10 years on: Why Lehman was a watershed moment for the post-trade

The collapse of Lehman Brothers 10 years ago flagged major risk management issues and led to a wave of regulation which has been challenging and in some cases conflicting for the post-trade industry, writes John Gubert, who makes the case for a move to more general principle-based rules.

Lehman was not only a defining moment for traders, it also propelled the post-trade industry rapidly up the risk management learning curve, into new products and services; and created a plethora of regulation of varying degrees of value.

The almost casual approach to risk management in pre-Lehman days was typified by a total misunderstanding of where risks lay by many in the industry, an imbecilic approach to leverage by several and a clear misunderstanding of liquidity, and especially intraday risks, across large swathes of the market.

The new products and services, which we have since launched, are less innovative, and more enhanced or improved ones. They included collateral management, liquidity management, trade reporting, adoption of settlement standards and, above all, the major move in derivatives to exchange trading and clearing rather than bilateral off exchange.

Regulations include Dodd-Frank, EMIR, UCITS, AIFMD, ring fencing. MIFID II and a raft of other obtuse names and confusing acronyms that have made law and compliance the financial services’ industry’s fastest growing sector.

Unfortunately, bureaucratic controls have increased, many banks are unresponsive as they struggle through their newly created stakeholder approval meetings; and fear of fines has become one of the defining forces of modern day business. Conversely, risk is better managed and the quality of management has been radically enhanced.

It is worth considering examples of poor risk management pre-Lehman. Much of the risk-free moniker that was so wrongly attached to custody in particular was a result of the zero-risk weighting on custody assets – a factor that continues despite the added regulatory burden on asset replacement arising from AIFMD or UCITS. The major example of risk blindness pre-Lehman arose from three linked historic features of our industry, namely a casual approach to intra-day risk, a misplaced belief in the legal certainty of multiple forms of DvP and a total misunderstanding of the ownership rights of parties to a transaction once the music stopped.

Regulation has clarified accountability for risk management although there is room for further clarification to avoid committee structures becoming surrogates for the personal responsibility of senior management. New banking rules relating to liquidity management have led to a more structured approach to intraday risk although there are gaps especially in the cross-border world with its different approaches to transaction finality.

We still have risks embedded in complex structures. Few funds now have the leverage risks of the late lamented LTCM hedge fund with its 25:1 leverage overlaid by its trillion dollars-plus derivative position. However, leverage is creeping up again in some market segments. Components of the ETF market are far from simple to understand and there is still a too large pool of short-term high volume traders whose tactics and trading strategies place longer term investors at risk.

Many of the new products and services that have been launched are structured around the demand for data and the need for collateral. The demand for data has led to a welcome increase in capital spend on technology with the growing alliances between the industry and FinTechs being a welcome case in point that brings in lateral thinking to an area of traditional conservatism. Changing the embedded IT architecture of the market to accommodate a demand for instant data is far from easy. In reality, this requires a major re-engineering project which may be beyond the budgets of most players. In practice, major change is made more difficult by the uncertain future, with strategies needed for cloud computing, blockchain, shared or dedicated joint platforms or artificial intelligence.

Data is being produced and some genuinely sound products are available from leading technology companies to facilitate demand. However, there are two key issues. First, it is unclear if regulatory reporting is being used to improve the immediate oversight of the industry or even if the data can be used to optimal effect by the recipients; and secondly client demand is unclear and consolidating data from multiple sources by anyone with multiple suppliers is a challenge requiring buy-side dictat on formats and content or smart buy side applications intelligent enough to reset the inbound information.

A second major product is around collateral with demand growing as market volumes recover and more transactions are collateralised. Major steps have been made in collateral substitution, collateral management, triparty arrangements and in ensuring finality in major infrastructures for DvP. These are all positives and the risk of a repeat of the collateral confusion of the immediate post Lehman period has sharply reduced. However, there is a serious risk of quality and concentration. Demand is for high quality collateral, mainly cash or government bonds, at a time when some of traditional sources of supply have dried up and the new ones are very susceptible to any change in the risk profile of the market or the demand segments.

A broadening of the range of acceptable collateral appears inevitable longer term in order to match supply and demand but care needs to be taken around the liquidity of any expanded collateral pool. Concentration risk is a further challenge as all infrastructures and private sector collateral takers prefer a limited range of instruments.

Although the credit risk associated with these instruments is generally low, the market risk is a concern. I have long railed against the idea that a sound test for infrastructure resilience can be based on the default of their largest clients, allied to little change to market values or liquidity. I still remember the 10% fall of bond values and the 20% fall in equities around Black Monday in 1987. A repeat of something of that scale or a greater one is far from impossible; therefore, a severe shrinking of liquidity, major fall in values and retreat from the market of stock lenders and their ilk has to be considered and we need to understand better how governments and central banks would respond in such a crisis where infrastructure capital, reserves and contingency arrangements may prove inadequate.

Regulation has improved the market. Asset safety is far improved albeit mainly through deep pocket allocation of risk. Trading volumes are more commensurate with capital adequacy for most of the market. Risks such as intra-day have been captured within banking regulation. Banks have been split between their investment and commercial banking activities in many jurisdictions.

But the system is ridiculously complicated for no one can operate a series of regulations that must amount, for multinational financial firms, to well over a million pages of laws, regulations and other guidance. As almost all laws in this area have a catch-all that gives regulators ultimate decision-making powers in areas of ambiguity, whether constructive or unintended, we need to consider a move to more general principle-based regulation with wider powers of interpretation by the regulators. The legalistic will throw their hands up in horror at the thought, but a pragmatist may agree they are lost and struggling in the confused world of parallel principles but conflicting rules they find themselves in these days.

Lehman led to improvements in the quality of post trade markets. The industry and the regulators have done a good job. But now is the time to take a deep breath and reconsider some of the changes we have implemented for they have had some quite dangerous unintended consequences.