Optimising the multilateral netting of fungible OTC derivatives

Dominic O’Kane

Quantitative Finance, 2017, vol. 17, issue 10, 1523-1534

Abstract: Multilateral netting, carried out via a procedure known as ‘compression’, is used to reduce counterparty exposure in over-the-counter derivatives markets. In compression, market participants share trade information via a third-party company, which then proposes a set of trades which will use multilateral netting to reduce counterparty exposures. In this paper, we propose and analyse a set of multilateral netting algorithms based on exposure minimization. As we assume fungibility, these methods are appropriate for derivative markets with wide-scale product standardization. We find that these compression algorithms all perform extremely well across a range of criteria and we discuss their relative attributes. We strongly favour compressions based on the ℓ1$ \ell _1 $-norm as we find that they eliminate a high fraction of bilateral connections and retain the greatest common divisor of existing positions. We argue that multilateral netting is an effective counterparty risk mitigation technique in OTC derivative markets if done optimally, and the benefits increase with the number of participants.

Date: 2017
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DOI: 10.1080/14697688.2016.1276297

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