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NCFM Course in Hyderabad : Capital Market - Risks in Settlement
The two risks discussed below are inherent in a settlement system:
In case the parties did not discharge their obligations fully when due or at any time thereafter. This has two components, namely replacement cost risk prior to settlement and principal risk during settlement.
Replacement cost risk stirs up from the failure of one party’s 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 dates of original transaction and replacement transaction. The seller/buyer of the security loses this unrealized profit if the current price is below/above the transaction price. Both parties encounter this risk as prices are uncertain. It has been reduced by minimizing the time gap between transaction and settlement and by legally binding netting systems.
Principal risk arises from a scenario of one party discharges his obligations but the other one defaults. The seller/buyer of the security suffers this risk when he delivers/makes payment, but does not receive payment/delivery, this can be eliminated with delivery vs. payment mechanism, which ensures delivery against payment only. This has been reduced by having a central counterparty (NSCCL) which acts as the buyer to every seller and the seller to every buyer.
i) Liquidity risk, which is variant of counterparty risk and arises if one of the parties transaction does not settle on the settlement date, but later, the seller/buyer who does not receive payment/delivery when due, may need to borrow funds/securities to complete his payment/delivery obligation.
ii) Third party risk is another variant, which arises if the parties to trade are permitted or required to use the services of a third party which fails to perform. Ex. 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.
Which are operational, legal and systemic risks. 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. Systemic risk arises when 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.,
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