08.12.2013
By Terry Flanagan

Systemic Risk Pervades Financial Markets

The fragility of the financial system to cyber-attacks and other threats has highlighted the need for rigorous testing of trading software prior to deployment.

In a white paper released last week, The Depository Trust & Clearing Corporation (DTCC) identified a number of emerging trends that could potentially impact the industry’s ability to protect against new and unidentified threats to the financial system.

One of these threats is “interconnectedness risk.” While Inter-linkages among financial firms and infrastructures greatly improve the effectiveness and efficiency of clearance and settlement activities and processes, they also create a complex network of interdependent legal, credit, liquidity, and operational risks.

This presents a possible source of systemic risk by increasing the potential for operational and other disruptions to spread quickly and widely through the financial system in a worst-case scenario.

DTCC is calling for closer and more continuous engagement and action among all key industry participants on this issue to reduce the systemic risks facing global markets.

“The paper is intended to initiate robust dialogue and help market participants gain a deeper understanding of how new or evolving systemic risks might impact the safety and soundness of global financial markets, and the steps the industry needs to take to be ready for the next crisis,” said Mike Leibrock, vice president of systemic risk at DTCC.

Possibly one of the biggest technological advancements in financial technology, the introduction of the FIX protocol, has allowed buy-side and sell-side to connect to each other quickly.

“One of the greatest strengths of the FIX protocol is it’s a standardized communication link between software, but it does allow for flexibility,” said Jamie Oschefski, vice president at trading technology company Embium. “There is nothing wrong with this, and we are constantly adjusting and tweaking our FIX engine to either conform to a counterparty or optimize on our end. The problem lies in the certification process we see in a majority of the exchanges and brokerages.”

Most exchange and brokerages do the bare minimum, and this is not acceptable.

“They need to be testing more functionalities in the systems that are connecting to them,” Oschefski said. “They need to be able to test hundreds of scenarios, because even though 10 – 15 tests may cover 80- 90% of the trade workflow, the edge cases are the issues that cause the biggest problems. The outlier events or “Black Swan” may occur very infrequent, but can be detrimental to a firm when they do.”

Regulation SCI imposed by the SEC will ensure these types of automated and documents processes will be the industry standard and not the exception.

“Automating this process is where the entire industry needs to go. BM&F BOVESPA and Direct Edge are leading the way here,” said Oschefski. “They have risen above and adopted automating their certification processes doing 80 – 100 tests. This is not something that can be accomplished with a manual process. We take a similar approach in our software testing.”

Unit testing is an extra bit of code where usage and operating procedures are tested to determine if the application is fit for use. “Unit tests are an integral part of our development cycle,” Oschefski said. “Technology firms that don’t follow and document strict testing procedures are setting themselves and their clients up for failure.”

The DTCC paper reports that despite progress over the past five years, systemic risks facing the global financial services industry are growing in complexity, are more difficult to anticipate and that new gaps continue to surface. These potential threats include a rise in cyber-attacks that can easily thwart U.S. and EU industry safeguards and laws; a potential shortage of high quality collateral in the future; and regulatory safeguards that are either years from implementation or introduce new forms of systemic risk.

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