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(This article provides information about Nasdaq Risk Platform, a cloud-based SaaS product, available to market participants.)
With higher volumes, more volatility, and a more active retail participation seemingly the ‘new normal’ for equities markets, settlement risk – the risk of a trade counterparty failing to deliver a security or its value in cash as per agreement – is elevated. This has become even more relevant given the transition from T+2 to T+1 settlement.
That risk hits squarely on the specialized business of correspondent clearing, which is when a broker handles the clearing and settlement of a trade, after another broker executes the transaction.
Malcolm Warne, Head of Product for Nasdaq Risk Platform, said: “More risk for correspondent clearers is why having real-time risk controls in place is more important than it was a few years ago, when volumes were lower, volatility was lower, and retail investors represented a lower share of the volume.”
Typically, the same broker handles the execution and clearing of a trade, but as Warne explained, a broker who excels at finding liquidity for a trade may not have the infrastructure in place to handle the post-trade process or may wish to focus on execution and not take on the risk of trades not settling. Enter the correspondent clearing firm, some of the best-known of which include brokers such as Goldman Sachs, National Financial, Broadcort, Hilltop Securities, and Pershing.
“The correspondent clearer has the risk management in place to take on the clearing aspect responsibly and safely, so they offer that as a fee-based service to the execution broker,” Warne said.
The most notable instance of retail trading driving up clearing risk was GameStop, whose shares swung from less than $5 in early January 2021 to $120 at the end of that month, then back below $10 a few weeks later, all on Reddit-inspired short-term trading rather than fundamental company news.
The U.S. Securities and Exchange Commission assessed the dramatic price swings of GME stock, and the implications for clearing firms, in an October 2021 report.
“A number of clearing brokers experienced intraday margin calls from a clearinghouse. In reaction, some broker-dealers decided to restrict trading in a limited number of individual stocks in a way that some investors may not have anticipated,” the SEC report stated. “This episode highlights the integral role clearing plays in risk management for equity trading but raises questions about the possible effects of acute margin calls on more thinly-capitalized broker-dealers and other means of reducing their risks.”
One way that correspondent clearing firms can reduce risk is via a modern risk management platform. Warne touched on the importance of having a platform that can be deployed via cloud as it can be connected and up and running within days.
“They don’t necessarily want to take on all the technical aspects of running a real-time risk service, so a market operator like Nasdaq can safely and reliably manage that for them,” Warne said. “We basically take on the IT problem.”
“Do you want to take on a big IT project where you’ve got to buy servers, install software, manage the software, and handle all the integration? That’s the old-school way of doing things,” Warne continued. “Or you can work with a managed service provider that provides the infrastructure, provides the connectivity, manages the software, and upgrades the software automatically. We take care of everything for you, and you just focus on managing risk.”
These are just some of the few things to consider when selecting a risk management platform. Nasdaq has developed a Risk Management buyers’ guide which identifies the key considerations in a step-by-step framework. If you’re interested in learning more, find it under the case studies & thought leadership section titled Key Considerations for Selecting a Risk Management Platform.
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