Clearing companies, also called central clearing counterparties (CCPs), clear and settle trades in securities carried out on inventory exchanges. These CCPs assume an vital position in guaranteeing environment friendly execution of all trades by standing as a counterparty, i.e. as purchaser to all of the sellers and vendor to all of the patrons. This is completed by means of intensive danger administration. The core operate of those CCPs is to protect in opposition to the chance of a dealer default; in such instances, CCPs perform the obligations of the dealer.
Other than dealer default, a CCP may also confront non-default losses (NDLs). These NDLs can come up attributable to its enterprise or operational failures (which may happen attributable to cyber-attacks, worker frauds, IT system failures, and so forth.), funding dangers, custodial failure, and authorized and regulatory dangers. As of now, there was no such episode which may help to establish the magnitude of such NDLs. Nevertheless, analysis means that the sum of money could possibly be giant sufficient to impression the survival of a CCP and could possibly be extra critical than the dangers posed by a dealer default. A extreme NDL calamity may end up in inadequate monetary sources held by the CCPs, resulting in systemic failure.
Of late, such NDLs have gained traction and this has turn out to be a debatable situation. There are just a few associations and market infrastructure establishments (MIIs) that advocate the popularity of NDLs and counsel that it’s crucial for CCPs to quantify losses arising from such NDLs by analysing numerous eventualities. For occasion, some CCPs, throughout their stress assessments, bear in mind excessive adversarial enterprise and operation conditions whereby they expertise monetary losses from system outages and cyber-attacks. This helps them to pre-empt dangers from NDLs and allocate sources to fulfill the chance. Some CCPs have additionally deployed the Basel II framework for quantifying the extent of dangers. However, there can’t be a set template as every CCP differs as per its possession construction, enterprise technique, and know-how and face totally different dangers and have totally different loss allocation mechanisms. For occasion, some world class CCPs don’t permit the spillover of the enterprise and operational danger to clearing members whereas sharing funding and custodial losses.
The world’s largest clearing members apprehend that losses arising from NDLs will simply percolate right down to the clearing members by CCPs. They advocate CCPs taking full-responsibility for NDLs and counsel supervisory authorities to ascertain clear requirements for coping with such dangers. External insurance coverage is one other measure prescribed by many of those members.
In India, on the regulatory stage, Sebi has prescribed risk-based capital and web price necessities for clearing companies to make sure that CCPs adequately seize the dangers confronted by them . Granular norms have been issued to fortify in opposition to credit score dangers, enterprise dangers, and authorized and operational dangers. Further, crucial frameworks have been laid down to assist cybersecurity, orderly winding down of crucial operations/companies of clearing company. Accordingly, the Indian CCPs have developed world class strong danger administration framework and are extremely capitalized to mitigate enterprise danger. They even have nicely outlined insurance policies for managing custody and funding danger. However, just a few questions must be addressed: Are CCPs conducting evaluation of particular non-default dangers to quantify losses? Quantification is the important thing right here. Is the extent of stress testing for NDLs as rigorous as within the case of dealer defaults? Are CCPs assessing useful resource sufficiency for NDLs? Is mere fulfilment of regulatory necessities sufficient to tide over the NDL problem? Talking about enterprise danger, one can by no means pre-empt the severity of a cyber-attack, due to this fact it’s best to be armed for the worst.
The CCPs must be nudged additional for gauging their preparedness for any form of NDL. CCPs can face one NDL occasion or a number of NDLs collectively or concurrently with dealer default. Having an express NDL administration is due to this fact elementary. The CCPs ought to explicitly disclose their methodologies for figuring out potential NDL eventualities and the sources and instruments employed for averting NDL disaster of any magnitude of their rule books. Overall, it could foster confidence, promote operational effectiveness, end in greatest governance practices and transparency in Indian securities market ecosystem.
The writer is working with the National Institute of Securities Markets. The views expressed on this article are private.
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Updated: 04 Sep 2023, 11:16 PM IST
