As the exchange model and its often tightly-coupled central counterparty clearing mechanism (CCP) become more central to capital markets globally, exchange operators must start to step up their game when it comes to enterprise risk management (ERM). This means that exchange businesses should focus not only on market uptime, cyber security, surveillance, and default management, but also on the entire comprehensive and aggregated risk profile of the exchange model, including strategy, pre-trade, operations, human capital, systemic integration, and regulation.
Through a focus on comprehensive risk management, exchange operators will strengthen industry's confidence in their business model. This will allow them to enhance their governance and strategic planning through aligning risk appetite with their business strategy.
Exchanges are essential to the world’s capital markets. For many exchanges worldwide, the CCP model is an integral part and an extension of the exchange model, since many CCPs are owned and operated by exchanges. Regulators trust and are familiar with this market structure model, to the extent that in the US and other parts of the world they determined that the solution to the most recent financial crisis lay in making the exchange model available for OTC derivatives.
ERM practices at exchanges have, however, historically been an afterthought. Risk management was in no way a formal activity and was carried out unofficially at the middle management level. The global financial crisis changed the whole industry’s perspective on risk. For this reason, a few exchanges kicked off comprehensive ERM programs as early as 2009.
These are a minority, and they have reaped the rewards of their programs in terms of a relatively cultivated and mature risk culture. However, a majority of the world's exchange community, for various reasons (primarily related to lack of competition within their markets), lagged in adopting ERM and is just starting to realize its importance. This majority has initiated or is currently in the process of initiating ERM programs.
Exchanges with little to show in terms of ERM are mostly based in emerging markets. They happen to be the center of attention of the investment community in developed economies. They are also the next logical conquests of high-frequency traders and larger exchanges who, under competitive pressures, are trying to build alliances or acquire international marketshare. For these smaller exchanges the move towards ERM is another burden of proof of their viability as investment destinations and of their level of attractiveness as acquisition or alliance targets.
Immediate growth strategies of emerging market exchanges, such as the introduction of new products and services attracting global investors or alliances with other emerging market exchanges (to create diversified markets of critical mass and sufficient liquidity), make it imperative for them to move swiftly towards a “top-down” ERM framework model. (In a top-down framework, ERM practices are pushed down the management hierarchy from the Executive Committee.) Since there is a lot of catching up to do, the bar of ERM is set too high from the start.
For the set of leading exchanges, ERM programs progressed naturally from “top-down” models to “top-down-bottom-up” customized hybrid ERM frameworks (where ERM practices are institutionalized at the business-unit level). In some instances, these programs were slowed down or terminated prematurely at the discretion of senior management the moment there was just enough ERM practice adoption to justify a perception of low risk.
In other instances, the ERM practices bar was set too low to start with. Evidence of this abounds in the form of gaps in comprehensive risk appetite definition and allocation, the use of lagging key risk indicators, poor or no integration with strategic planning processes, etc.
The bottom line is that leading exchanges are unconsciously operating with a higher risk appetite than their risk committees and senior executives tend to believe. As these leading exchanges acquire or partner with smaller exchanges, ERM capabilities of target exchanges should be a primary consideration of due diligence, since any such transaction may result in taking on significant new risk.
Implementing an ERM program from start to finish is a daunting multi-year initiative during which the chances for delay or derailment are very high. Given the critical role they play, exchanges should not be given the leeway to decide independently how much risk to take on, whether knowingly or unknowingly.
Doing so makes exchanges the weakest link in the capital markets industry ecosystem. In the same way financial institutions have been asked to comply with materially significant capital requirements to avert crises, exchanges around the world should also be asked to demonstrate a level of enterprise risk management maturity commensurate with their newfound popularity and role.