There have been a variety of systemically important banking issues making the headlines since the global recession of 2008, but the challenge to mitigating credit risk during settlement seems to be a constant frontrunner. This article discusses the importance of effective liquidity management, particularly from the sphere of timely payment settlement via financial market utilities (FMUs), defined as “multilateral systems that provide the infrastructure for transferring, clearing, and settling payments, securities, and other financial transactions among financial institutions or between financial institutions and the system.”

In November, The Clearing House held its annual payments system conference and a number of panels dealt with effective risk and liquidity management, particularly for financial market utilities. In January, at the World Economic Forum’s Annual Meeting, the global financial crisis was a revolving topic across a number of panels.

Real time delivery of securities to a buyer and payment of funds to the seller require financial market utilities to behave as a central counterparty to both sides of the transaction, taking on significant credit risk should any side of the transaction default on its obligation. The objective of FMUs becomes one of having a list of collateral instruments to use when its member banks cannot obtain funding.

The process behind how these utilities protect themselves against credit risk is complicated, but one vehicle they use is requiring counterparties to put up initial margin amounts to insure the transaction can settle.

The focus of the discussions at The Clearing House’s conference resided in managing operational risk failures at the financial market utilities designated as systemically important under the Dodd-Frank Act. Currently there are eight systemically important financial market utilities (SIFMUS):  The Clearing House Payments Company; CLS Bank International; the Chicago Mercantile Exchange; the Depository Trust Company; the Fixed Income Clearing Corporation; ICE Clear Credit L.L.C; National Securities Clearing Corporation; and the Options Clearing Corporation.

Given how unique the systemically important utilities are in terms of their limited ability to access capital outside of the financial institutions that are their members, a one-size-fits-all solution will not work for effective risk management across all utilities. The internal controls and enterprise risk management standards cannot possibly be the same across all eight SIFMUs. Unconventional policies such as the transfer of authority from one utility to another in order to meet settlement obligations could insure real-time payment settlement and requires further discussion.

To get a sense of the magnitude of the transactions these institutions facilitate, the Chicago Mercantile Exchange helps coordinate settlement for more than $4 trillion in contracts on a daily basis.

Regulators of all financial market utilities expect these multilateral payment systems to monitor the investment and liquidity risk at participating settlement banks, and to resume business operations within a two-hour window should any FMU experience a disruption of any sort. The ability to receive short-term finance is not a guarantee, as the collapse of Lehman Brothers and Bear Stearns reminds us.

Even more important is the dialogue between participating SIFMUs and the other financial market utilities. Risk managers at large financial institutions that use one of these utilities must be in constant dialogue with senior management at the FMUs on process and infrastructure enhancements for settlement, making sure liquidity is available when their payments are due.

Reflecting on the panel sessions at The Clearing House annual conference, an ethics panel – introduced by Gregory Baer, President of The Clearing House Association and including senior management from Barclays and Wells Fargo – recognized the importance of accountability in corporate governance standards for payments settlement.

The ability of SIFMUs to efficiently monitor, manage and measure liquidity risk resides in their board of directors consisting of individuals who are not their owners or employees. The requirement of independence at the board level is something that must be communicated throughout each utility’s business lines, so that all personnel are encouraged by the integrity and ethical standards being set at the board level.

The prevention of systemic contagion rests on managing liquidity in highly uncertain economic times. The dependence of participating financial institutions on SIFMUs for providing real-time clearing and settlement services echoes the importance of maintaining resilience in the face of liquidity shortages. Maintaining resilience depends not only on effective operational and analytical risk management tools or simulation and stress testing, but in an equal emphasis on open dialogue and clear communications across and within SIFMUs.

The communication of conduct standards that trickles down to all business lines within each utility helps address liquidity shortages with all participants responding in the fastest and most efficient manner to mitigate any disruption and insure timely settlement of transactions. If the standards for open and clear communications are established and continually refined, both across large financial institutions and FMUs, financial market infrastructure will be more robust and better able to manage the need for just-in-time liquidity in an uncertain world.