- Clearinghouses (CCPs) played a significant role in providing stability for financial markets during COVID-19.
- The success of the preparedness efforts from clearinghouses could serve as an example to other sectors and industries needing continual investment in continuity and other protection measures.
This March, turmoil in global financial markets drove extreme volatility and volume trading records, with hundreds of millions of transactions executed. Despite this unprecedented activity, the financial markets never faltered: The massive number of transactions were cleared and settled every day, ensuring that buyers received their securities and sellers were paid for them on time.
Clearinghouses (CCPs) played a significant role in providing this stability, operating behind the scenes to flawlessly process transactions, mitigate risk by monitoring exposures and requiring margin to protect against a firm default, and promote efficiency and liquidity. These activities, and many others, helped to ensure that firms and markets remained stable and that investors could have confidence in the integrity of the financial system.
As the economy continues to cope with the challenges brought by the pandemic, the important role clearinghouses play is coming into sharper focus. Here are four key functions that clearinghouses serve and how they have been helping to keep markets stable and secure during the COVID-19 crisis.
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Protecting the integrity of the financial system
The most important responsibility of a CCP is guaranteeing trade completion in the event that one or both parties’ default. After a trade is compared and verified by a CCP, it steps in between the two sides, serving as the legal buyer to the seller and the legal seller to the buyer. At that point, regardless of what happens to either party, the CCP guarantees the trade will be completed.
Following the market crash of 2008 and the expansion of central clearing for a wide range of financial products, CCPs are now required by regulation to meet heightened risk management standards, including its margin methodology. Margin is the lifeblood of a clearinghouse because it must have sufficient funds on hand to complete the outstanding trading activity of its members should one, or several, firms fail. Therefore, CCPs must have adequate resources to cover both market exposure and liquidity needs to deal with a default, appropriate reserves to reduce systemic risk, and they must be able to measure risk exposure and make adjustments in real time.
By building processing capacity and stress-testing systems to ensure their ability to handle record volume, CCPs act as a steadying force when markets are at their most volatile, such as in March when volume spiked to nearly three times normal levels. And when one firm failed in late March, CCPs stepped in to auction the portfolio efficiently and wind down positions without counterparties or the industry suffering losses. This incident clearly illustrated a critical role of clearinghouses: Preventing significant liquidity or credit problems from spreading quickly through financial institutions that are linked by transactions. In addition, CCPs’ risk management framework includes ensuring the soundness and solvency of trade partners by maintaining rigorous membership standards, requiring financial disclosure and conducting financial surveillance of participants. These steps ensure that a singular firm’s default does not spread into a market-wide contagion.
Promoting competition through open access
Clearinghouses in the U.S., including those run by DTCC, help promote competition among trading platforms by providing equal access to their services. This creates operational efficiencies, netting opportunities and standardized margin requirements to support market integrity, transparency, systemic risk reduction and lower operational costs.
Rather than having a single, national exchange – more typical in Europe or Asia – the U.S. features about 50 registered equity exchanges and alternative trading platforms, up from less than 10 in the 1970s. All these venues have open access to connect into the centralized clearinghouse serving the marketplace, which is operated by DTCC. Our CCP is market neutral and shows no preference for one exchange or trading venue over another.
As a result, platforms can freely compete on the front-end of trading while commoditizing critical post-trade services to protect market stability. This structure has helped to create the broadest and deepest capital markets in the world, lowering trading costs and the cost of capital formation, which in the end benefits the issuers of and investors in securities. While open access does exist globally, it is a mandate in the U.S. As financial services continue to consolidate, the importance of CCPs increases in terms of providing fair and open market access and equal treatment regardless of size. They also help promote a diversity of clearing members and market participants, which is critical to the stability of the broader financial markets.
Battle-tested for crisis
The ability of CCPs to seamlessly manage significant volume and volatility during the pandemic is no accident. Markets remained stable this past March because clearinghouses have spent years investing in technology and conducting comprehensive resilience planning. Those efforts include running industry tabletop exercises that simulate market, operational and business continuity stress scenarios, including technology outages, denial of access, loss of critical or key third party, natural disasters and even a pandemic. During the current crisis, the industry seamlessly transitioned to a remote work environment because we had tested and planned for it previously.
CCPs by nature learn from each crisis – a market disruption, hurricane or terrorist attack – and incorporate those lessons going forward in areas such as automation and digitization, and strengthening risk management for financial and non-financial risk.
As part of a CCP's risk management framework, we also plan and regularly conduct exercises for high-volatility and high-volume events, as well as the failure of one or more member firms, to ensure that we have the appropriate financial resources, people and systems in place to complete settlement and mitigate systemic risks during extreme market conditions. CCPs examine a combination of factors, including historic volumes, and conduct stress testing on individual systems and on an end-to-end basis for processing.
As markets plunged in March, this experience and training proved invaluable. At DTCC, our teams sprang into action as the markets began gyrating, closely monitoring intraday portfolios, margin, asset classes and activity, and a host of other key indicators to manage the turmoil. We remained in frequent contact with regulators and clients, our cyber group was on high-alert and processing and technology teams monitored our systems so we could flawlessly handle the volume. All that preparation and infrastructure investment proved essential to responding quickly to market swings and ensuring that all trades were processed, cleared and settled. To borrow a phrase, failure was not an option.
Future innovations and efficiencies
Today, CCPs continue to help shape the future of the financial system and are using fintech to drive improvements in market structure. Emerging technologies, such as distributed ledger technology (DLT), artificial intelligence, machine learning and cloud computing, are also playing a role by creating opportunities to optimize existing processes or completely reimagining them. Some market infrastructures are already taking steps, and their experiences are guiding the industry. The Australian Stock Exchange, for instance, is advancing plans to replace its 25-year-old clearing and settlement system with a DLT platform while the SIX Swiss Exchange continues to make strides in bringing to market a trading, clearance and settlement platform for digital assets.
DTCC is moving forward with efforts to transform certain services using fintech while also actively exploring new ways to further digitalization, including implementing no-touch processing through settlement finality, optimizing settlement, extracting value from data for clients, expanding clearing and reporting capabilities, and automating the collateral management lifecycle.
The pandemic, far from over, will continue to challenge markets. However, the success of the preparedness efforts from clearinghouses could perhaps serve as an example to other sectors and industries needing continual investment in continuity and other protection measures. Predicting when the next crisis might come is a fool’s errand, but preparedness is key to weathering the storms ahead.