Risks in Settlement

There are two types of risks in settlement system.

• Counterparty risk
• System Risk

1) Counterparty Risk

     Counterparty risk arises if parties do not discharge their obligations fully when due or at any time thereafter. These have two major components, replacement cost risk prior to settlement and principal risk during the settlement

1.1) Replacement Cost Risk

• The replacement cost risk arises from the failure of one of the parties to the transaction.
• While the non-defaulting party tries to replace the original transaction at current prices, he loses the profit that has accrued on the transaction between the date of the original transaction and date of replacement transaction.
• The seller/buyer of the security loses the unrealized profit if the current price is below/above the transaction price.
• Both parties encounter the risk as prices are uncertain.
• It has been reduced by reducing the time gap between transaction and settlement and by legally binding netting systems.

1.2) Principal Risk

• The Principal Risk arises if a party discharges his obligations but the counterparty defaults.
• The seller/buyer of the security suffers this risk when he delivers/makes payment, but does not receive payment/delivery.
• This risk can be eliminated by delivery vs. payment mechanism which ensures delivery only against payment.
• This has been reduced by having a central counterparty (NSCCL) which becomes the buyer to every seller and the seller to every buyer

1.3) Liquidity Risk

• A variant of counterparty risk is ‘liquidity risk’ which arises if one of the parties to transaction does not settle on the settlement date, but later.
• The seller/buyer who does not receive payment/delivery when due, may have to borrow funds/securities to compete his payment/delivery obligations.

1.4) Third Party Risk

• Another variant is the third party risk which arises if the parties to trade are permitted or required to use the services of a third party which fails to perform.
• For example, the failure of a clearing bank which helps in payment can disrupt settlement. This risk is reduced by allowing parties to have accounts with multiple banks. Similarly the users of custodial services face risk if the concerned custodian becomes insolvent, acts negligently etc.

2) System Risk

This comprises of operational, legal and systematic risks etc.

The operational risk arises from possible operational failures such as errors, fraud, outages etc.

The legal risk arises if the laws or regulations do not support enforcement of settlement obligations or are uncertain.

Systematic risk arises when the failure of one of the parties to discharge his obligations leads to failure by other parties. The domino effect of successive failures can cause a failure of the settlement system.

These risks have been contained by enforcement of an elaborate margining and capital adequacy standards to secure market integrity, settlement guarantee funds to provide counter-party guarantee, legal backing for settlement activities and business continuity plan etc.