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While much of Wall Street, The City and continental Europe were away for summer vacation this past August, Depository Trust and Clearing Corporation published an important thought piece on the most significant systemic risks impacting the financial services industry today and likely tomorrow, entitled "Beyond the Horizon." This publication deserves the attention of everyone in the financial services business for serious reflection and prompt consideration regarding systemic risks their businesses confront, appropriate mitigation efforts, and opportunities, if any. But did DTCC identify the top systemic risks?
According to DTCC, among the largest emerging systemic risks are:
In fact, DTCC identified 13 major systemic risks overall. The others are counterparty risk; collateral risk; market quality risk; liquidity risk; interconnectedness risk; securities settlement risk; business continuity risk; shadow banking risk; and Eurozone risks.
However curiously, DTCC does not identify as the most significant systemic risk, the risk that brokers in the financial services industry – who, particularly in the futures industry, provide the financial backbone to the clearing process – generate insufficient profits to invest in systems necessary to protect themselves against the serious systemic risks highlighted by DTCC, let alone day to day credit, market, operational and compliance risks.
Indeed, just a quick reflection on the common denominator between the top two broker insolvencies during 2011 and 2012 – MF Global and Peregrine Financial Group – reminds us all of how challenging it has been in the first place for brokers to generate adequate ROEs since the 2008 financial crisis. In both instances the firms' principals were trying to address their firms' lack of profitability when they embarked on paths (in one case, outright theft) that ultimately led to their firms' collapse.
Moreover, some of the risks that futures brokers who are clearing members of Central Clearing Counterparties confront may be totally outside their control and which they cannot readily protect themselves – the risk of a fellow member default at a clearing house after which they may lose all or some of their guaranty fund deposit, be liable for an additional clearing house contribution, or receive an allocation of positions, including some very volatile and risky transactions, previously held by the defaulting member (some of these issues are discussed in the August 12, 2013 CPSS/IOSCO Consultative Report on the Recovery of Financial Market Infrastructures). It is also possible they may have to deal with initial or variation margin haircuts for their own proprietary positions, or positions on behalf of their clients.
Firms will improve profitability by continuing to be mindful of all costs (including potential contingent costs) and emphasizing aspects of their business that differentiate themselves from their competitors. Bigger is not necessarily better, and when business is capital intensive as some aspects of financial services are, the highest ROEs will be awarded to those firms that offer the most differentiated service to their clients. A niche, high quality offering is often the most sensible offering in this environment, in my view.
However, at some point there will also need to be serious discussions regarding the allocation of risks (typically to clearing members) and rewards (typically to shareholders) at CCPss, and the process of de-mutulization that was so heralded just a few decades ago. It seems very strange that a cornerstone of the financial services industry promoted by the G-20 post the 2008 Financial Crisis – central clearing – is premised on a reinsurance model where effectively the insurer (i.e., a CCP), who collects ongoing premiums on an ongoing basis from the insureds (i.e., fees from clearing members) also demands payments from the insureds (e.g., assessments from clearing members) when there is an industry catastrophe requiring the insurer to pay up.
Another top risk that DTCC may have underestimated, is regulatory and litigation risk, namely the potential cost to firms of wrong-doing – not only in terms of fines, payments to plaintiffs and legal costs (not to mention the opportunity cost when businessmen spend time preparing for litigation as opposed to developing business), but lost business because of harm to reputation.
Indeed, newspapers are daily filled with stories about criminal and civil actions against financial service participants. LIBOR, ISDAfix, LME warehouses, FERC, mortgage related matters, and numerous insider-trading matters are just a few acronyms and terms that most educated citizens had no idea about a few years ago, but now see routinely discussed in the financial media, let alone sometimes as the top story on the television evening news. And the implications are expensive. As of December 2012, JP Morgan Chase estimated that in excess of already established reserves, it could sustain additional losses up to $6.1 Billion because of its various legal contingencies, while Goldman Sachs estimated its aggregate losses because of its actual or potential legal proceedings at up to $3.5 billion. By comparison, the GDP of 30 countries were less than $3 billion during 2011.
It is no secret that regulatory actions and private litigation are expensive. The only way to help minimize problems is to continue to emphasize a culture where it's not only about profits, but that a firm's principles of conduct mean something too. This is what a compliance culture is all about. And central to a strong compliance culture are compensation arrangements within firms that reward not only the profit makers, but differentiate between employees who break the rules, live by the rules as minimally as possible, or truly embrace and act according to a firm's principles of conduct.
However, despite downplaying the importance of profitability and legal/regulatory risk, DTCC's analysis is outstanding.
DTCC's discussion of the danger of cyber attacks is downright terrifying. According to it, in 2013 56% of exchanges surveyed reported experiencing a cyber attack during the last year. And there are three types of cyber attacks that are worrisome: those aimed at:
Firms are already spending great resources to confront cyber risks and the industry is frequently conducting more sophisticated preparedness tests (e.g., SIFMA's Quantum Dawn 2 cyber security exercise on July 18, 2013) but the bad guys are persistent and deploying increasingly sophisticated technology that firms need to try to anticipate and defend against.
And DTCC is also very accurate in considering the impact of developing regulations: in many cases, they are expensive to implement and arguably do not even achieve the objective the regulator seeks, let alone sometimes create a contrary result. Consider the US Commodity Futures Trading Commission's proposal in response to the insolvency of MF Global to require all futures brokers to ensure that they maintain as so-called "residual interest" an amount 24/7 equal to clients' margin obligations – even when there is no expectation that the clients will not pay their obligations on a timely, even on a same day, basis. This proposal is based on a new interpretation of the relevant law by the CFTC after 30+ years of a different interpretation. However, in fact, the likely outcome of this proposal will be for futures brokers to require customers to post extra funds in advance of trading. So at the same time customers desire to have less exposure to their brokers, the CFTC will cause them to have greater exposure. Moreover, the "solution" does not address the problem of MF Global anyway -- namely a break down of internal controls.
In any case, "Beyond the Horizon" is well worth reviewing, and more importantly, thinking about in terms of the risks each financial services firm believes its confronts and how it is going about to mitigate them. Moreover, addressing these risks can sometimes create business opportunities for savvy financial institutions that can market their bulwarks as an additional reason why customers should trade through them, as opposed to a competitor!
For questions or assistance, do not hesitate to contact Gary DeWaal and Associates at (212) 382-4615 or at http://www.garydewaalandassociates.com/request/
The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of August 31, 2013, but no representation or warranty is made regarding the accuracy of any statement.
For more information, see:
http://www.dtcc.com/downloads/leadership/whitepapers/Beyond_the_Horizon_White_Paper_Systemic_Risk.pdf
Regarding matters referenced in this article:
SIFMA's Quantum Dawn 2:
http://www.sifma.org/services/bcp/cybersecurity-exercise--quantum-dawn-2/
IOSCO/CPSS Consultative Document of Recovery of Financial Market Infrastructures:
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD418.pdf
The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of September 4, 2013, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.
Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office.
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Gary DeWaal
Katten Muchin Rosenman
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1 (212) 940-6558
Summer Reading You May Have Missed -- An Important Article on Systemic Risks by DTCC: But Did They Identify the Top Risks?
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