Compression and Portfolio Tear-Ups
intermediatePublished: 2026-01-01
Compression and Portfolio Tear-Ups
Compression and tear-up services reduce the gross notional outstanding of OTC derivatives portfolios by terminating offsetting positions. This reduces counterparty exposure, operational burden, and regulatory capital requirements while maintaining the same net risk profile.
Definition and Key Concepts
Types of Portfolio Optimization
| Type | Description | Participants |
|---|---|---|
| Bilateral compression | Two counterparties net offsetting trades | Two parties |
| Multilateral compression | Multiple counterparties in single cycle | Many parties |
| CCP compression | Clearing house coordinates compression | Clearing members |
| Tear-up | Terminate trades for cash settlement | Two or more parties |
Why Compress?
| Benefit | Description |
|---|---|
| Notional reduction | Lower gross exposure figures |
| Trade count reduction | Fewer trades to manage |
| Capital efficiency | Lower regulatory capital requirements |
| Operational savings | Reduced confirmations, payments, resets |
| Counterparty limit | Free up credit lines |
Key Terms
| Term | Definition |
|---|---|
| Gross notional | Sum of all trade notionals |
| Net notional | Notional after offsetting long/short |
| Compression ratio | Notional eliminated / initial notional |
| Tolerance | Acceptable change in risk profile |
| Trade population | Trades eligible for compression cycle |
How It Works in Practice
Bilateral Compression
Simple example: Party A and Party B have offsetting trades:
| Trade | Party A | Party B | Notional |
|---|---|---|---|
| Trade 1 | Pays fixed 4.50% | Receives fixed | $100M |
| Trade 2 | Receives fixed 4.45% | Pays fixed | $80M |
After compression:
- Net position: Party A pays fixed on $20M
- Trades reduced from 2 to 1
- Notional reduced from $180M to $20M
Cash settlement: Small payment to adjust for rate difference (5 bps on $80M).
Multilateral Compression
Process flow:
| Step | Activity |
|---|---|
| 1 | Participants submit trade populations |
| 2 | Compression service identifies offsetting chains |
| 3 | Optimization algorithm finds maximum compression |
| 4 | Proposals sent to participants with tolerances |
| 5 | Participants accept or reject |
| 6 | Accepted trades terminated |
| 7 | Replacement trades created (if needed) |
Compression cycle example:
- 15 participants submit 50,000 trades
- $2 trillion gross notional
- Compression eliminates 30,000 trades
- $1.4 trillion notional eliminated
- Compression ratio: 70%
CCP Compression Services
| CCP | Service | Frequency |
|---|---|---|
| LCH SwapClear | SwapClear Compression | Weekly |
| CME | Portfolio Optimization | Weekly |
| ICE | Trade Compression | Bi-weekly |
| Eurex | Compression Service | Weekly |
CCP compression benefits:
- No change in clearing relationship
- Automated within CCP infrastructure
- Reduced margin (fewer positions)
Worked Example
Initial portfolio between Party A and Party B:
| Trade | Direction (A) | Rate | Notional | Maturity |
|---|---|---|---|---|
| 1 | Pay fixed | 4.50% | $200M | 5Y |
| 2 | Receive fixed | 4.48% | $150M | 5Y |
| 3 | Pay fixed | 4.55% | $100M | 5Y |
| 4 | Receive fixed | 4.52% | $100M | 5Y |
Portfolio metrics:
- Gross notional: $550 million
- Net position: Pay fixed on $50M
- Trade count: 4
- Weighted average rate (pay): 4.52%
- Weighted average rate (receive): 4.50%
Compression proposal: Terminate trades 1-4, create single replacement:
| New Trade | Direction (A) | Rate | Notional | Maturity |
|---|---|---|---|---|
| 5 | Pay fixed | 4.51% | $50M | 5Y |
Results:
- Gross notional: $550M → $50M (91% reduction)
- Trade count: 4 → 1 (75% reduction)
- Net risk: Unchanged (pay fixed on $50M)
Cash settlement: Rate adjustment: (4.51% - 4.52%) × $50M × 4.5 duration = -$22,500 Party B pays Party A $22,500 to adjust for rate difference.
Tolerance Settings
Participants set tolerances for acceptable changes:
| Parameter | Typical Tolerance |
|---|---|
| DV01 change | ±$5,000 |
| Gamma change | ±$1,000 per bp² |
| Vega change | ±$10,000 |
| Cash payment | ±$50,000 |
Compression algorithm finds solutions within all participants' tolerances.
Risks, Limitations, and Tradeoffs
Risk Profile Changes
| Risk | Description | Mitigation |
|---|---|---|
| Curve risk | Different points on curve may shift | Set specific tenor tolerances |
| Basis risk | Compressed trades may have basis differences | Include basis in tolerances |
| Convexity | Gamma profile may change | Set gamma tolerance |
Operational Risks
| Risk | Description | Mitigation |
|---|---|---|
| Settlement failure | Cash settlement not completed | Clear settlement procedures |
| Documentation error | New trade terms incorrect | Verify all trade details |
| System reconciliation | Systems don't reflect compression | Automate feeds from compression service |
| Timing mismatch | Trades terminated at different times | Coordinate execution |
Regulatory Considerations
Documentation requirements:
- Maintain audit trail of compressed trades
- Document risk tolerance settings
- Retain original trade records
Reporting:
- Report trade terminations to SDR
- Report new replacement trades (if any)
- Update regulatory capital calculations
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Over-tight tolerances | No compression possible | Start with wider tolerances |
| Missing trades | Incomplete trade population | Reconcile before submission |
| Timing conflicts | Compression during trading | Schedule during market close |
| Cash settlement disputes | Disagree on settlement amount | Pre-agree calculation methodology |
Compression Service Providers
| Provider | Type | Products |
|---|---|---|
| TriOptima (CME) | Multilateral | Rates, credit, FX |
| Quantile | Multilateral | Rates, credit |
| Capitalab | Multilateral | Rates |
| LCH | CCP | Cleared rates |
| CME | CCP | Cleared rates |
Selection Criteria
| Factor | Consideration |
|---|---|
| Participant network | More participants = better compression |
| Product coverage | Supports your asset classes |
| Frequency | Aligns with your compression goals |
| Integration | Connects to your systems |
| Cost | Per-trade or per-cycle fees |
Capital Impact Analysis
Before compression:
| Metric | Value |
|---|---|
| Gross notional | $10 billion |
| Trade count | 500 |
| SA-CCR EAD | $200 million |
| Risk weight | 50% |
| Capital charge | $8 million (8% of RWA) |
After compression (70% reduction):
| Metric | Value | Change |
|---|---|---|
| Gross notional | $3 billion | -70% |
| Trade count | 150 | -70% |
| SA-CCR EAD | $80 million | -60% |
| Risk weight | 50% | — |
| Capital charge | $3.2 million | -60% |
Capital savings: $4.8 million annually
Checklist and Next Steps
Compression preparation checklist:
- Identify eligible trade populations
- Reconcile trade details with counterparties
- Define risk tolerances for each parameter
- Calculate acceptable cash settlement range
- Coordinate with operations on settlement
- Notify front office of compression schedule
- Update systems for trade terminations
Post-compression checklist:
- Verify all terminated trades removed from systems
- Confirm new replacement trades booked
- Settle cash payments
- Update regulatory reports
- Recalculate margin requirements
- Document compression results
- Report to SDR
Related articles:
- For clearing structures, see Cleared vs. Bilateral Swap Structures
- For valuation adjustments, see Valuation Adjustments: CVA, DVA, FVA