The derivatives industry has significantly reduced counterparty risk over the past five years, beyond the benefits gained from central clearing, according to a report from the International Swap and Derivatives Association (ISDA).
Netting, collateralisation and portfolio compression have all led to significant reductions in notional amount outstanding, while clearing has had the opposite effect, artificially increasing notional outstanding, ISDA claimed.
The industry association's research found the notional amount outstanding the OTC derivatives market, excluding FX, fell 3.3% during 2012. Over a five-year period, if double counting of cleared transactions is eliminated, the OTC derivatives market, excluding FX, shrank by 17.5% to US$392 trillion.
Portfolio compression is seen as being particularly influential in this, reducing notional amount outstanding by about 25%.
Over a five-year period ending on 31 December 2012, if compressed transactions are added back in, the notional amount of outstanding OTC derivatives would increase from US$492.9 trillion to US$606.3 trillion, or 23%.
Portfolio compression reduces the notional amount outstanding, by eliminating matched trades and trades which do not contribute risk to a dealer's portfolio. By eliminating these trades, there is a reduction in counterparty risk, contributing to the G20's goals of reducing risk in the derivatives market.
However, ISDA said that the impact of clearing is actually increasing notional amounts by 100%. For example, if two parties execute a $100 million swap on a bilateral basis, only a single US$100 million contract exists, but the clearinghouse will be booked as two contracts worth a total of US$200m, artificially inflating the figures.
As well as the impact of portfolio compression, netting and collateralisation are also causing a reduction in counterparty risk.
According to ISDA, gross market value provides a measure of credit exposure and fell from US$25.4 trillion to US$24.7 trillion in the final six months of 2012. Another measure that shows the impact of netting, gross credit exposure, fell from US$3.7 trillion to US$3.6 trillion.
Collateralisation is also playing a role in reducing credit exposure, with trades covered by collateral agreements showing exposure equivalent to just 4.4% of gross market value. Overall, netting and collateral reduced gross market value to around 0.2% of notional amounts outstanding.
Robert Pickel, ISDA CEO, said: "The industry has made great strides to reduce counterparty credit risk and help make the derivatives markets safe and efficient through netting, collateralization, portfolio compression and central clearing.
"While the increase in compression continues to impact adjusted OTC derivatives volumes, underlying market activity remains robust."