Barclays: Swaps Compression/Central Clearing will reduce the Balance Sheet beyond Expectations

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Derivatives compression (the restructuring of derivatives portfolios so that unwanted leverage exposure declines while target risk exposures remain within tolerance) will likely reduce industry notional amounts by over $60tn in 2013 (near 10% of the outstanding of ~$700tn – see Exhibit) and, together with central clearing, by ~15% in 2014.

-Until this year, the motivation for derivatives compression was reducing the risk-weighted assets used to calculate risk-based capital ratios. However, the leverage ratio is now the gating factor for positions that are balance-sheet, rather than risk-capital, intensive including inter-dealer derivatives and repo positions, particularly the matched book.

If Barclays does no worse than the industry (and, given prior under-management, will likely do meaningfully better), derivatives-related leverage exposure will decline from the current ~GBP360bn, by GBP35bn through mid-2014. The additional GBP15bn of exposure reduction needed to meet target leverage represents just 15% of that related to repo positions of which the matched book is the most significant portion. This book generates less than ~$100 million of revenue and a sub-5% return-on-equity; as such, Barclays will likely reduce it substantially.

There is large scope for on-going increases in the balance-sheet efficiency of the derivatives portfolio beyond mid-2014 because of network effects in derivatives compression: the more motivated counterparties participate the more potential relief is available. Increased regulatory focus on the leverage exposure provides the motivation as noted in August by Zar Amrolia, head of FICC at DB:

-“It’s fair to say the industry was blind-sided by the leverage ratio; compression will be a key tool for us to manage down our exposures and we need as an industry to get on and do this.. the rates business has historically been high-margin which meant it could afford to be less efficient [than FX]; there is large scope for further compression

Clarification from Barclays, at or before year-end, around the large scope for balance-sheet reduction through derivatives compression and repo downsizing will be a significant catalyst for the stock. We expect the current discount of ~15% to tangible book value/share of GBX295 to reverse to a premium which will expand through 2014 as investors gain confidence in management of the investment-bank balance sheet and the achievability of the 2016 target for 11%+ return-on-equity.

Please see our published research for the full note.

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