Global financial market infrastructures (FMIs) performed “remarkably well” amid unprecedented market volatility and record trade volumes in the wake of the COVID-19 outbreak but the Depository Trust & Clearing Corporation (DTCC) says its “considerable impact” on the macroeconomic environment and systemic vulnerabilities will likely cause structural changes to the financial services industry, as well as the regulatory landscape and legislative agendas.
A DTCC whitepaper, COVID-19: Impact and Implications for FMIs, identified a number of key challenges and implications for FMIs, which play a crucial role in safeguarding global financial stability.
The paper suggests that FMIs should constantly reassess a clearing member’s available liquidity, which can deteriorate quickly in periods of market stress.
Obscure stipulations may render a liquidity source nonexistent in a crisis, and a firm that appears to have ample liquidity ahead of a crisis may in reality be strapped for cash in a crisis as liquidity sources evaporate, says DTCC.
Maintaining sufficient liquidity is also a concern for all counterparties, not just those facing obvious challenges amid market turmoil.
DTCC notes the whipsawing of financial markets in March allowed many firms to generate substantial profits due to market-making activity or being well-positioned for the market gyrations.
“However, these market swings can generate daily or intraday need for liquidity, while a counterparty’s resources may be tied up in securities that cannot be immediately converted into liquidity, creating a temporary timing mismatch and insufficient liquidity even for a highly profitable counterparty,” explains DTCC.
Elsewhere, it shows that FMIs need to ensure their clearing members can meet margin calls at all times, not just when the dust clears and firms can cash out their gains to generate additional liquidity.
This issue around liquidity was further highlighted in March this year at the Summit for Asset Managers (TSAM), where one panelist noted “Liquidity is like a mirage, it evaporates as soon as you try to reach it. All of that risk and liquidity provision has effectively been moved to the buy side”.
Aside from this, the paper also identified the challenges and implications around remote working.
“An extended remote working environment creates new operational risks with respect to cyber security, third-party dependencies and other aspects, which must continue to be managed,” says DTCC.
It observes that in response to the pandemic, many financial institutions were forced to make significant changes to their cyber security practices in an incredibly short period of time.
Rather than vetting these changes through internal steering committees and lengthy product evaluations, many of these changes were rolled out virtually overnight.
In the whitepaper, DTCC affirms financial sector firms must address these emerging risks by developing appropriate risk monitoring tools and integrating such tools into their existing cyber risk management frameworks.
Elsewhere in the paper, DTCC highlights the impact of the pandemic on markets was a real-life stress test for FMI risk management regimes, and lessons learned from this crisis should be factored into risk models moving forward.
Additionally, it notes that the market turmoil observed in March 2020 provided additional data on margin procyclicality and illustrated that providing greater margin transparency to clients is key to helping them navigate extreme volatility.
DTCC outlined: “It is important for FMIs to promote margin transparency by developing tools that allow their members to better understand their risk models and accurately project margin requirement increases under a wide range of circumstances.”
The paper also shows that although FMIs around the globe performed remarkably well amid unprecedented market volatility, the longer-term effects of the pandemic will likely reverberate through the financial industry for years to come.
According to DTCC, this could weigh on the financial sector’s profitability, potentially contributing to further consolidation within the industry.
“Extreme events, such as the COVID-19 pandemic, illustrate and reinforce the importance of an unwavering commitment to risk mitigation and resilience across the industry. While FMIs continued to perform as expected throughout unprecedented market turmoil, risk management practices must continue to evolve,” says Andrew Gray, managing director and group chief risk officer at DTCC.
Gray concludes: “As the industry adapts to the new normal and ultimately a post-pandemic world, we must take a close look at the risk management implications for FMIs that emerged from this crisis and address those areas to help us prepare for the next one.”
