Title: Portfolio Compression in Financial Networks: Incentives and Systemic Risk
Abstract: We study portfolio compression, a post-trade mechanism that eliminates cycles in a financial network. We study the incentives for banks to engage in compression and its systemic effects in terms of all banks’ equities. We show that, contrary to conventional wisdom, compression may be socially and individually detrimental and incentives may be misaligned with the social good. We show that these effects depend on the parameters of the financial system and the compression in a complex and non-monotonic way. We then present sufficient conditions under which compression is incentivized for participating banks or a Pareto improvement for all banks. Our results contribute to a better understanding of the implications of recent regulatory policy.
