"The liquidation of Lehman was complex, involved multiple asset classes, and required a methodical approach to mitigate potential losses from outstanding trading obligations," said Donald F. Donahue, DTCC chairman and CEO. "Without question, our ability to manage risk and see exposure from a central vantage point was instrumental in helping us ensure that market risk – and systemic risk – was avoided.
"During the crisis, DTCC also seamlessly processed four consecutive days of record high equity trading volume, which reached 209 million transactions in a single day on Oct. 10, thus providing certainty and stability for the financial system at a time of extreme market volatility."
Lehman was a leading participant in DTCC's depository, clearing corporations and OTC derivatives business. It ranked as a top three user of DTCC's Mortgage Backed Securities Division (MBSD); in the top five largest users of the Government Securities Division (GSD) and Deriv/SERV and in the top 10 participants of National Securities Clearing Corporation (NSCC) and The Depository Trust Company (DTC). Lehman Brothers International (Europe) was a participant of DTCC's European Central Counterparty Ltd. (EuroCCP) subsidiary.
DTCC subsidiaries, NSCC, the Fixed Income Clearing Corporation's (FICC) GSD and EuroCCP, are central counterparties (CCPs) guaranteeing that most trades outstanding at the time of a bankruptcy of a member firm such as Lehman will be settled on the original terms. By acting as CCPs, the clearing corporations step in between the seller and buyer of each trade to assume the counterparty risk and the responsibility to deliver the securities to the buyer and payment to the seller.
Mortgage-backed and Government Securities
FICC's MBSD handled the liquidation of a gross position of $329 billion in par value of Lehman's book of "to be announced" mortgage-backed securities trades that were outstanding at the time of its bankruptcy. Working with all the dealers, banks and other firms with which Lehman had conducted trades, and acting as a "CCP for a day," FICC MBSD was able to net down and resolve almost 90% of the forward trades. Over the following few weeks, FICC gradually sold the remaining net obligations into the market with no losses assessed against MBSD members' clearing deposits and with no observed market impact.
Lehman's pending U.S. Government securities trades ran to $190 billion (gross positions) at the time of the bankruptcy. FICC's GSD guarantees the settlement of these trades once it accepts them for clearing. In order to make good on its guarantee, FICC had to close out the various positions, which ranged from repos to government bonds. FICC successfully closed out these positions without impact on customers.
Equities, Municipal and Corporate Bonds
NSCC, which is responsible for clearing and settlement of virtually all broker-to-broker trades in the U.S. in equities and corporate and municipal debt securities, faced total exposure of approximately $5.85 billion from Lehman Brothers at the time its accounts were closed.
NSCC's goal at this stage was to mitigate risk for its members and avoid significant disruption in the marketplace. This included processing and guaranteeing $3.8 billion in options exercises and assignments from The Options Clearing Corporation for the quarterly expiration on Friday, Sept. 19. The close out of these Lehman positions at NSCC is substantially complete. Most of these positions have been liquidated, and there are not expected to be any losses in excess of the Lehman clearing fund held, resulting in no losses to be allocated to other NSCC members.
A portion of Lehman's obligations at NSCC was successfully resolved when DTCC's subsidiary, The Depository Trust Company (DTC), took the lead in working with Lehman's pledgee bank to arrange for the release of $1.9 billion in securities, which were used to satisfy open trades at NSCC. As a result, NSCC did not need to go to the marketplace to purchase securities to complete these trades. In addition, DTC managed the net debit cap controls on Lehman's accounts throughout this period to limit any potential loss to the depository and its participants.
FICC and NSCC retained an investment manager to assist in liquidating positions held by the clearing corporations. The investment manager provided advice and helped determine the best strategy to hedge the portfolios, minimize risk and conduct an orderly liquidation without disrupting the markets.
EuroCCP, a U.K.-based subsidiary of DTCC which is providing pan-European clearing and settlement services for multilateral trading facilities, also had to deal with closing out trading positions for Lehman Brothers International (Europe) just one month after its start of business and even before EuroCCP officially went into full production on Sept. 22.
EuroCCP suspended Lehman from new trade input on Sept. 15, but continued to settle as many of the open positions as possible with Lehman's agent banks so it could deliver the securities to other participants on the same day. Lehman had open trades in 12 markets and six currencies, totaling almost €21 million. About €5 million in trades were settled by Lehman's agents on Sept. 15.
The next day, EuroCCP ceased to act for Lehman once it became clear that Lehman's agent banks would no longer be settling the remaining positions. EuroCCP engaged a broker to close out the €16 million in remaining positions. EuroCCP settled with the broker on T+1, instead of the usual T+3 cycle, which accelerated the fulfillment of its obligations to participants who were awaiting delivery of securities. EuroCCP successfully completed its closeout of Lehman's open positions without the need to use EuroCCP's Guarantee Fund.
OTC Derivatives Trade Information Warehouse
DTCC also acted to minimize risk for its OTC derivatives customers from the Lehman bankruptcy. The actions included stopping the automated central settlement of credit default swap (CDS) payment obligations on Sept. 15 that were maintained in DTCC's Trade Information Warehouse (Warehouse) for counterparties of Lehman Brothers International (Europe) and Lehman Brothers Special Financing, Inc. DTCC also assisted counterparties in removing from the Warehouse more than 300,000 CDS contract positions that market participants held with Lehman.
On Oct. 21, DTCC also completed, without incident, the automated credit event processing of Lehman Brothers Holdings Inc. (LBHI) involving $72 billion of credit default swaps. DTCC calculated and bilaterally netted all amounts due on credit default swaps written on LBHI. This resulted in approximately US$5.2 billion owed from net sellers of protection on LBHI to net buyers of protection. The portion of this net funds settlement allocable to trades between major dealers was handled through the normal settlement procedures of CLS Bank International, DTCC's settlement partner for the Warehouse and the world's central settlement bank for foreign exchange.
DTCC's Comprehensive Risk Management and Strategy
With a 35-plus year history in clearance and settlement, DTCC was able to draw upon its proven experience in effectively managing and controlling risk associated with a financial firm failure. As part of its comprehensive risk process, DTCC regularly puts its risk and operating systems, as well as staff, through intensive testing that simulate the possibility of a crisis. These exercises involve simulating the steps DTCC would have to take to respond to a major financial firm failure. Even though it seemed like a far-fetched scenario at the time, on two occasions over the past 12 months, DTCC actually conducted tabletop exercises simulating the failure of a major investment bank. Members of DTCC's Board and representatives of various regulatory authorities participated in the second of these exercises as observers.
"Although we didn't really expect to have to put the experience we gained from those exercises to work any time soon, events proved otherwise," said Donahue. "They both provided highly useful practice runs for what DTCC and our market participants have been dealing with in recent months."