FICC's risk management processes help to provide the U.S. Government securities industry with a stable and reliable environment for the clearing, netting and settlement of trades.

Overview

FICC’s risk management processes help to provide the U.S. Government securities industry with a stable and reliable environment for the clearing, netting and settlement of trades. Risk management is also the means by which FICC’s Government Securities Division (GSD) maintains sufficient liquidity to protect itself and its members from the risks inherent in the settlement process, including the possibility of a member default.

Among the tools FICC employs to help manage risk are requirements that members post collateral and that securities be marked to market prices daily. FICC’s risk management is also intrinsic to the operation of GSD’s central counterparty service and trade guarantee. In addition, FICC carefully manages which firms or institutions are eligible to be a member of its GSD and the trading exposure of its members. FICC permits various types of entities to join as netting members of the GSD, including banks, broker-dealers, futures commission merchants, and government securities issuers.

Who Can Use the Service

Risk management is automatically provided to all clearing members of the GSD.

Benefits

• By guaranteeing all trades as soon as they are compared, the GSD provides a high degree of counterparty risk mitigation.
• Central counterparty netting reduces the financial obligations requiring settlement to a greater degree than bilateral netting, thus reducing the value that must be settled and related clearing costs.
• Increases operational efficiencies by eliminating a manually intense process of tracking waivers for late payments and of collecting late payment penalties.
• Under FICC’s risk management practices, members of the GSD have a choice about how they want to margin for the trades they submit. If they are dual members of the FICC’s GSD and Mortgage-Backed Securities Division, they can decide whether they would like to participate in portfolio margining across the two divisions, potentially reducing the amount of collateral that must be posted in either division.

How The Service Works

Each member’s trading activity is constantly analyzed to ensure that the GSD’s exposure is appropriately assessed and margined.

The GSD’s Forward Margin procedures guard against potential risk incurred by FICC in guaranteeing the settlement of forward transactions at contract value on their settlement date. Because netted forward settling cash trades and repo close legs are guaranteed, the GSD must maintain funds sufficient to meet the associated settlement obligations in the event of a member default. Forward Margin does this by protecting against market value fluctuations in the prices of the securities (and interest rates for repos) involved in forward settling transactions for the period beginning with the dates the transactions enter the net until their scheduled settlement dates.

Each day, Forward Margin revalues forward settling trades by marking them from contract value to market value. This procedure is known as the daily mark-to-market process. For repos, the procedure includes the cost of financing repos from current date to repo close leg settlement date. The Forward Margin process then facilitates settlement of mark-to-market by paying and collecting margin payments on a cash basis through the daily Funds-Only Settlement process.

Forward Margin also provides for cross-margining of the cash and repo markets, as well as Forward Margin offset across securities. This makes for an efficient and cost-effective margin process since margin credits can be used to offset margin debits regardless of whether they are in the same market or security. Another function of this process calculates overnight interest on the margin. The GSD then collects interest from members in a credit margin position and pays interest to members in a debit margin position.

The GSD’s Clearing Fund addresses potential exposure as a result of applying projections of future price movements based on historical market volatility. It provides that the GSD should have sufficient liquidity to guarantee orderly settlement and provide the collateralization required to cover each member’s overall exposure. The Clearing Fund consists of collateral deposits posted by members in the form of cash and eligible securities. Deposit requirements are based on a combination of a member’s recent trading activity and the potential impact historical market fluctuations will have on the member’s overall position in the GSD’s netting system. FICC employs a number of tools to calculate deposit requirements, including the Value at Risk (VaR) methodology. VaR Measures Three Key Variables:

• Market volatility. This factor drives gains and losses for a given portfolio and is the most challenging part of a VaR model.
• Time horizon. This refers to the period of time required to close out a portfolio.
• Confidence level. This factor determines in percentage terms how much protection a firm requires. For example, if a 99% three-day VaR is $10 million, it means that the maximum expected loss during a three-day liquidation period is at or about $10 million 99% of the time.

DTCC’s Enterprise Risk Management group has built a highly sophisticated pricing engine which has the capacity to calculate key variables that impact portfolio valuation.

Fund calculations include repo activity and the impact of repo rate volatility to ensure that Fund deposits accurately reflect the GSD’s total exposure. Members’ deposit requirements are calculated daily to ensure enough funds are available to offset the GSD’s risk exposure. If a member’s Clearing Fund parameters are exceeded, a margin call is triggered for the amount necessary to maintain compliance. Approved forms of eligible collateral that may be deposited into the Clearing Fund include cash, U.S. Agency mortgage-backed securities, U.S. Government Agency and U.S. Treasury securities. Excess Clearing Fund deposits are returned daily upon member request.

GSD conducts periodic stress tests on members’ portfolios to assess the adequacy of clearing fund requirement in stress events. The stress tests compare the returns of simulated liquidation of insolvent members’ portfolios with their respective clearing fund requirements. The stress tests are conducted at both the member level and the family level.

The stress scenarios used in the stress tests are broadly categorized in two categories: (1) historical stress scenario and (2) hypothetical (what-if) scenarios. The historical scenarios are selected from the stress events in the most recent 10 years of history plus the special events in 1994 and 1998. The hypothetical scenarios are constructed to reflect the current market condition and potential risks.

The Loss Allocation Procedure ensures that a systemic failure of the settlement process never occurs. If a member becomes insolvent, the GSD first uses the member’s Clearing Fund and Margin deposits to absorb any losses that may result from the liquidation of the member’s positions. If such an extraordinary event occurred where those deposits were insufficient to cover the liquidation of all positions, the GSD’s Loss Allocation procedure would be used. The procedure allocates any remaining liabilities pro rata among the members who most recently traded with the failed firm, subject to certain limitations. This minimizes the impact such a situation would have on all GSD members. In the event of a remaining loss not covered in this way, the GSD would be able to invoke loss mutualization.

For More Information

Please contact your relationship manager via the Relationship Services Group Hotline at (800) 422 0582, or by email at rmsupport@dtcc.com.