CDS Compression - why?

[sneakyplacebo]

Hi, I am reading through the material and in all honesty I just don't understand how this is any different to simply netting off positions. Surely the position itself is already netted within the risk system, so simply displaying a net impact won't change anything at all and therefore the counterparty risk will stay completely identical to how it was?

"CDS compression is one tool for limiting counterparty risk: this is the reduction in volume of redundant contracts with the same reference entity. A firm might put on long and short protection positions on the same name as it varies the size of its position. Compression reduces the set of CDS to a single net long or short position, thus eliminating a certain amount of nominal exposure and counterparty risk. There are many practical difficulties in carrying out compression trades, since in general the contracts will not be identical as to counterparty, premium, and maturity"

Can you please explain how this works to physically reduce the exposure or point out what I am missing?

Thanks.

 

[ShaktiRathore]

CDS compression here means we are reducing the net long or short position to any particular reference entity,this means net exposure is reduced to counterparty with whom these cds contracts are entered into. The reduction of exposure reduces counterparty risk. E.g. A enters into cds with net long with B ,exposure on default be 100mn but now new cds contracts are entered with short position with exposure of -50 so net exposure now is overall 100-50=50mn reduced from 100 mn. This means max 50 mn could be lost when cp defaults thus reducing counterparty risk. Thru compression trades offsetting positions are entered to initial position like we took short cds to our net long cds position on same name which rreduces exposure to counterparty hence counterparty risk.
Thanks

 

[sneakyplacebo]

Hi, thanks for this ShaktiRathore.

It still doesn't really clear up for me how the exposure actually has changed at all. Initially there was a long of 100 and a short of 50, so to my mind the exposure would be viewed as 100-50 = 50 without doing anything at all (assuming they were against the same underlying bond for the CDSs). Much the same as if I have an equity swap long 100 and another swap short 50, then I have created a box position and only have exposure for 100-50 = 50.. is this a swap compression is the entire concept just intended to be a trading strategy to reduce the position of a swap? I have potentially read too much into this and am expecting this to be something more complex than simply unwinding part of a swap by doing an offsetting trade..

Even in the example stated the exposure is never really netted it is all theoretical, so I really don't understand the difference between the standard exposure and the CDS compression here.

Thanks.

 

[ShaktiRathore]

Hi
As i can understand but may be David can clear on this later when he comes,
You see the cds compression in context of reducing a net long/short position in cds to a counterparty. By carrying out the compressive cds trades this net long/short position is reduced to counterparty and thus reducing net exposure to counterparty. Eg if A has long cds of exposure 100 and short cds of exposure 50 on some reference entity name to counterparty B making a net long cds exposure of 50 to B.A carry out cds trades (cds compressive trades as these are reducing size of cds trafes or exposure to B)of going short cds on same name of exposure 20 now when this position is combined with As net long position on same name with B making overall net exposure of 50-20=30 this is reduced exposure to counterparty B on same name.
Thanks

 

[afterworkguinness]

@sneakyplacebo , I'm also a bit confused about CDS compression. The below description from ISDA along with ShatkiRathore's examples have helped me out (emphasis is mine)

Portfolio compression reduces the overall notional size and number of outstanding contracts in credit derivative portfolios. Importantly, it does so without changing the overall risk profiles of these portfolios. This is achieved by terminating existing trades on single name reference entities and on indices and replacing them with a smaller number of new trades with substantially smaller notionals that carry the same risk profile and cashflows as the initial portfolio.

Not sure how this has an effect on the level of counterparty risk though.