The ESMA's draft advice to the European Commission on portfolio compression posted below is the extract from ESMA's Technical Advice to the Commission on MiFID II and MiFIR of 19 December 2014, ESMA /2014/1569, p. 443 - 446).
Criteria of the definition of portfolio compression
1. The criteria for the definition of portfolio compression should cover the process, the legal documentation and the economic outcome of portfolio compression.
The process and steps
2. The portfolio compression between two or more counterparties should result in the reduction of the notional value of their derivative portfolio. In order to achieve this reduction, the risk management framework of the counterparties should be respected. It is therefore necessary that the service provider or the counterparties allows the participants in the portfolio compression activity to apply the criteria set in its risk management framework when performing compression. The participant should inform the service provider or the counterparties which should consider and apply those criteria.
3. Before the compression exercise is initiated, for each compression exercise, the counterpar-ties or the service provider, the investment firm and market operator providing portfolio compression should allow the participant to provide criteria reflecting its risks tolerance for instance a limit to counterparty risk, a limit to market risk, a cash payment tolerance.
4. In the absence of service provider, counterparties should exchange their respective criteria when they analyse the interest of compression and at the latest before starting the com-pression exercise.
5. The portfolio compression should respect the risk framework of the participants.
6. The service provider or the counterparties should establish links between transactions submitted for compression.
7. As a result, the service provider should submit to the participant a compression proposal that includes at the minimum the identification of the counterparties, the related change to the notional value of the transaction proposed by the counterparties, the variation compared with the risk criteria provided. This compression proposal would allow the participant to have a view on the outcome of the compression exercise and to adapt some criteria in order to maximise the efficiency of the compression exercise within the respect of its risk framework.
8. In case where there is no service provider, counterparties should exchange simulation of the compression outcome so that each counterparty can ensure that its risk framework would be complied with.
9. The service provider could, but would not be obliged to, give some time to the participant to add transactions that would increase the pool of trades eligible for termination or reduction, to adjust the risk limits in order to maximise the efficiency of the compression exercise.
10. When there is no service provider, counterparties could agree, but would not be obliged to, add transactions or perform adjustments in order to maximise the volume of transactions for compression and comply with their risk policy.
11. Participants in a portfolio compression activity should not use the process to submit bids and offers to enter into specific transaction. They should not use portfolio compression for the purpose of circumventing the clearing or trading obligation.
12. Finally, the service provider or the counterparties should perform compression when all participants agree on the compression proposal. Agreement could be given on the initial compression proposal or on a subsequent compression proposal.
13. Compression between two or more counterparties results in some derivative transactions to be reduced or terminated and replaced by other transactions with a reduced notional value. It means that the contractual documentation between the counterparties to the transactions, when there is no service provider, and between the participants to compression and its ser-vice provider, when there is one, should provide for the compression process and its legal effects.
14. The relevant legal documentation should therefore be in place in order to ensure, at the minimum, that the compression exercise allows to amend or terminate a trade that has been submitted to compression and to replace such trades by the transactions resulting from the compression exercise as need be.
Economic outcome of the process
15. The process whereby contracts are aggregated into fewer contracts or are simplified e.g. by standardising the coupons and coupons period, without reduction of notional value, should not be in the scope of portfolio compression.
16. The total aggregated notional value of portfolio submitted by all participants to compression should have decreased.
17. The economic outcome of the compression process should be assessed at portfolio level and not at the level of individual transactions within a portfolio.
18. The notional value of the portfolio submitted by each participant to compression should decrease. The notional value of the portfolio of a participant could however remain at the same level as before compression, if the notional value of the portfolio of other participant(s) decreases.
Measurement of the portfolio compression
19. In order to specify the measurements for determining that the combined notional value following compression is less than the combined notional value of the submitted derivative portfolio, the aggregated notional value of the portfolio submitted to compression before compression should be compared with the aggregated notional value of the portfolio after compression.
20. In line with the approach adopted with respect to the economic outcome of the portfolio compression, the measurement should focus on the reduction of the aggregated notional value of the portfolio submitted for compression for all participants on an aggregated basis. This measure will allow determining the efficiency of the compression globally per compression exercise.
21. The measure should also be performed at the level of each individual participant in a portfo-lio compression activity. In this case the notional value of the portfolio of the participant should be compared with the value of the portfolio of that participant resulting from the compression. The outcome of the compression should be a reduction of the notional amount or a status quo. The compression should not result in an increase of the notional value of the portfolio of a participant.
Information to be published
22. Investment firms and market operators that are providing portfolio compression services are required to publish the volumes of transactions subject to portfolio compression and the times they were concluded within the time limit specified in MIFIR i.e. for the purpose of post-trade transparency "market operators and investment firms operating a trading venue shall make details of all such transactions public as close to real-time as is technically possible".
23. The volume of transactions to be published should be expressed in number of transactions and in value. Concerning the value, it should be expressed in notional amount given that the information is provided by the firm providing portfolio compression that aims at decreasing the notional value of derivatives. The marked-to-market value should not be considered an appropriate measure of the volume for the purpose of post-trade transparency as it differs over time and may depend on counterparties.
24. The publication should cover the transactions submitted to portfolio compression, the replacement transactions and the transactions reduced or terminated. The value and number should be provided per compression exercise, per asset or product class, and per currency.
25. The publication should be made shortly after the compression proposal is a confirmed as legally binding by the service provider or the counterparties following the acceptance by all participants. That information is known by the firm providing portfolio compression as it is the one respectively receiving the acceptance and informing participants that compression is legally binding. The publication should refer to each compression exercise, provide information per category of product (such as Rates, Credit, ...), and per currency. The service providers usually have sophisticated systems that would allow them to perform publication in a matter of minutes following the confirmation as indicated above. For compression performed between counterparties, the process may be more manual and they may need more time which should however not extend behind the next business day.