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 

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

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.” 

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