Risk Management in Settlement System/Different types of settlement risks

An efficient settlement system mitigates all risks inherent in the settlement system. It constantly monitors and enhances risk measures to pre-empt market failures. It tracks the record and performance of members and their net worth. It monitors members’ exposures and collects margins and disables the license of members if the limits are breached. 

There are two types of risks involved in the settlement system

Counter Party Risk:  It arises when a member doesn’t discharge his/her obligations fully in time or any time thereafter. This leads to two risks – replacement cost risk prior to settlement and principal risk at the time of settlement.

Replacement cost risk: When one of the parties of the transaction fail to deliver their obligations, the non-defaulting party tries to replace the original transaction for his client at current market price. So he loses the profit, that would have accumulated between the date of original transaction and date of replacement transaction, had the counter party would not have defaulted, but not the principal because by that time he has not delivered his obligations. It can be reduced by reducing time gap between trading and settlement and by legally binding netting systems.

The Principal Risk: This risk arises when one party delivers obligations and the other party doesn’t.  This risk is rare in current day market scenario wherein the clearing corporation makes sure that delivery versus payment mechanism works properly. Clearing corporation acts as third party to every transaction and delivers the securities to the buyer upon receiving the funds and transfers funds to the seller upon receiving the securities.

Liquidity Risk:  When one of the parties defaults his/her obligations the other party looks for replacement. But it has to arrange funds/securities by borrowing from other members which may not have at that point in time.

Third Party risk:  This arises not because of the defaults by the original parties of the trade but by a third party for example failure of clearing bank, custodian etc. Allowing parties to have accounts with multiple clearing banks reduces this risk.

Systematic Risk: This risk arises because of operational risks like errors, frauds and outages and systemic risk for example failure of one part to deliver obligations may lead to the failure of other and it may lead to domino effect and complete failure of the settlement system itself.
 

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August 16, 2008 | Filed Under Stocks 

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