NSCC’s year of living dangerously

As the saying goes: third time’s a charm. Except this isn’t the case for the lynchpin of the US equity markets, the National Securities Clearing Corporation (NSCC).

Between January and March last year, the central counterparty (CCP) was caught $600 million short of its Cover 1 obligation. Simply put, it didn’t have enough liquid resources to cover the default of its largest clearing member in an extreme-but-plausible stress scenario.

Had the worst happened, members would have had to plug the hole to avoid the clearing house’s collapse. Luckily, and despite a frenzy of activity driven by the meme-stock volatility that unfolded in Q1, the worst didn’t happen.

Good news all round, some market participants may have thought. Not so fast.

As the second quarter rolled in, the NSCC was again caught off-guard to cover its worst-case hypothetical loss. This time its deficit was even greater. On two separate days in June, the CCP’s funds were short of the level required to absorb the default of its largest member by $5 billion and $1 billion, respectively.

Perhaps the CCP had learned its lesson by the third quarter. Indeed, the utility replenished its liquidity pool over this period, boosting its reserves by 7%. But again its resources proved insufficient. Option expiration days in July and September led to a spike in clearing activity, leaving the CCP’s liquid funds short by $594 million and $32.7 million, respectively.

Given its size and the role the NSCC plays within the financial system, it is paramount it is able to sustain spikes of clearing activity

A rule change implemented in June came to the rescue this time, allowing the CCP to collect extra liquidity deposits daily to cover its short-term liquidity squeeze. Without it, we might be writing a very different story today.

Given its size and the role the NSCC plays within the financial system, it is paramount it is able to sustain spikes of clearing activity. These spikes may be unpredictable, as was the case with the meme-stock surge. Or they may be foreseeable, as with option expiry dates and index rebalancing. As one of the main pipes in the plumbing of finance, the NSCC is ill-advised to leave anything to chance. But this seems to have been the case a number of times last year.

The root of the problem seems to be the NSCC’s own models. They have been repeatedly underestimating how much liquidity would be needed at all times to account for the default of any single participant and its affiliates. They have also performed poorly in helping the CCP navigate bouts of volatility by setting a member’s payment obligation too low.

So far, the worst hasn’t materialised and everything continues to be on a hypothetical level. But this might not be the case in future. Serious questions need to be raised – and answered – about the CCP’s ability to navigate stressful times. The chain reaction a failure could trigger is the stuff nightmares are made of.