When does portfolio compression reduce systemic risk?

Veraart, Luitgard A. M. ORCID: 0000-0003-1183-2227 (2022) When does portfolio compression reduce systemic risk? Mathematical Finance, 32 (3). 727 - 778. ISSN 0960-1627

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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.

Item Type:	Article
Official URL:	https://onlinelibrary.wiley.com/journal/14679965
Additional Information:	© 2022 The Author
Divisions:	Mathematics
Subjects:	Q Science > QA Mathematics
JEL classification:	D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D85 - Network Formation and Analysis: Theory G - Financial Economics > G2 - Financial Institutions and Services > G28 - Government Policy and Regulation G - Financial Economics > G3 - Corporate Finance and Governance > G33 - Bankruptcy; Liquidation
Date Deposited:	04 Feb 2022 17:15
Last Modified:	16 Nov 2024 08:03
URI:	http://eprints.lse.ac.uk/id/eprint/113638

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