Portfolio Compression

Trading firms’ build-up economically redundant trades over a period of time. Portfolio Compression (Trade Compression or Portfolio Trade Compression or Tear-up) is a technique to remove such redundant or non-economic trades from the portfolio of firms. It aims at reducing the gross notional exposure, while keeping the net exposure the same. In other words, trade compression looks to eliminate chains of trade in a network. The below diagram shows the effect of trades before and after compression.

Ideally, compression would eliminate all such cycles of trades from a network. In practice, all cycles may not be eliminated as it requires parties to voluntarily participate and agree to compress trades. The general market practice is that firms take the help of third-party vendors that provide compression as a service and remove only certain trades from their portfolio. While submitting the trades for compression, firms provide their constraints and tolerances.