We live in an interconnected global financial marketplace driven by technological transformation. As our industry continues to evolve, the risk landscape has changed rapidly and profoundly leading to dramatic shifts in the interconnected risk threat faced by businesses.
In our new paper, Interconnectedness Revisited, we examine interconnectedness risk through the lens of direct and indirect linkages that are the result of a wide variety of factors, including but not limited to: trade patterns, financial transactions, macroeconomic trends, economic variables, statistical correlations between the prices of financial assets, market structures, operational processes and dependencies, business arrangements (contractual or not), external events and other developments.
A Look Back
DTCC’s 2015 white paper, Understanding Interconnectedness Risks, underscored the importance of looking at the global financial system as a complex network of interdependent components. Our initial definition of interconnectedness was limited to relationships that are created through financial transactions and supporting arrangements among economic agents, more specifically between and across:
- financial institutions (banks and non-banks)
- providers of financial market infrastructure (FMI) services
- vendors and third parties supporting these entities
"While interconnections can provide firms operational efficiencies and other benefits, it's important to recognize that they may also pose certain risks." – Michael Leibrock, DTCC Managing Director and Chief Systemic Risk Officer
Importance of Analyzing Interconnected Risks
Understanding Interconnectedness Risks is designed to highlight emerging systemic risks that are associated with recent changes in how the global financial system is interconnected.
It should be emphasized that interconnectedness provides a wide range of operational efficiencies and other benefits. Many of the operational and other linkages that exist between financial services firms and other agents today are necessary building blocks for a well-functioning infrastructure that supports a wealth of financial products and services.
However, it should also be recognized that these interconnections can pose certain risks. Broadly speaking, analyzing interconnectedness risks is important for at least three key reasons:
- The identification of connections and linkages uncovers dependencies that may not be immediately apparent, which helps us better understand how risks can be transferred between entities and how they can spread across the global financial system.
- Interconnectedness analysis provides greater insight into critical thresholds and tipping points, given that networks are capable of absorbing shocks up to a certain level, while they tend to spread (or amplify) losses beyond a critical threshold.
- The analysis of interconnections and networks highlights the importance of concentration risk and substitutability as two key factors in assessing potential system-wide vulnerabilities.
FMIs themselves are interconnected with the financial ecosystem in a myriad of ways, which presents their own set of risk management challenges. DTCC has taken various initiatives to reduce these risks:
DTCC’s Clearing Agencies have entered into specific agreements with each other and with other FMIs in order to mitigate the risk that a common member of multiple FMIs could negatively affect several FMIs simultaneously.
DTCC has established a cross-functional effort to address the risk that an entity on which it relies for the provision or support of its services becomes unavailable or fails to operate as expected.
DTCC has developed a comprehensive framework to identify, monitor, and manage risks related to any link with one or more other clearing agencies, FMUs, or trading markets.