The utility that provides clearing services for the equities trading industry could be asked to produce the “control mechanism” that keeps brokerages, market makers and other trading participants from imploding due to flawed technology.
An industry working group that includes all four major national stock exchange operators, broker-dealers, buyside firms and the Financial Industry Regulatory Authority suggested in its September 28 letter to the Securities and Exchange Commission that the Depository Trust and Clearing Corporation (DTCC) and its clearing agencies might provide a “consolidated control mechanism” that could help keep trading from running wild, as occurred in the August 1 flood of erroneous orders that nearly swamped market maker Knight Capital.
That’s because its clearing operations are in “a unique position” to limit risks, able to act “as the ultimate receiver of the potential risks resulting from technology-related and similar events,” according to the group.
In particular, the group pointed to two proposals by the DTCC’s National Securities Clearing Corporation (NSCC) agency that are already under review at the SEC.
The first is a rule filing that would require that amounts, prices and other details on trades be “locked-in” when buy and sell orders are matched and that the “locked-in-trade data” be submitted by market participants to the clearer on a real-time basis.
This proposal was designed to prevent the hazards of not having up-to-the-moment trade data. Late day trade data now limits NSCC’s ability to “effectively monitor counterparty credit risk and to risk manage those trades on an intra-day basis,” according to the letter.
The DTCC is also calling for accelerated trade guarantees. Currently, the NSCC guarantees trades at midnight the day after a trade takes place.
If the trade guarantee were moved up, the clearer could become the central counterparty earlier in the trading cycle. This also would reduce intra-day counterparty exposure.
These proposals, still to be fleshed out by the industry group and worked out with regulators, is designed to prevent the hazards of not having up-to-minute trade data.
Late-day trade data now limits NSCC’s ability to “effectively monitor counterparty credit risk and to risk manage those trades on an intra-day basis,” according to the letter.
DTCC confirmed that the utility is discussing faster, more effective trade guarantees.
“The group is discussing what actions the industry can take to improve the stability of the markets without inhibiting the ability for firms to conduct their normal business,” said Bari Trontz, a DTCC spokeswoman. “As these discussions are in their early stages, it is premature to determine the direction of the group’s views,” she added.
Trontz said it was too early to go beyond general comments, saying discussions with the working group are ongoing.
“The DTCC suggestions are meant to get the DTCC to a more real-time environment so they could perhaps function longer in some sort of centralized risk management capacity in real time,” one industry professional familiar with the talks said. He said the first step is to “get the DTCC systems more real time.”
However, the working group, according to the individual familiar with the discussions, is focusing on the idea of using a calculation called “Peak Net Notional Exposure’’ as the trigger for a shutdown of aberrant activity. That kill switch would be maintained by the exchanges.
The working group includes Bank of America Merrill Lynch, Citadel, Citigroup Global Markets, Deutsche Bank Securities, GETCO, Goldman, Sachs & Co., IMC Chicago, ITG, Jane Street, Morgan Securities, RBC Capital Markets, RGM Advisors, Two Sigma Securities, UBS Securities, Virtu Financial and Wells Fargo Securities.
The September 28 letter is signed by NYSE Euronext, Nasdaq OMX, BATS Global Markets, Direct Edge, the Chicago Stock Exchange, FINRA and the Depository Trust & Clearing Corporation, the industry’s post-trade utility.
The group was formed this summer after Knight Trading Group’s 45-minute technology trading glitch caused a $440 million loss. That loss that nearly pushed the giant liquidity provider into bankruptcy.
The working group says it is interested in both the DTCC’s accelerated trade guarantee and ensuring trade data is provided to the utility on a real time basis.
“If approved, both proposals would contribute to the goal of mitigating counterparty risk and would provide a means for the NSCC to identify cross market credit issues on a timelier basis,” according to the letter. It was signed by Joseph Mecane, executive vice president, head of equities, NYSE Euronext, executives of BATS Global Markets, Direct Edge, Nasdaq OMX Group, the Chicago Stock Exchange and Murray Pozmanter, general manager of clearing services for the DTCC.
The DTCC campaign to improve the clearing and settlement standards of U.S. markets has been going on for years. The nonprofit industry utility has contended that the United States is falling behind the clearing, settlement and trade guarantee standards of many other advanced markets. Indeed, three years ago, a DTCC official, in arguing for accelerated trade guarantees, said the current T+1 trade guarantee standard is insufficient.
In Traders Magazine’s sister publication CQ&D, Michael Bodson, executive managing director of business management strategy at DTCC at the time, warned that “recent market events, including firms like those of Lehman Brothers and Madoff Securities, underscore the importance of a real-time guarantee.” (See CQ&D, Summer 2009).
In the same 2009 story, Richard Closs, director of credit risk management at Pershing, contended that many healthy firms continue to fear that they could be hurt by a counterparty if and when the next brokerage or banking giant fails.
Today’s standard trade guarantee and settlement standards, critics say, are not fast enough. That’s because intra day and other kinds of problems can arise. As an example, let’s assume two parties trade on Monday, which is T. The NSCC applies its trade guarantees at midnight at midnight of T+1 (midnight Tuesday into Wednesday). The trade is settled, with the movement of money and securities, on Thursday (T+3).
Critics complain that, within the trade guarantee and settlement periods—-T+1 to T+3—many things can go wrong. These problems can hurt well-run firms that have done nothing wrong.
For instance, say the counterparty of healthy firm is under regulatory review, which can hurt a firm even though it has dome nothing wrong. Say a firm files for bankruptcy, then your business could be tied up. Pershing’s Closs cited the Lehman Brothers’ bankruptcy as an example.
“Euroclear,” he adds, “was refusing to honor transactions with Lehman Brothers International and many people were confused.”
Since the market meltdown of 2008, DTCC officials have noted the utility was able to weather the Lehman Brothers bankruptcy and other crises without any financial fallout to its members. Still, many industry players, including the Omgeo post-trade services joint venture between DTCC and Thomson Reuters, continue to argue for faster trade and settlement guarantees.
