The recent period of market volatility and tight credit has highlighted the critical connection between risk management controls and market stability. The primary mission of DTCC’s central counterparty (CCP) subsidiaries include ensuring settlement can be completed in the face of member failure and reducing risk of loss due to member failure. They do so by ensuring that, for most clearing and settlement activities, they step into pending trades that have not settled yet. If a participant firm cannot or will not complete settlement, usually due to that firm’s failure or bankruptcy, the relevant CCP subsidiary will complete those trades.

In order to accomplish its mission, DTCC’s CCP subsidiaries – National Securities Clearing Corporation (NSCC), the Government Securities Division (GSD) of Fixed Income Clearing Corporation (FICC), and EuroCCP (DTCC’s European clearing and settlement subsidiary) calculate a risk-based margin requirement for each member on a daily basis and collect collateral (cash and/or securities) from each member firm. DTCC plans to launch a fourth CCP, for the Mortgage-Backed Securities Division (MBSD) of FICC, in the second half of 2009, pending regulatory approval. The job of determining how much collateral to collect and how to measure the risk involved falls to DTCC’s Enterprise Risk Management group.

DTCC’s Enterprise Risk Management Organization

Q. What is the role of DTCC’s Risk Management area?

A. Risk management at DTCC is a much different role than at most participant firms. It basically entails protecting the safety and soundness of the clearing and settlement system. We insure that settlement can continue in the face of a member firm failure, and we reduce the risk of loss due to that member failure. To perform that role, we have to do a number of different things. They include assessing new applicants, doing ongoing financial surveillance, and performing market surveillance. Furthermore, we have to properly identify exposure presented to DTCC and calculate a margin requirement to cover that exposure. The sufficiency of the margin requirements is assessed through the performance of back tests (i.e., margin requirements collected on a portfolio are compared to the calculated profit and loss on the same portfolio based on actual market moves) as well as, of course, through practical experience with the actual default of DTCC plans to launch a fourth CCP, for the Mortgage-Backed Securities Division. 3 member firms. During 2008, DTCC’s CCP subsidiaries ceased to act for three member firms with no losses resulting for the remaining members of the CCPs. In each case, the CCP had sufficient liquidity to make settlement and also had sufficient clearing fund to cover any loss incurred on the liquidation of securities in the defaulting member’s portfolio.

Q. How is DTCC’s risk management staff organized?

A. Risk management methodologies are integrated into key areas of our operations. Leading DTCC’s risk management work is our Enterprise Risk Management (ERM) group, headed by Chief Risk Officer Douglas George. ERM is comprised of a team of credit specialists, market risk specialists, mathematicians and operational risk specialists.

When new firms apply for membership at one of our subsidiaries that are involved in clearing and settlement activities, ERM performs a detailed assessment of the firm, including organizational structure, management, regulatory review, business plan and a financial review and a recommendation as to whether the applicant should be accepted for membership. We present the assessment to the Credit and Market Risk Management Committee, a committee of DTCC’s Board, for a final decision.

ERM receives guidance important to their daily work from multiple committees, including the Internal Risk Management Committee, as well as two Board-level committees, Compliance & Operational Risk Management and Credit & Market Risk Management.

Q. Which DTCC subsidiaries are subject to risk management controls?

A. The subsidiaries for which DTCC provides central counterparty (CCP) services are directly subject to the company’s risk management policies and procedures. They are the equities clearing corporation, NSCC; the GSD of the Fixed Income Clearing Corporation (FICC); and our European central counterparty, EuroCCP. Risk management controls are also in place for the depository, The Depository Trust Company, which handles both custody and settlement, but is not a central counterparty, as well as for FICC’s Mortgage-Backed Securities Division (MBSD). As previously noted, MBSD is scheduled to go live as a CCP in the second half of 2009, pending regulatory approval, and at that time risk management controls will be strengthened to support that CCP.

NSCC Guarantee

Q. Explain what is happening with the proposed change in the NSCC guarantee. You’ve proposed moving the trade guarantee almost to the point of trade?

A. Currently, under NSCC rules, trades that are submitted to NSCC for clearing and settlement are typically guaranteed at midnight of T+1. Trades that are received on T and T+1 are “optionally guaranteed” at NSCC’s discretion.

Historically, NSCC has chosen to guarantee these “optionally guaranteed” trades in every participant firm liquidation we have managed, with one exception (where fraud was involved), but our customers now want to eliminate the ambiguity of optional guarantees. So, after much study, the DTCC Board in 2008 approved a change in the guarantee to the point at which those trades are submitted and the trade is validated by NSCC. Since we have real-time submission of most trades at this point, that means we are talking about effectively guaranteeing most trades within seconds of execution.

Q. Why wouldn’t everyone want that kind of protection?

A. Under the new system, we will effectively guarantee an additional two days of trading, and an average trading day through NSCC currently involves about $1.2 trillion in trades.

We have to ensure that both we and our regulators are comfortable with the collateral coverage we have, while at the same time being as efficient as possible with our clients’ funds. We don’t want to over-collect, since we recognize the cost and impact collateral collection has on market liquidity and the difficulty firms may have in acquiring funds when needed.

The one thing that we have heard from our customers is that they would like to have more transparency in how we calculate collateral requirements, whatever the guarantee is, so they can begin to anticipate how their trading will affect those requirements.

Q. How are you going to provide more visibility to customers on your collateral calculations?

A. We have been discussing that with our customers, and basically what they have told us is that they would like to see more about our methodologies and calculations, better MIS and reporting, as well as the ability to model and predict more accurately what funds will be required with changes in their portfolios.

So we are building a tool to enable customers to model changes in their portfolios in order to understand the impact of those changes on their funding requirements. We intend to have an action plan, including a roll-out schedule, developed by the fourth quarter of this year.

Q. So what else are you doing specifically to address any customer concerns about additional collateral?

A .First, we have selected a third party firm to conduct a comprehensive review of our models to ensure that we are achieving both appropriate coverage and maximum efficiency. That review began in February, and we expect to have results in June. If changes are warranted, we will seek both regulatory and Board of Directors approval for those changes in the fourth quarter, and, of course, we will be announcing any changes to our customers at the same time. And this review won’t just cover NSCC, but also FICC and DTC as well.

We are also exploring opportunities for cross-margining, both within DTCC and outside of it, to reduce overlaps in required funds for our customers. We’ve recently enhanced our agreement with OCC (Options Clearing Corporation), resulting in a savings of $1.6 billion in clearing fund requirements. We plan on introducing common margining between our Government Securities Division and MBS Division in FICC at the time we implement the market’s first-ever central counterparty in mortgage-backed securities trading.

MBS Central Counterparty

Q. Let’s talk a bit about the central counterparty of the MBS division of FICC. This raises some new risk issues, doesn’t it?

A. This new capability will certainly require FICC to assume new risks as a central counterparty that don’t exist currently, but it also marks a significant advance in the industry’s ability to reduce systemic risk. When we handled the Lehman bankruptcy, $330 billion of the $500 billion total exposure across the DTCC complex that had to be liquidated represented mortgagebacked securities positions. Since a formal CCP for these trades did not exist, we normally would have let the parties exposed to Lehman unwind their trades on a bilateral basis. But industry participants wanted a centralized approach. So we became, in effect, a “CCP for a day” to net and reduce the overall exposure. We ended with about $30 billion to be liquidated, much more manageable than the original amount, and proved to the industry and regulators the value of having a central counterparty for this market.

We’ve already moved to a “value at risk” (VaR) model for MBSD. Assuming we get regulatory approval for the CCP to go live in the third quarter, MBSD will provide a guarantee at the point of trade comparison for all MBSD activity. Our clearing fund methodology will include, in addition to a VaR component, a mark-to-market, margin requirement differential (put in place to cover the risk that trades are guaranteed prior to the collection of clearing fund) , and a coverage component (a back-test like component that will assure coverage at a certain confidence level.) In addition, we have proposed new membership standards for the CCP. And, from the outset, we plan to implement common margining between FICC’s MBSD CCP and its Government Securities Division.

Lehman Bankruptcy

Q. You mentioned the Lehman bankruptcy. Were there any lessons learned for the future?

A. Quite a few, in fact. We had used a Lehman bankruptcy as one of our simulation exercises some months earlier and learned some valuable lessons at that time, but we still learned additional lessons from the actual “cease to act” for Lehman. One thing we learned is that the arrangements for closing out a failed member we had in place didn’t “scale” well for a firm of Lehman’s size, and more complex arrangements with a variety of hedging strategies were needed. We didn’t have these arrangements in place, and getting them done on the fly wasn’t easy. So we are making arrangements now to have all of the investment advisory resources and hedging agreements in place, ready to execute on that responsibility if we need to do so again.

This bankruptcy was more complicated than most, because when the holding company declared bankruptcy, the brokerage subsidiary, which was a member of FICC, DTC and NSCC, was not included in the bankruptcy and remained operating. As a result, we actually had to stop and reverse out ACATS (Automated Customer Account Transfer Service) transfers at one point in the process to avoid a severe liquidity demand at Lehman that could have severely strained resources. So another lesson learned is that we need to review with our members and regulators how and when the ACATS service should be allowed to operate in a bankruptcy. We are already planning a significant redesign of the ACATS system to address these issues.

Q. You recently changed the way you handle the DTC participant fund. What was that about?

AWe had some concerns about the systemic risk involved in the way we applied the net debit cap in DTC. We allowed each legal entity at DTC to have a net debit cap up to $1.8 billion. Because a family of legal entities associated with one company could all fail at the same time, we felt we needed to reassess the application of the maximum net debit cap. We began discussing this requirement with DTC member firms in July 2008, and released several Important Notices about activating this change at the end of April, which places a $3 billion maximum net debit cap on families of legal entities within a single company. As a result, those companies may have to put up settlement pre-payments more frequently than they do now.

Q. What are some of the other things Risk Management is working on?

A. We’ve got quite a few things in the works. For one, we are doing a complete review of membership standards, given the fact that we are now accepting global membership at our subsidiaries. We are also looking to develop a “Quant Lab” historical database to improve our analysis of various types of risk that should enhance our back and stress testing capabilities.