Despite being among the most sophisticated operators in global financial markets, hedge funds seem a world apart. While banks struggle with endless regulation and the frustrations of managing legacy and complexity, multiplied over scale and geography, funds respond quietly and rapidly to clients and markets alike. In some areas, however, funds miss out. This is particularly true of trade compression, whose benefits have historically only been realised within banks.

1. Compression: three vital steps
to maximise capital savings
www.catalyst.co.uk
1
1 The process of tearing up OTC trades within predefined and agreed risk tolerances.
How taking a ‘maximise, minimise, optimise’ approach to compression can release
dramatic amounts of capital.
November 2014
Why more really is more
Compression1 is hardly new. But today, the rewards of submitting the maximum volume of trades
into a compression cycle have never been more dramatic, nor more strategically significant.
Globally, all banks are suffering an acute need to improve capital efficiency. A combination of the
banking crisis, regulatory pressure and chronically depressed interest rates has brought the
industry to a dangerously low point of profitability. In fact of all major industries, banking is the only
one significantly to have destroyed shareholder value over the past five years.
All this is well documented. What has been less clear until now is how maximising compression
can help free up as much capital as possible. Now, by combining three critical steps, firms can
increase the volume of trades submitted, minimise their risk profile and optimise their tolerances,
increasing the reduction in gross notional by two and half times (on average) and thereby
achieving material capital savings.
This paper explores how these steps complement each other and explores how they can be
applied in practice.

2. © Catalyst Development Ltd 2
How did it all start?
Compression is a mature tool that has
been used by the market for over a
decade. But as regulations have
changed, so have the benefits of the
process varied.
 Under Basel I, RWA was based
on gross positions and hence no
netting was available. In addition,
European banks could use
compression to reduce their
(again un-netted) IFRS balance
sheet.
 Then came Basel II and the ability
to net derivatives exposures for
RWA. Compression still gave
IFRS balance sheet benefits.
However, the market turned its
focus to OTC Clearing and
compression took a back seat.
 Now, following Basel III and
CRDIV, leverage ratios have
placed a firm focus on gross
derivatives exposures and brought
compression for both bilateral and
cleared trades right back to centre
stage.
During the intervening years, most banks
have unwound their ‘easy’ trades: trades
in books that were non-controversial to
submit; trades that were easy to find and
to reconcile with the right counterparty.
What remains can be considerably more
complex to compress – but equally, far
more valuable to address.
Simple does not mean easy
The biggest problem that reduces the
impact of compression is simple: too few
trades are submitted into unwind cycles to
begin with.
Of those trades which are submitted, the
selection process brings the next highest
attrition and greatest loss of potential
terminations, as eligible trades are
removed from the submission file for a
wide variety of reasons. That directly
impairs the ability to match against other
2
The ratio of unwinds to submitted trades.
counterparties, as most participants are
only submitting a subset of their trades to
the matching process in the first place.
Once through the submission process,
the next hurdle is when trades are put
through an algorithm that produces a
proposed set of trades to unwind.
The optimum unwind ratio2
for any set
of trades submitted into an unwind
cycle is around 70 – 80%. Yet most
banks only achieve around 50%: a
fraction of the available trades with the
direct result of a major loss of
potential savings.
This is further compounded by the fact
that most banks manage their interest
rate risk in multiple books. The number of
books facing the other participants
exponentially decreases the number of
achievable unwinds and increases the
inefficiency of the algorithms, making the
unwind increasingly complex and
expensive.
In fact our experience shows that:
 if you have one book facing the
street you should expect to
achieve a 70 – 80% unwind ratio;
 if you have two books that’s likely
to fall to 60%;
 with three books or more, this is
likely to drop to 50% - or less.
This dramatic fall happens because the
unwind ratio is directly related to the
number of tolerances submitted. Each
risk profile submitted increases the
number of tolerances and decreases
efficiency.
For example:
 In a typical swap portfolio of
40,000 eligible trades, an average
50% are lost during the
submission and filtering process,
so that only 20,000 trades are

3. © Catalyst Development Ltd 3
actually submitted. Multiple books
and suboptimal tolerances reduce
that by a further 50%. By now only
10,000 trades are unwound: a
quarter of those eligible.
 By contrast, taking a ‘maximise,
minimise and optimise’ approach
would enable the bank to submit
closer to 35,000 trades and in
addition, to unwind closer to 75%
of those submitted. As a result
26,000 trades are terminated:
more than doubling the final
unwind result.
In addition, achieving a high unwind ratio
can also have a significant positive
effect on the Basel III Leverage Ratio, as
the calculation of derivatives exposures
for the Leverage Ratio is linked to
the gross notional amount outstanding.
When assessing the Leverage
Ratio under Basel III, the gross notional
derivatives exposure is multiplied by
a fixed conversion factor, determined by
asset class and expiry. The final amount
can then be reduced by the application of
a Net to Gross Ratio, but the calculation
effectively floors the impact of the Net to
Gross ratio at 40%.
However by reducing gross notional
through compression, the total calculated
exposure, and thus the denominator of
the Leverage Ratio, can be substantially
reduced.
Maximise, minimise, optimise
The key to maximising the benefits of
compression lies in this three-stage
approach:
 maximise the number of trades
available for submission. There
are a number of key steps here,
each of which offers an
opportunity to reduce attrition.
 minimise the number of risk
profiles with which you face the
rest of the unwind community.
Crucially, this allows you to
unwind as one entity. The ability to
face the street with one risk profile
also brings significant additional
benefits around maximising
submission volumes, as well as
ancillary benefits outside
compression.
 optimise your tolerances and
maximise the unwind result.
There is an optimal “width” of
tolerances where you can achieve
the highest unwind ratio, before
encountering diminishing rates of
return as tolerances widen beyond
this point.
This is what the process might look like.
1. Maximising the volume of trades
submitted
This is where the most significant gains
are to be made. If you don’t maximise the
number of trades you submit in the first
place, you can’t reap the full rewards of
optimising the rest of the process.
As well as challenging which trades are
not submitted and why, you should
examine the process itself. Most banks
have a mature BAU submission process
run by their back office or operations
team. This goes through a number of
steps and each stage brings a risk of
attrition through the loss of eligible trades.
Your approach here should be:
 Step A – Capture outlying
trades.
In a rates unwind, you will know the
currency and the other participants
and banks will filter from their
database that rate of interest rate
swaps. The main cause of attrition
here is the number of trades sitting in
outlying books not submitted for
unwinds. There is huge benefit to be
had from solving this.

4. © Catalyst Development Ltd 4
 Step B – Use filters intelligently.
Banks often filter out trades which are
used for FAS 1333
hedging. Again,
there is significant opportunity for
process optimisation here. You should
also check whether other filters
around basis and strategy could be
optimised.
 Step C – Perfect your matching.
Trades go through a matching
process, once again risking significant
attrition. Submitting a higher
proportion of your full set of eligible
trades will increase your matching
result. There is a significant
opportunity to reverse leakage and
tackling these issues will also bring
clear ancillary benefits such as
resolving margin disputes, alongside a
significant reduction in reconciliation
volumes and related break
investigation and resolution.
2. Minimising your risk profile
Books can be excluded for many reasons
and that reasoning, while being
challenged, also needs to be understood.
A thorough review of individual books’
trading needs will allow you to include
some that were previously thought
unsuitable and ideally, to face the street
with a single risk profile.
Any solution needs to be appropriate to
the scale of the bank and the bank will
also need to resolve what and how to
recharge costs back to the right trading
desks and reconcile different trading and
hedging strategies among different books.
Throughout this process, human
dynamics will be strongly at play. There
may be a need to overcome internal
resistance to the submission of particular
books or to calm fears that the ability to
manage distinct risk profiles with integrity
might be lost in the process.
2
Financial Standards Accounting Board
http://www.fasb.org/summary/stsum133.shtml
Two key points to remember are:
 internal risk impact can be hedged
using hedges appropriate to that
book’s trading strategy;
 internal book trade volumes can
minimised with the right smart
solution.
3. Optimising your risk tolerances
It is not only possible but also increasingly
essential to optimise your risk tolerances,
whether you are participating in a multi-
lateral unwind solved by algorithms or
participating in a simple bi-lateral
compression.
Correct use of tolerances can increase
the number of unwinds achieved without
materially increasing risk. This requires
thorough, detailed understanding of
discount spread deltas, fixings, risk,
counterparty exposure and the interplay
of all of these on the algorithm result.
There is an optimal tolerance level at
which firms achieve the biggest impact
from unwinds. Exceeding this brings
diminishing returns, making it vital to
calculate exactly where that point occurs.
Conclusion
Submitting previously inaccessible trades
and using the ‘maximise, minimise,
optimise’ approach to compression offers
all participants a major opportunity to
release significant amounts of capital and
achieve impressive, quantifiable results.
That process starts with the single most
important step: enable access to all
trades, regardless of which book or “risk
group” they sit in, capturing your outlying
trades, then presenting those trades to
the external world as one book or “risk
group”.
However although apparently ‘simple’,
this is not easy. Expert advice is critical to
achieve the most dramatic, demonstrable
results.

5. © Catalyst Development Ltd 5
How can we help?
Our unique solution allows you to balance
risk between books, significantly increase
your unwind volume and have a similarly
significant impact on capital reduction.
This solution is different to anything else
on the market: it minimises any internal
hedges required and integrates with
existing processes, architecture and STP
with appropriate controls.
Our team is also unique, combining world-
leading expertise in risk with expert
understanding of front office, P&L,
operational flows and STP technology as
well as the dynamics of team work,
leadership and collaboration across different
parts of complex organisations.
Meet our authors
tomlodge@catalyst.co.uk
Disclaimer: Comments in this presentation on are based on Catalyst's understanding of the global regulatory landscape as of June
2014. This document is neither intended to be comprehensive, nor to provide legal or accounting advice.
Catalyst Development Ltd, 167 Fleet Street, London, EC4A 2EA
T +44 (0) 870 901 4155 F +44 (0) 871 433 8876 www.catalyst.co.uk
seancoote@catalyst.co.uk
About Catalyst
We are experts in optimising our clients’ balance sheet, reducing the total cost of trading and enabling regulatory
compliance. We work in joint teams with our clients, combining our experience in financial markets and programme
execution to deliver results. We provide honest guidance to help you succeed. We are Catalysts for enduring excellence.
Tom Lodge
Tom is an experienced
practitioner and pioneer in
compression.
He is an expert in OTC and
has over 17 years’
investment banking
experience spanning
trading, middle office,
clearing, change
management, and finance.
Tom has a deep
understanding of front to
back OTC flows and has
successfully delivered on
multiple accounts.
Sean Coote
Sean has unique practical
experience covering sell side,
buy side and CCP clearing
operations. His derivatives
expertise is based on over 25
years in senior operations and
project management positions.
His experience includes
consulting at a major US
corporate on the impact of
Dodd Frank on their global
operations. He has also set up
clearing operations for clearing
brokers covering
harmonisation and
implementation of both SCM
and FCM models.