Volatility Institute & DTCC Sponsor Forum on Managing Counterparty & Systemic Risk Under Dodd-Frank
November 17, 2010
New York, November 17, 2010 – More than 100 representatives from the financial, academic and regulatory communities participated in a forum sponsored by New York University Stern School of Business’ Volatility Institute (NYU Stern) and the Depository Trust & Clearing Corporation (DTCC) that discussed cutting-edge thinking and approaches to achieving the risk mitigation goals under The Dodd–Frank Wall Street Reform and Consumer Protection Act, particularly as it relates to regulation of derivatives.
“Stern faculty have been at the forefront of the dialogue on the financial crisis, examining its causes, proposing solutions that influenced the regulatory response, and now, in assessing the enactment of the most significant financial reforms since the 1930s,” said Peter Henry, Dean of NYU Stern School of Business. “In partnering with the DTCC, we have the opportunity to bring together academics, practitioners and policymakers for an important dialogue on how best to implement the new rules of Dodd-Frank, which will shape the future direction of global capital markets.”
The conference was led by three highly-regarded industry experts, including Professor Robert Engle, Nobel Laureate and the Michael Armellino Professor of Finance at NYU Stern; Professor Darrell Duffie, the Dean Witter Distinguished Professor of Finance at Stanford University; and Commissioner and Former Acting Chairman Michael Dunn of the US Commodity Futures Trading Commission (CFTC).
Approaching risk 10 by 10 by 10 at a timeStanford’s Professor Duffie challenged the audience to think about managing systemic risk in a dramatically different fashion.
“The key—in headline form—is having a systemic risk regulator that is able to monitor the sizes and directions of flows of risk through the center of the financial system. The top 10 systemically important firms would report their gain or loss with each of their top 10 counterparties, for each of 10 key stress scenarios,” he said. “While in practice there may be more than 10 such firms, counterparties or stress scenarios, regulatory monitoring of exposures along these three dimensions is the bedrock of systemic risk management as it captures both a range of systemically important stress scenarios as well as interconnectedness of exposures,” he added.
Professor Duffie suggested that stress scenarios and exposure measures would be refined over time as experience is gained, but initial examples of stress scenarios include:
- the default of a single entity;
- a 4% simultaneous change in all credit yield spreads;
- a 50% change in a global equities index;
- a 50% change in the prices of all energy-related commodities, etc.
- He also suggested that initial exposure measures should be computed on both a net and (except where legally enforceable close-out netting agreements are in effect) gross basis and should be determined both before and after the use of collateral. Exposure in terms of potential cash flows should also be monitored.
NYU Stern’s Professor Engle warned conference attendees that some of the new measures under Dodd-Frank, such as requiring the use of central counterparties (CCPs) for OTC derivatives transactions, may create new systemic risks while reducing old ones.
Systemic risks posed by CCPs
“Large one-sided executions by systemically important firms in the OTC derivatives markets were key creators of systemic risk contributing to the crisis of 2008. Under stress, even very large firms with one-sided positions can fail, as demonstrated by AIG. Such failures may lead to further insolvencies, thus creating system-wide distress,” said Professor Engle. “In a world where most OTC derivative trades were not cleared, the natural mitigant of this risk was increasing execution costs as these exposures become better known in the market, but this was always hampered by incomplete information and hence not particularly effective.
“Standardizing OTC derivatives contracts and requiring standardized contracts to be cleared through CCPs will not eliminate this systemic risk, but rather will merely transfer it to the CCPs and by extension, to those market participants relying on the viability of the CCPs,” he argues. “Further, since the existence of a CCP obviates the need for individual counterparties to charge more for executions that increase large one-sided positions, the central counterparty itself must institute alternative processes and procedures that effectively mitigate the risks created by large, concentrated positions.”
Professor Engle recommended that these should include concentration and possibly credit-based margins, particularly when the maximum loss is very big relative to natural margins as in credit default swaps. “In any event, regulators and particularly the Financial Stability Oversight Council, should pay particular attention to these issues as the systemic risks posed by central counterparties will increase with the increased clearing of OTC derivatives. Fortunately, these institutions are easily identified and regulated,” he added.
Participants at today’s conference, “Managing Counterparty and Systemic Risk under Dodd-Frank,” included regulatory officials from the CFTC, Securities and Exchange Commission (SEC), Federal Reserve Board of New York, academics, senior members at top-tier financial firms and key Congressional staffers. The conference was held at the Henry Kaufman Management Center at the NYU Stern School of Business in New York City.
“Our shared aim with NYU Stern is to host a timely forum to explore issues that meet at the intersection of public policy, regulatory interpretation and market experience,” said Donald F. Donahue, chairman and CEO for DTCC during his welcoming remarks. “The rulemaking process here in the U.S. is moving at warp speed as regulators look to propose, revise and finalize hundreds of new rules that will literally transform market structure in virtually every area of financial services – and to do it all by the July 2011 legislative deadline mandated by Congress.
“I can tell you from my conversations with our regulators that they understand the magnitude of this responsibility – and we recognize the transformative change their actions will have on global markets and the global economy. Our collective challenge, therefore, is to help regulatory agencies write new rules that effectively meet their goals of greater risk mitigation and transparency while still maintaining the competitiveness, efficiency, liquidity and robustness that has long characterized the U.S. marketplace.”
NYU Stern School of Business has a long history of sponsoring topical and insightful forums that provoke discussion about key issues shaping the financial marketplace. More recently, 40 Stern professors have authored a book, “Regulating Wall Street,” which assesses the strengths and weaknesses of Dodd-Frank.
View copies of the various presentations
- On the DTCC website: 10 By 10 by 10 (PDF)
- On the DTCC website: Regulatory Reform (PowerPoint)
- On the NYU Stern website: Event coverage
New York University Stern School of Business, located in the heart of Greenwich Village, is one of the nation’s premier management education schools and research centers. NYU Stern offers a broad portfolio of academic programs at the graduate and undergraduate levels, all of them informed and enriched by the dynamism, energy and deep resources of the world’s business capital.
About NYU Stern
DTCC, through its subsidiaries, provides clearance, settlement and information services for equities, corporate and municipal bonds, government and mortgage-backed securities, money market instruments and over-the-counter derivatives. In addition, DTCC is a leading processor of mutual funds and insurance transactions, linking funds and carriers with their distribution networks. DTCC's depository provides custody and asset servicing for more than 3.6 million securities issues from the United States and 121 other countries and territories, valued at US$33.9 trillion. In 2009, DTCC settled nearly US$1.48 quadrillion in securities transactions.
DTCC also operates a global trade repository for over the counter (OTC) credit default swaps (CDS), through its wholly owned-subsidiary Warehouse Trust Company LLC. Warehouse Trust holds data on more than 98% of CDS trades worldwide. DTCC has operating facilities and data centers in multiple locations in the United States and overseas.
Stuart Z. Goldstein, DTCC
Joanne Hvala, NYU Stern
Jessica Neville, NYU Stern