight the fact that dealers are the prime beneficiaries of compression as their intermediary role is key to the generation of excess. We then show how different initial market structures are affected by compression under different scenarios and discuss the implications. Finally, we apply our theoretical framework to a unique and comprehensive transaction-level dataset on OTC derivatives. First, we find important levels of excess across all references. Second, we show that compression when applied at the global level can reduce a large fraction of these levels of excess. Our results are of interest for both policymakers and market participants as they highlight the mechanics of trades compression and discuss the externatilities at the systemic level.