Increased volume and volatility threatened to overwhelm markets in March and April of last year. Tim Cuddihy, DTCC Managing Director for Financial and Operational Risk Management, spoke with industry stakeholders at a recent ISDA panel on the role that DTCC plays in safeguarding the markets and the impact on CCP risk management frameworks during the COVID crisis.
Market Reaction to COVID
While headlines during the broad market event were focused on equity movements, credit market spread widening, Treasury prices, and the financing markets, several points went largely unnoticed. Specifically, cash market volumes increased substantially. “We saw cash equity volumes up two-to-three times historical averages last March. For 2020, volumes were up 50% over historical levels,” Cuddihy said.
Intraday changes in clearing portfolios are dynamic, and during times of stress can become more directional, affecting the ability to net margin requirements and ultimately settlement obligations. Cuddihy noted that these amounts could change dramatically as portfolios become more unbalanced versus business as usual.
While many headlines highlighted the “dash for cash” in the Treasury market, Cuddihy noted that behind the scenes, the issue was more complex. “When we looked at data points out of the crisis, there was a more significant rotation rather than outright selling. More market participants migrated to the shorter end of the Treasury curve to potentially sell long-dated assets.” With regards to liquidity, foreign investors, including central banks, sold approximately $300 billion in treasuries, long-term bond funds sold about $15 billion, while the Treasury issued around $150 billion during the period. The majority of this activity was absorbed by financing markets, particularly U.S. repos, which expanded pre-Fed intervention by about $400 billion.
Panelists noted that crisis exposed several observations in initial margin models across CCPs. For example, around exchange-traded derivative products, these included the absence of stress periods, use of only one-day margin period of risk and insufficient anti-procyclicality measures. These resulted in sizable breaches of initial margin and derivative CCPs increasing their initial margin levels.
"The need to provide more information and increased client engagement during the crisis was crucial."
Post-crisis analysis has identified that rising margin requirements may have squeezed Treasury futures contracts and contributed to selling pressures. Additionally, not having access to the margin mechanics was a detriment during the events of last year, as it prevented firms from being able to make predictions. Initial margin levels jumped to unexpected levels and were skewed to the future trades.
Critical Needs / Suggestions
All panelists noted that business continuity was critical in the crisis and has shown the benefit of investments in operational readiness and resilience.
Cuddihy further discussed that the need to provide more information and increased client engagement during the crisis was crucial. “NSCC increased availability of client margin requirements, from hourly to 15-minute increments, to allow clients to monitor their portfolios more real-time, and better manage their exposure.” DTCC also looked at how to provide clients with more tools, including providing the algorithms supporting the initial margin models. Additional support requests for the future include improvements to current disclosures and transparency, as well as the ability to offer margin “what-if” simulators to clients.
Panelists also spoke of how any enhancements to margin models needed to be a cross-border effort and not based on a single jurisdiction to provide enhanced risk protection for clients.
Removing Market Risk
What are some ways risk can be removed from markets? DTCC has been focusing on reducing risk in the settlement cycle, particularly for US equities. Cuddihy spoke about the balance between the length of the settlement cycle and risk, “The less in clearing at any time, the less risk we have to manage. We are working with industry to find the right balance between the settlement cycle and the benefits of netting.”
Another way to remove systemic risk is to move more into clearing. Additional opportunities for participants to have exposures netted at CCPs would be to both participants and also to those who don’t have access to services, particularly in Treasury markets.
Noting how subsequent crises will be different, Cuddihy mentioned the need to work with market participants and industry groups to look at tail risk. Finding the correct information on how various firms manage tail risk and how exposures are aggregated in various areas, including prime brokerage arrangements, at CCPs or in the bilateral markets, is a focus for DTCC.
CCP Recovery Resolution
Panelist takeaways from the crisis included the need for additional framework and CCPs should be consistent with corporate finance principles. Additionally, CCP equity capital should be at risk ahead of end-investors and clearing members' capital.
From a recovery and winddown perspective, Cuddihy noted the cornerstones for DTCC, including the need to manage liquidity resources and provide continuity of its services during a stressful period. At DTCC, mechanics including early warning and escalation processes are essential. There is a vital need to understand how governance works and the roles of both the Board of Directors and management.