Risk 25 firms of the future: DTCC

Mike Bodson, DTCC

According to Don Donahue, the recently departed chief executive of the Depository Trust & Clearing Corporation (DTCC), the securities market is approaching a fork in the road. In one direction lies fragmentation, stunted competition and poor liquidity; the other leads to margin efficiency, inclusivity, liquidity and transparency. He’s talking about the contest between so-called vertical and horizontal business models. The DTCC sits firmly in the horizontal camp, and Donahue is confident about the outcome.

“I haven’t lost a minute of sleep wondering who is going to win in the vertical versus horizontal contest in the cash securities clearing space. It seems obvious to me vertical structures have a number of serious and irredeemable flaws,” he says.

The over-the-counter markets face the same choice. The vertical model offers execution, clearing and, possibly, data reporting under one roof, allowing a single firm to control the trading life cycle from end to end. It is a model embraced by big exchanges such as CME Group and Eurex, which tie trading customers into their clearing houses and prevent other execution venues from offering access to the critical mass of trades cleared there. Horizontal structures, in contrast, allow market participants to pick and mix their trading, clearing and reporting providers. And the DTCC has designs on the last two areas, launching two innovative clearing initiatives in recent years, while also rolling out swap data repositories (SDRs) to cover the five big OTC derivatives asset classes on a global basis.

“Putting all cash market activities in vertical silos can be a very dangerous thing. It can lead to fragmentation, and that cannot be good for the market. For the DTCC’s entire existence it has been a verticalisation atheist, if you like. We don’t believe it works for the cash markets. If dealers are locked into rigid structures, then margin efficiency is reduced, costs increase and liquidity falls away,” says Donahue. “Further, we don’t think boutique repositories in the derivatives market are going to work. That is why we have set ourselves up as a truly central and global repository.”

That thinking was behind the DTCC’s decision to launch New York Portfolio Clearing (NYPC) – a joint venture with NYSE Euronext. The service allows customers to calculate margin on a net basis for interest rate futures positions cleared by NYPC and cash bonds cleared by the DTCC, with multiple exchanges able to list the futures. The approach has been dubbed one-pot margining, and those involved hope the venture will enable other venues to challenge CME Group, which has a near-monopoly in eurodollar trading – the world’s biggest futures market (Risk January 2012, pages 66–67).

For the DTCC’s entire existence it has been a verticalisation atheist... We don’t believe that it works for the cash markets – Don Donahue, ex-DTCC

The path taken by the Chicago exchange is littered with roadkill – firms that have tried to take the CME on in interest rate futures and been crushed – but Mike Bodson, who replaced Donahue as the DTCC’s chief executive in early July, argues NYPC is trying something new. “We are providing a very innovative approach to margining, which is something that no one else has done before. One-pot margining is totally new, and the margining efficiencies this process can provide will be very important as available collateral becomes more constrained,” he says.

Bodson is kinder about vertical structures than his predecessor, but still thinks the DTCC’s way of doing things will win out in the end. “Vertical structures aren’t inherently evil. They’ve served certain market segments very well, such as interest rate futures, as long as counterparties can opt out of parts of the service and there isn’t a monopoly on pricing. With NYPC, we’re just trying to provide an open access choice, and dealers have been very positive about this offering so far,” he says. The platform cleared an average of 180,000 trades per month from January to June this year. 

The DTCC hopes to add another string to NYPC’s bow with Project Trinity, which aims to bring LCH.Clearnet’s interest rate swap clearing service, SwapClear, into the one-pot margining structure.

“Once Project Trinity is completed, NYPC will be a very powerful service indeed,” says Bodson. “Participants will be able to cross-margin cash positions, futures and OTC swaps in one place. It’s the first time this has been done in an open access environment. This is three very different corporate structures – DTCC, NYSE Euronext and SwapClear – joining forces to create something for the benefit of the market. It shows what can be achieved if firms work together.”

But there are challenges to overcome before everyone is happily singing around the campfire (Risk November 2011, pages 22–25). Bodson is quick to note that all three parties have to work out how best to put cash and OTC derivatives positions into a single margin pot – the products are liquidated in different ways in the event of a member default (see pages 16–19). Donahue also says that different legal entities may use different exchanges that connect to the service, bringing its own complexities.

While this work goes on, the DTCC is also trying to manoeuvre its repositories into a winning position. The US Dodd-Frank Act mandates that OTC trade information be reported and stored in SDRs, and dealers are hoping they won’t need to use too many of them. Concluding in the first half of 2011, the industry ran a series of beauty contests to find the best repository for equities, interest rates, credit, foreign exchange and commodities – with the DTCC winning in each asset class, although it did so in co-operation with other firms for commodities and foreign exchange (Risk September 2011, pages 56–59).

Bodson says the idea of a single SDR is to make life easier for regulators, not necessarily dealers. “We’re trying to make data access as easy as possible for regulators. The reporting process will be split up into asset classes, but we are aiming for a central, unified system where regulators can access market exposure data for a specific institution across a variety of asset classes on one screen. That way, we deal with any data fragmentation concerns, and regulators can get an early warning of problems they might otherwise miss. They could have seen the large concentration of credit default swaps (CDSs) at American International Group before the 2008 crisis, for instance. The biggest challenge now is filtering that data so there is a common standard of presentation, and making sure regulators ask the right questions when they use the service so they can see the data they want,” he says (see pages 57-59).

Although legislation such as the Dodd-Frank Act has been a boon for the DTCC, it also contains clauses the firm isn’t happy about. One such clause demands that foreign regulators agree to foot the bill if their requests for data from US SDRs result in any unexpected cost – lawsuits over confidentiality breaches, for example. Without this so-called indemnity agreement, the DTCC would be banned from passing data to overseas supervisors, encouraging these jurisdictions to set up their own domestic SDRs. The DTCC is setting up repositories in Europe and Asia to work around the problem, but still wants the offending clause struck out and a bill working its way through US Congress would do that.

“We don’t support indemnification, and no-one really knows why it was put into Dodd-Frank in the first place. We have been pushing hard against it because it defeats the purpose of a single, global SDR and will only lead to more fragmentation. Regulators have to respect each other’s boundaries, but they also have to learn to trust one another,” he says.

Trust also crops up in the issue of data leakage. Dealers are worried about what they see as a lack of data protection standards when regulators use SDRs, and fear sensitive trade data could escape into the public domain. These concerns came to light in mid-2010 when it was rumoured that the DTCC had been pressed by European regulators to give up CDS information – the region’s authorities were trying to work out what effect, if any, CDS protection-buying was having on European government bond yields.

The DTCC declined to comment on the episode at the time but, according to Donahue and Bodson, there has been no problem with regulators leaking data. “No-one gains if people leak data,” says Bodson. “If it does happen, it’s game over for the SDR model because no-one will trust it. We’ll go back to a more fragmented and secretive market-place. We have to rely on the regulatory framework that is built up around these institutions and maintain a dialogue to keep everyone happy.”

These are all long-term themes for the industry, but the DTCC also has a more pressing project: the rush to create legal entity identifiers (LEIs), one of the tags that will be used to aggregate and sort data within SDRs. The DTCC, in conjunction with the Society for Worldwide Interbank Financial Telecommunications (Swift) and the Association of National Numbering Agencies (Anna) had hoped to provide a single solution, with Swift handling LEI registration, Anna issuing the new tags to the various reporting entities and the DTCC storing the LEIs and associated reference data (Risk April 2012, pages 51–53).

That plan did not go down well with the Financial Stability Board (FSB), which has been asked by the Group of 20 nations to oversee the creation of a global LEI framework – on June 8, the FSB issued its own recommendations, which diverged significantly from the DTCC’s vision. The regulator wants the LEI system to be run by a centralised, not-for-profit foundation – although the foundation’s board would be allowed to outsource certain functions – and to be supported by a host of local LEI agents, that would register entities, issue LEIs and maintain the reference data. These local units could be privately or publicly run, so there may still be a role for the DTCC, but perhaps not the grand, global role for which it had hoped. Still, the firm is upbeat about the situation. “While there is great alignment between the FSB’s and the industry’s model for a global LEI solution, the FSB appears to favour a more immediate implementation of the federated approach. The timetable for that will be a key topic for discussion between the implementation group the FSB forms and the industry experts that can provide much needed guidance and insights into the issue,” it says, in an emailed statement.