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When does portfolio compression reduce systemic risk?

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  • Veraart, Luitgard A. M.

Abstract

We analyze the consequences of portfolio compression for systemic risk. Portfolio compression is a post-trade netting mechanism that reduces gross positions while keeping net positions unchanged and it is part of the financial legislation in the United States (Dodd–Frank Act) and in Europe (European Market Infrastructure Regulation). We derive necessary structural conditions for portfolio compression to be harmful and discuss policy implications. We show that any potential harmfulness of portfolio compression arises from contagion effects. We show how portfolio compression affects systemic risk depends on the resilience of nodes taking part in compression, on the proportion of debt that they can repay, and on the recovery rates in case of default. In particular, the potential danger of portfolio compression comes from defaults of firms that conduct portfolio compression. If no defaults occur among the firms that engage in compression, then portfolio compression always reduces systemic risk.

Suggested Citation

  • Veraart, Luitgard A. M., 2022. "When does portfolio compression reduce systemic risk?," LSE Research Online Documents on Economics 113638, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:113638
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    File URL: http://eprints.lse.ac.uk/113638/
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    More about this item

    Keywords

    systemic risk; portfolio compression; financial networks; cycles; netting; Wiley deal;
    All these keywords.

    JEL classification:

    • D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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