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Addressing Increasing Sources of Interconnectedness Risk to Ensure Resilience

By Michael Leibrock, DTCC Chief Systemic Risk Officer and Head of Counterparty Credit Risk | 3 minute read | October 26, 2022

To advance industry preparedness for such extreme events by way of evolving industry participants’ risk management practices, in 2015, DTCC issued a white paper offering insights and key principles around identifying and managing interconnectedness risks. At the time, our definition of interconnectedness was focused on relationships created through financial transactions.

Related: Dive into the Emerging Risks of Global Financial Interconnectedness

The industry has come a long way since that time in driving further improvements to risk management practices. However, the operational context has changed vastly over the past 7 years, and new systemic risks have emerged. It has become clear that links exist not only between the economic agents covered in our initial definition of interconnectedness, but have expanded to include national and regional economies, clients of financial institutions, financial markets and their participants, and third- and fourth-party providers supporting these entities.

From our perspective, 4 drivers have prompted an accelerated change in the global interconnectedness landscape.

First, there has been a significant increase in cross-border financial exposures. This has created substantial benefits for market participants with increased international capital flows and better access to new markets, as well as more accessible funding. However, greater cross-border interconnectedness has also created new or increased vulnerabilities, especially in countries that rely heavily on foreign capital inflows, resulting in higher susceptibility to systemic shocks.

Second, the role of Non-Bank Financial Intermediation (NBFI) in credit intermediation has grown notably, driving up the number of market interconnections. These linkages are hugely valuable, as they provide additional sources of financing, both for corporates and for consumers, but they also create new channels for shock transmission should a crisis occur.

Third, the accelerating use of third- and fourth-party suppliers and increased adoption of cloud computing and other FinTech solutions, coupled with the continued proliferation and increased sophistication of cyberattacks, has heightened the importance of operational interconnectedness risks.

Fourth, and perhaps most importantly, cryptocurrencies and Distributed Ledger Technology (DLT) applications are increasing in their use and, as a result, have become intertwined within the global financial system, introducing a host of new challenges to financial stability. It is important to note that the use of blockchain technology to record and transfer ownership of assets does not create additional risk; indeed, it can provide several benefits. However, cryptocurrencies that underpin DLT applications differ from traditional financial instruments in several ways that are material from a risk management and financial stability perspective.

Interconnectedness is not a negative phenomenon. It can offer a wide range of operational efficiencies and other benefits. That said, it is important to recognise that the growing interconnectedness of the financial marketplace may pose new risks. To be prepared for any challenging scenario, financial services firms must scrutinise their own risk management practices on an ongoing basis.

As a financial market infrastructure (FMI), DTCC is interconnected with the financial ecosystem in a myriad of ways, and, as a result, we have evolved our risk management practices. To reduce risks, we have taken various steps, such as establishing a cross-functional effort to address the risk any entity on which we rely for the provision of or support of our critical services becomes unavailable; developing a comprehensive framework to identify, monitor, and manage risks related to any link with one or more other clearing agencies, financial market utilities, or trading markets; and enhanced operational processes with respect to Settling Banks, among various other initiatives.

Financial services firms, as well as FMIs, must continuously reassess their processes and their network of direct and indirect financial and operational connections to third parties, and evolve their risk management frameworks based on new insights and the changing risk landscape. What is more, risk management, especially in such an interconnected and evolving environment, is a multi-disciplinary matter, so close industry collaboration is also key to advancing our collective ability to withstand operational shocks.

This article was originally published to IBS Intelligence on October 18, 2022.