Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition

4.3 Termination Features and Trade Compression

Whilst netting reduces OTC derivative exposure by almost an order of magnitude, there is still a need to find ways of reducing it still further. Typical ISDA netting agreements by their very nature operate bilaterally between just two counterparties. One idea is to take netting further and gain multilateral netting benefits via the cooperation of three or more counterparties. The first way in which this can be achieved is via trade compression.

Long-dated derivatives have the problem that, whilst the current exposure might be relatively small and manageable, the exposure years from now could have easily increased to a relatively large, unmanageable level. An obvious way to mitigate this problem is to have a contractual feature in the trade that permits action to reduce a high exposure. This is the role of break clauses and reset agreements.

4.3.1 Reset Agreements

A reset agreement avoids a trade becoming strongly in-the-money by means of readjusting product-specific parameters that reset the trade to be more at-the-money. Reset dates may coincide with payment dates or be triggered by the breach of some market value. For example, in a resettable cross-currency swap, the MtM on the swap (which is mainly driven by FX movements on the final exchange of notional) is exchanged at each reset time in cash. In addition, the FX rate is reset to (typically) the prevailing spot rate. The reset means that the notional on one leg of the swap will ...