If the US Bond Market is the Eighth Wonder of the World, the Depositary Trust & Clearing Corporation (DTCC) is certainly the Ninth.
Most people have never heard of DTCC but in 2012 it and two of its subsidiaries were named Systemically Important Financial Market Utilities (SIFMU’s”). SIFMUs are TOO BIG TO FAIL and must be regulated. In this case DTCC is supervised by SEC and Financial Stability Oversight Board.
If you are an investor, you interact with DTCC every day. Say you want to buy 100 shares of Microsoft through your brokerage firm, JP Morgan. Trading rules require your purchase to settle within 2 or 3 days of the trade. Your trade is processed and settled by DTCC and it keeps a ledger of your ownership. A funny thing happens to most securities that enter the trading process – they are separated into legal and beneficial ownership. You “cede” legal ownership of your securities to JP Morgan and you get a beneficial interest in a limited partnership called “CEDE”. CEDE and Co then passes dividends declared on MSFT to DTCC, who then passes them on to JPM who then credits your account. Here is how DTCC describes the accounting in its 2018 Annual Report:
“The Company receives cash and stock dividends, interest, reorganization and redemption proceeds on securities registered in the name of its nominee, Cede and Co., and interest and redemption proceeds on bearer securities, which it distributes to Participants. These balances are included in Other Participants’ assets with a corresponding liability recorded in Payable to Participants on the accompanying Consolidated Statements of Financial Condition. “
Unless you restrict it, JPM now has legal ownership of your MSFT and can loan it to short sellers of MSFT stock at a handsome profit which they keep. This process goes on every minute of every trading day for almost every single security that is traded in the world including all bonds, mortgage backed securities and derivatives.
Think of a single electric utility that intermediates all the electricity in the world and you have the DTCC. Keeping track of who owns that electricity on a minute to minute basis must be a gargantuan task. You have to wonder whether all the super- computing in the world can really keep track?
Privately Held Ownership Group
The interesting thing about DTCC is its private ownership. The same businesses who own most of Wall Streets’ brokerage firms also own the clearing and record keeping functions for almost all the securities in the world.
The club has the usual suspects on its Board of Directors: JP Morgan, Goldman Sachs, BNP Paribas, Citigroup, Morgan Stanley, State Street, UBS, Barclays, Mellon and E -Trade. It is interesting that neither Charles Schwab nor Fidelity is represented on the Board of DTCC, and presumably, neither is an owner.
Being in this club is also important because DTCC has to recognize and agree to process trades for newly issued IPOs. It is probably wise to use a member of the club to sponsor and underwrite your securities in the IPO- another high margin line of business. As you read about Fidelity and Schwab trying to cut out the middleman and underwrite securities directly of companies needing capital, it will be interesting to see if DTCC allows them to clear through it when they are bypassing the usual underwriting syndicates? DTCC also has the power to “chill” a security when it believes the issuer is engaged in fraudulent behavior. That decision is non-appealable. DTCC has the unfettered right to decide who are card counters at the blackjack table.
$52 Trillion Held on Deposit
What keeps me up at night is remembering what happened when SuperStorm Sandy flooded the vaults of DTCC at 55 Water Street in 2012, and literally submerged a huge swath of the world’s securities (They Call It Water Street For A Reason). They had to be restored. It was at this moment someone asked the question about insurance and capitalization of DTCC. If 10% of the securities in the world are destroyed by flood, how can you possibly have enough insurance or capital to get an issuer like MSFT to issue replacement securities? The answer is you cannot, and what happened was DTCC was so thinly capitalized in 2012 it had to issue IOUs (literally scrip) to issuers around the world to get them to supply replacement securities. Issuers cooperated because they had no choice. DTCC then was required to raise more equity which took until 2015 and amounted to a mere $800 million.
Good news for stockholders came when DTCC abandoned its vaults at 55 Water Street and moved to Jersey City in 2015. They don’t disclose the street address for many reasons.
The total value of securities held by DTCC in 2018 was $52 Trillion. According to CFO Diane Cosgrove in the DTCC 2018 Annual Report the net equity of DTCC is now $2 Billion. It sounds like a big number but the net equity of JP Morgan alone is $250 Billion and $2 Billion as a capital base for custody of $52 Trillion of securities is less than 1/10th of 1 percent.
Regulators Permit This Monopoly
DTCC is quite profitable. In 2018 they earned $234 million and distributed p dividends of $140 million, a large portion of which was to members who put up the additional $800 million of equity in 2015. This is a sharp contrast to the stingy dividend restrictions imposed by Dodd Frank on Too Big To Fail Banks. Only recently have their dividend increases been permitted after serial stress testing for capital adequacy.
I could not find anything that explains how DTCC really keeps track of what you own. In footnotes to its financial statements it discloses that members have to keep deposits at DTCC of cash and marketable securities commensurate with the member’s trading volumes and unsettled trades. In 2018, according to their own Annual Report he total value of all securities processed by DTCC was $1.854 Quadrillion ($1,854,000,000,000,000,000,) comprising 389 million transactions. That means the average trade was around $450 Billion. If these numbers are right (I must be misunderstanding what they mean?), there must be some sort of netting process by the transacting brokerage firm, probably on an annual basis.
A Great Business Model
This is an unbelievable business model. The member firms shift liability for processing and registration off balance sheet to DTCC. They keep legal ownership so they can hypothecate securities and give the investor a beneficial ownership in a limited partnership called Cede and Co. They settle up on a periodic basis, like a gamblers ledger, and pay themselves dividends of more than half of their net income per year on their capital base of $2 Billion.
For a Too Big To Fail institution this seems preposterous which is exactly why I think it is true. These Wall Street guys are smart. They survived the Big Recession in 2008 and SuperStorm Sandy in 2012. I don’t think there is a regulator in the universe who has the hubris to think it can do it better. For now, DTCC is really just the back office of a really profitable casino. And don’t forget- IT IS THEIR CASINO!
