WTF is DTCC? The Story of Clearing
Plus: Real Time Settlement, PayPal, Regulatory Muscle
|Marc Rubinstein||Feb 5||26||6|
Welcome to another issue of Net Interest. If you’re new here, thanks for signing up—you join 12,500 others for a weekly fix of commentary on the finance industry. If you have any feedback, please reply to the email; I’d love to hear from you. And if you like what you’re reading, please spread the word.
WTF is DTCC? The Story of Clearing
“So Thursday morning, right... So I’m sleeping, but at 3.30AM Pacific, our operations team receives a file from the NSCC, which is the National Securities and Clearing Corporation. So basically as a clearing broker, and this is where Robinhood Securities comes in, we have to put up money to the NSCC based on some factors, including things like the volatility of the trading activity, concentration into certain securities… So they gave us a file with a deposit, and the request is around $3 billion which is, you know, about an order of magnitude more than what it typically is.”
— CEO of Robinhood talking to CEO of Tesla on Sunday night
Power comes in many forms. Last week’s events surrounding GameStop show how power can coalesce in the hands of individual investors when they pool their intellectual and financial resources. But the events also reveal a different manifestation of power: the power to call a high-profile tech company in the middle of the night and demand $3 billion. That’s quite some power!
The entity wielding that power is the NSCC, which – as Vlad Tenev, the CEO of Robinhood spelled out to Elon Musk – stands for the National Securities and Clearing Corporation. The NSCC in turn is a part of the DTCC, which stands for the Depository Trust and Clearing Corporation. And the DTCC is perhaps the most powerful entity you’ve never heard of. It’s the engine of the US securities markets; in 2019 alone, it processed over $2.15 quadrillion worth of securities (yes, quadrillion!) It’s big and ugly enough to be included among a very short list of entities designated by people in Washington as “systemically important financial market utilities”.
To understand what (and who) the DTCC is, we need to delve a little into market structure, and the best way to do that is with some historical perspective.
In My Liverpool Home
My home town of Liverpool is famous for lots of things. There’s the Beatles, of course; I grew up on the same street that John Lennon did, within walking distance of Penny Lane and Strawberry Fields. And there’s football; our team is floundering, but we remain – for now – champions of England.
Less well known, even among the people of Liverpool, is the city’s role in the development of financial market infrastructure.
In the nineteenth century, Liverpool was one of the busiest ports in the world and a destination for cotton shipments that came steaming across the Atlantic. Before the American Civil War, cotton would arrive at the docks, and the merchants responsible for importing it would then sell it to spinners in Lancashire.
The American Civil War disrupted that. Volatile price movements in cotton encouraged the development of a ‘to arrive’ or forward market. Rather than waiting until the cotton had reached port, merchants could sell their cotton forward to protect their positions. Over time, the practice attracted speculators keen to take a view on the price of cotton. Merchants didn’t mind because the influx of speculators increased the range of counterparties with which they could trade.
There was one issue that needed to be resolved though: because the same cotton could be bought and sold multiple times, a chain of financial obligations would develop which could become unwieldy. One commentator talked about the “wranglings and heart burnings” of the process. (Not dissimilar to the issues the credit card industry faced at its outset; the founder of Visa, Dee Hock, talked about how “back rooms ﬁlled with unprocessed transactions…and suspense ledgers swelled like a hammered thumb”.)
Back in Liverpool, a local cotton broker Joseph Morgan proposed a solution: to set up a special clearing house where all the trades along the chain could be tidied up. Each day, the clearing house would take in cash from the traders who needed to make a payment for cotton due, and pay cash out to those who had payments to receive. Opposition arose from some people who thought the process could lead to excessive speculation and some who harboured suspicions the clearing house would have access to sensitive market information. But it worked.
Over the 1870s and 1880s – when my great great grandparents were arriving in the city – Joseph Morgan and his successors refined the idea. They replaced cash with a system of credit; and they introduced fixed weekly settlement dates which forced a weekly ‘mark to market’ on traders, preventing them from getting overexposed over the duration of the contract. 1
The Liverpool system of clearing laid the groundwork for the modern clearing house, and similar systems popped up in trading cities all over the world. The French port city of Le Havre, on the English Channel, set up a clearing house which went as far as to guarantee the contracts it registered. If one side of a trade went sour, the other side would have nothing to worry about; the Le Havre clearing house would provide a backstop. To mitigate its risk, buyers and sellers would need to be known to the clearing house and would have to put down a deposit before being allowed to trade; they would also be asked to top-up their deposits if positions swung into a loss. Le Havre’s innovation in market structure led it to become the leading market for coffee in Europe.
In the US, development of clearing was slowed by anti-gambling sentiment. Just as people today are concerned about the cross-over between trading and gambling inside apps like Robinhood, so they were concerned then about the cross-over via futures trading. Nevertheless, a small clearing house emerged in Minneapolis alongside the city’s grain exchange. It introduced a novel twist. Rather than guaranteeing risk like the Le Havre model, the Minneapolis clearing house would assume the role of seller to every buyer and the role of buyer to every seller. The ends were the same, but the process had the advantage of making life pretty easy for those involved because traders had only to deal with the clearing house. The model became known as ‘complete clearing’ and it is the foundation for most clearing institutions today.
Clearing Houses’ Sources of Power
Whether based in Liverpool, Le Havre or Minneapolis, clearing houses throughout the world fulfill two main functions:
They protect buyers and sellers against the risk that the other party doesn’t deliver on their side of the trade. This poses a greater risk in derivatives markets like the cotton futures market of Liverpool than it does in cash markets like stock trading. In stock trading, buys and sells are settled within days; in derivatives markets it may be weeks, months or years before a contract is due to expire.
They promote efficiency by netting positions of counterparties and providing anonymity of trades. Remember that $2.15 quadrillion of securities that DTCC processes? Well, it nets down to (only) $121 trillion of settled transactions. So around 94% of the money flow gets soaked up by the clearing house as it nets off who owns what to whom.
Clearing houses are like a combination of a bank, a post office and an insurer. As a former chairman of one of Europe’s largest clearing houses said, “We allow the City to sleep at night.” (Unless you’re Vlad Tenev and you get a call at 3.30AM.)
Before the global financial crisis, clearing was a dull, backroom affair. But the bankruptcy of Lehman pushed clearers into the limelight. In the aftermath of that day in September 2008, the biggest clearer in London, LCH.Clearnet, found itself with the task of untangling Lehman’s $9 trillion portfolio of interest rate swaps. It pulled off the job without any losses. Regulators noticed and, two months later at a G20 summit, introduced provisions to make central clearing of derivatives mandatory.
That meant more business for clearing houses. Or a few of them, anyway, because the dynamics of clearing lend themselves to economies of scale. The more outstanding trades a clearing house has on its books, the more it can offset long and short positions against each other; this influences the amount of margin the clearing house demands from its trading members. A clearing house with a large volume of business can be more competitive than one which clears few transactions. Clearing houses tend towards monopolies, but that brings the risk that they abuse their position by jacking up fees.
Clearing houses derive their power from three sources. They have regulatory sanction; they tend to monopolies; and they have the power to call you in the middle of the night.
On his call with Elon Musk, Vlad Tenev described how his clearing house got to its $3 billion number. On top of a quantitative formula, “there’s a special component, which is discretionary.” That same discretionary component confronted the Italian Republic at the height of the Eurozone crisis. In November 2011, clearing houses raised their margin requirements against positions in Italian government securities “based partly on discretionary criteria” (according to a report by The Banca d’Italia). The substantial increase in margins had a big impact on the secondary market of Italian government bonds, provoking a widening of their spread against safer German bonds and causing “liquidity strains for participants in the guarantee system” (the Banca d’Italia again).
Vlad Tenev should think himself lucky!
Given the extent of their power, it is useful to know who sits behind the clearing houses.
There are two models. In one, a monopoly is tolerated but the entity is highly regulated and required to operate at cost. The DTCC follows this model. It is owned by its users and re-allocates equity every three years as user share shifts. In the past 12 months (to September 2020) it earned $1.9 billion in revenues, of which it absorbed $1.5 billion in operating costs and returned $158 million as rebates to its users.
The DTCC’s user-owners include: Citigroup, BNP Paribas, JP Morgan, State Street, UBS, Goldman Sachs, Morgan Stanley, Virtu, Barclays, BNY Mellon, Bank of America.
Wall Street, basically. So it’s easy to see how the narrative of Wall Street power develops. But the DTCC’s structure is somewhat anachronistic. Away from the DTCC, another model is prevalent, where clearing and settlement is vertically integrated on top of trading execution in a common ownership structure. This is how most derivatives markets have evolved. Unlike with stocks, where intellectual property is deemed to reside with the issuer, in derivatives the intellectual property is with the exchange that created the contract. For the exchange, clearing is a strategic asset, a way of adding more value in the chain of transactions from trading to clearing to settlement.
Consequently, the largest clearing houses in the world are owned by exchange groups. In 2014 when the numbers were run, exchanges owned 83% of central clearing houses globally, up from 55% in 2006. And that number has only gone up since, with CBOE having taken control of EuroCCP and London Stock Exchange having taken control of LCH.Clearnet. These two clearing houses account for over 80% of European securities clearing.
This shift in power away from the big investment banking firms that embody Wall Street towards exchange groups is something we looked at in The New Power Brokers a few months ago. Exchanges have amassed power through their control of two assets: index construction (as discussed in The Business of Benchmarking) and central clearing houses. The former entrenches them in workflows the world over; the latter makes them too big to fail.
Bemoan the might of Wall St, fine, but the real power lies elsewhere.
The definitive history of clearing is this book: The Risk Controllers, by Peter Norman. I’d also recommend Lorenzo Genito’s PhD thesis, What Markets Fear: Understanding the European Sovereign Debt Crisis Through the Lens of Repo Market Liquidity.
More Net Interest
Postscript: Real Time Settlement
Vlad Tenev rightly doesn’t want to be subject to a nightly call again any time soon. His proposal is that the market switches to real-time settlement for stock trading. Sheila Bair, former chair of the Federal Deposit Insurance Corporation agrees. It’s a debate that’s been had before. Werner Seifert, the CEO of Deutsche Börse, vetoed a three-way merger of European securities settlement infrastructures in 1999 because he held out hope for real-time clearing.
The problem is that for positions to be immediately funded, the system needs to be endowed with a lot more cash. Pre-funding trades is a pain. Buys and sells need to be perfectly coordinated if one is used to fund the other; foreign exchange conversions need to be done in advance. It was tried in Russia, but authorities back-pedalled to T+2 as costs to participate escalated. Real-time also eliminates a window in which errors can be rectified.
So it doesn’t seem likely that we’ll be shifting to real-time anytime soon. In the meantime, clearing houses retain their grip on power.
PayPal’s market capitalisation went over $300 billion this week, following its earnings report and accompanying announcement that it expects to grow earnings by 17% this year. That makes it larger than Bank of America, and it’s closing in on JP Morgan (“And we have to be prepared for that. I expect it to be very, very tough, good competition in the next 10 years. I expect to win. So help me, God.” — Jamie Dimon, CEO of JP Morgan).
Unlike banks, PayPal is rolling out new functionality very quickly in an effort to win and engage customers. It added 73 million net new active customers to its platform over 2020 to take its total to 377 million. Crypto is helping; it launched crypto in October and it led to an explosion of interest. Crypto customers log in at twice the rate they did before buying digital currency. It also added Buy Now Pay Later. This was launched in the second half and 2.8 million unique customers took up the service (compared with 3.9 million customers at Affirm which has been going a bit longer).
One of the secrets to growth in fintech is to keep adding flashy new products. It’s what Ant Group did and it’s what PayPal, Square and Revolut are doing. Saturation is some way off, but banks must be waiting to see what happens when it kicks in.
Regulatory Muscle 💪
There’s a view that all companies eventually evolve into a bank. I touched on it in Introducing Net Interest:
Unzip companies across a range of industries and you will find financial companies lurking inside. In 2018 US car dealerships made over twice as much on finance and insurance as on actual vehicle sales. It doesn’t even matter whether the core product is high priced or low. The Foschini Group, which sells clothes in South Africa, does a quarter of its sales on credit; Wyndham Destinations, which sells timeshares, does over two thirds.
These are less car/retail/hospitality companies, and more credit companies with a sideline in subsidised pick-up trucks or T-shirts or holiday lets.
Byrne Hobart calls it La Fin du Tech; others call it embedded finance. If it’s true, it means that financial regulators are the ultimate regulators of everything and if they’re not, it could present a problem. This week, two financial regulatory agencies flexed their muscles to peer into areas outside their traditional domain.
In the UK, the Financial Conduct Authority (FCA) has been taking a look at Buy Now Pay Later. For sure, Buy Now Pay Later – as a retail credit product – should sit on their turf. But then there’s this:
As part of this recommendation consideration will also need to be given to the regulatory treatment of partner retailers…
The FCA suggests that any retailer wanting to offer Buy Now Pay Later will have to be authorised in a way that they aren’t for credit cards. It acknowledges that some retailers may not want the responsibility of being authorised, in which case they will have to withdraw from the market.
Meanwhile, in Basel, the Bank for International Settlements’ Financial Stability Institute took a look at some of the exploits of big tech companies. They said this:
Given the increasing reliance by both financial and non-financial firms on cloud services, a significant incident affecting the security or the operational continuity of CSPs [cloud service providers] may have potentially large systemic effects. The services that CSPs offer to financial institutions are subject to the outsourcing controls imposed by financial regulation. Yet so far there are no specific rules and standards on CSPs themselves. Recently, a debate has emerged in the United States on whether large CSPs should be designated by the Financial Service Oversight Council (FSOC) as systematically important financial market utilities (SIFMUs).
So whether you’re a retailer or AWS, you better watch out, the financial regulator is looking at you! I’ll tackle this theme more closely next week. If any reader has any comments, please get in touch.
Alright, alright, clearing wasn’t invented in Liverpool. Joseph Morgan didn’t know it, but clearing houses had actually been in operation since the 18th century in Japan, where they were part of the infrastructure of the Dojima rice market in Osaka.