Financial institutions step in with management adjustments to mitigate counter-party risk
New market research from Fitch Ratings measures the impact and implications of share price volatility in Gamestop and other stocks. Visit here.
Fitch Ratings-New York/Chicago-04 February 2021: U.S. financial institutions appear to have effectively managed the recent significant share price volatility in GameStop and other stocks experiencing heavy retail trading volume, with no rating actions as a result thus far.
However, these new market dynamics, including social media’s ability to increase retail investors’ impact on price discovery (particularly for small capitalization or thinly-traded equities), could have longer-term implications for financial institutions in terms of regulation, market structure, risk management, political and reputational risks and overall financial stability, Fitch Ratings says.
Since a small group of stocks began exhibiting extreme price volatility last month, U.S. banks, clearinghouses, securities firms, and retail brokers, have been implementing risk management adjustments to mitigate counter-party risk, including raising margin requirements and restricting more complex option strategies such as naked call writing that can result in material unsecured margin exposure for retail brokers.
Sever Market Volatility
Financial institutions are sensitive to bouts of severe market volatility, which can be exacerbated by margin calls, other leveraged trades and residual effects on market confidence. Potential contagion risks could stem from the interconnectivity between the bank and non-bank sectors amid the continued migration of certain activities out of the banking sector since the global financial crisis (GFC).
Fitch expects limited rating implications for clearinghouses given strong risk management frameworks including intraday margining, ability to adjust collateral requirements, mutualized guaranty funds and ongoing counter-party monitoring. Clearing members are mainly the largest banks and brokers, with little direct retail exposure. However, increased retail trading in commodities, such as silver, could increase price volatility and raise margin requirements from derivatives clearinghouses, such as CME Group (‘AA-’/ROS) or Intercontinental Exchange.
The broad introduction of central clearing in the equities and derivatives space post-GFC strengthened systemic resilience. Counter-party defaults during the pandemic-driven stress in 2020 were limited to a few relatively small players and Fitch-rated financial institutions exhibited fairly stable credit performance. However, decisive actions from major central banks were a meaningful contributor to the stability, particularly in the face of liquidity strains on banks and other clearing members as a result of elevated margin calls from clearinghouses.
Market Movements Exceed Exposure Estimates
Although coordinated retail trading may have limited direct systemic impacts, it can result in elevated margin model risk, whereby market movements exceed exposure estimates based on historical prices. Furthermore, central bank liquidity support may not be as forthcoming in an idiosyncratic stress, thus raising brokers and clearinghouses’ counter-party risk.
Fitch-rated U.S. globally systemically important banks offer prime brokerage services to hedge fund clients and credit lines to hedge funds and broker/dealers creating indirect exposure to current market dynamics, although banks have made meaningful risk management enhancements around these businesses since the financial crisis while substantially increasing capital and liquidity positions.
Retail brokers have recently faced operational challenges related to unprecedented volumes and have experienced various technological issues. However, brokers (and/or their ultimate parents), including Charles Schwab (‘A’/ROS), TD Ameritrade (recently acquired by Schwab) and E*Trade (recently acquired Morgan Stanley), benefit from robust capital levels and significant contingent liquidity to meet clearinghouse requirements. Conversely, Robinhood Financial (not rated by Fitch) raised $3.4 billion of capital and reportedly drew on bank lines.
Retail brokers will likely face modest earnings headwinds from increased investment in technology and staff to meet increased volumes, and may also face regulatory scrutiny related to recent trading stoppages, investor protections and product suitability, particularly for options.
Retail brokers and electronic market making firms such as Virtu Financial (‘BB-’/ROS) generally benefit from increased retail trading activity, however, they could face increased regulatory scrutiny of payment for order flow mechanisms. Market makers may also be subject to higher liquidity requirements resulting from execution on directional client portfolios.
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.
