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STRESS FATIGUE: Addressing the Urgent Threat of Settlement Risk in the Global Financial System

by Jerome Kemp - Senior Advisor, Baton


While financial markets appear to have recovered almost without damage from the Global Financial Crisis (GFC) more than a decade ago, the truth is not so uplifting. The threat now is not the products that are being traded, or even the creditworthiness of participants, but the industry infrastructure itself. Failure to address the inadequacies of the creaking settlements process, most likely by using distributed ledger technology (DLT), could result in tragedy for the financial system – one that could easily be avoided.

The G20’s September 2009 Pittsburgh meeting set in motion a multi-year process to address systemic risk. Its intent was to ensure that the risks and exposures arising from the trading of standardized derivatives would be captured, quantified, collateralized, capitalized, and buffered against the potential contagion arising from the default of a market participant. Pushed along – and at times shoved – by global regulatory authorities and national governments, market participants and infrastructures have, at least to the naked eye, made good progress with the implementation of this vision.

“In March 2020, when markets became unhinged, most risk managers found themselves staring down the barrel of unprecedented, and often unsecured, exposure.”

By 2020, cleared traded notional value for interest rate swaps and credit default swaps represented 90.2% and 82.5% of traded notional value respectively.¹ Banks around the globe are now much better prepared to withstand severe, adverse shocks, thanks to the significant increases to regulatory capital requirements necessitated under the provisions of Basel III. While the industry is still digesting the reform agenda introduced over the past decade, the migration from a world dominated by outsized risk, multi-layered bilateral exposures, poor risk management, lax credit practices, and undercapitalized exposures to the more secure global ecosystem we enjoy today, was clearly warranted.

Yet while we sing the praises of the success of central clearing and the greatly enhanced capital rules as key elements of the post-GFC global economic order, sleeping more soundly than we did as the walls came crashing down over ten years ago, a threat of even more significance looms.

1 – ISDA “Swaps Info Full Year 2020 and the Fourth Quarter of 2020 Review: Summary” January 2021 at https://www.isda.org/a/MWCTE/SwapsInfo-Full-Year-2020-and-Q4-of-2020-Review-Summary.pdf

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