Explain multilateral offset, compression and netting, illustrating each with a case.
The idea
Three tools reduce exposures in a cleared market. Netting offsets positive and negative values into one amount. Multilateral offset arises because novation puts all trades with one counterparty, the CCP. A member who bought from one firm and sold the same contract to another ends with a net position of zero, or the small difference, which bilateral netting could not achieve. Compression tears up redundant or offsetting trades, for example a ring of identical swaps. It reduces the number of trades and the gross notional, and leaves each member's net position and net market risk unchanged. Netting and offset reduce credit exposure and margin. Compression mainly reduces gross notional, operational burden and gross-based capital or leverage measures. Benefits exist only within one CCP, because splitting trades across CCPs forfeits the offset.
A practice question
A member bought a swap from firm X and sold an identical swap to firm Y, and both trades are novated to the same CCP. This outcome, which bilateral netting could not achieve, is called:
- bilateral netting: the two swaps are offset because both are with the same counterparty.Why not: Wrong because the original counterparties were different; bilateral netting needs one counterparty.
- multilateral offset: the positions cancel against each other even though they were with different original counterparties. - correct
- compression: the CCP reduces the notional of existing trades by tearing them up.Why not: Confuses offset of positions with tearing up of trades to cut gross notional.
- variation margin: the CCP calls the loss on one swap and pays the gain on the other.Why not: Confuses offsetting positions with the daily settlement of value changes.
Novation makes the CCP the counterparty to both trades, so the long and short positions in the same contract offset even though X and Y are different firms.
A harder one
A dealer has long USD 60 million with firm B and short USD 45 million of an identical swap with firm C, with both trades cleared at the same CCP. The dealer's net cleared position is:
- USD 105 million gross, since the positions are with different original counterpartiesWhy not: Adds the two positions; this ignores multilateral offset at the CCP.
- USD 60 million long, since the short position with C is a separate netting setWhy not: Applies bilateral logic and treats the C trade as a separate netting set.
- USD 15 million long - correct
- USD 45 million short, since the CCP keeps the smaller positionWhy not: Takes the smaller position instead of the difference.
At the CCP, long 60 and short 45 offset: net = 60 - 45 = USD 15 million long. This offset is not available bilaterally.
The hardest tier
Three dealers hold swaps with identical terms in a ring: A pays fixed to B on USD 100 million, B pays fixed to C on USD 80 million and C pays fixed to A on USD 60 million. Gross notional is USD 240 million. Compression may only reduce the notional of these three existing trades, keeping each dealer's net position unchanged, and tears up as much as possible. Gross notional afterwards is:
- USD 60 million - correct
- USD 240 millionWhy not: Assumes compression cannot change anything, treating it as a pure netting exercise on values.
- USD 180 millionWhy not: Subtracts the smallest notional (60) only once, instead of from each of the three trades.
- USD 100 millionWhy not: Assumes the largest trade survives intact instead of being reduced to preserve net positions.
A's net is pay 40, B's is receive 20, C's is receive 20. Cutting each trade by 60 gives A to B 40, B to C 20, C to A 0, which reproduces these nets. Gross = 40 + 20 = 60.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Central Clearing
- State what a central counterparty (CCP) is and outline how central clearing works.
- Account for novation as it applies in central clearing.
- Outline how margin and default funds are applied and estimated under central clearing.
- Discuss the exposures a CCP bears and how it controls them.
- Show a loss waterfall at work through illustrations.
- Account for the ways losses are absorbed and the default of one or more CCP members is handled.
- Contrast clearing done bilaterally with clearing done through a central counterparty.
- Contrast the initial margin and default fund contributions asked of clearing members, with respect to how losses are covered, what clearing costs and the moral hazard created.
- Outline the strengths and weaknesses of central clearing.