Central Counter Party to guarantee settlement of financial transactions
The Colombo Stock Exchange (CSE) recently announced the proposed establishment of an institution to act as a Central Counterparty (CCP), which is an entity that will take up the risk of transaction in the market in the event of a clearing and settlement failure.The CCP inserts itself between counterparties to financial contracts traded in one or more markets (becoming the buyer to every seller and the seller to every buyer) and this will fast track the demutualisation (the process through which a member-owned company becomes shareholder-owned) of the CSE.
“In order to guarantee settlement of the financial transaction, the CCP acts as a buyer for all sellers and seller for all buyers in all secondary market transactions,” Rajeeva Bandaranaike, CEO CSE told the Business Times on the sidelines of a media conference on CCP. This institution is a 100 per cent owned company of the CSE. Now for equity securities(shares) the delivery of shares from the seller to the buyer occurs immediately upon execution of the share transaction while the fund settlement to the seller takes place only after three market days from the transaction date (t+3), thus exposing the seller to a three day settlement risk.
“Although certain stringent measures have been imposed by the CSE over the years to minimise the settlement risk and none of the stock brokers and custodian banks have defaulted payments, the globally accepted mechanism for minimising the settlement risk is through a CCP system under a Delivery Vs Payment (DVP) settlement environment where the securities and funds are exchanged simultaneously, finally with full irrevocability on the settlement day,” Mr. Bandaranaike said.
With a CCP in place the CSE will see a 20 to 30 per cent like in turnover, he said. Industry analysts say that Sri Lankan capital market involves high risk. CCPs benefit both parties in a transaction because they bear most of the credit risk. If two individuals deal with one another, the buyer bears the credit risk of the seller, and vice versa. “When a CCP is used the credit risk that is held against both buyers and seller is coming from the CCP, which in all likelihood is much less than in the previous situation,” an industry analyst said. A CCP will add to the liquidity of the market because it tends to reduce risks to participants, he added.
Mr. Bandaranaike added that this process is identified as ‘novation’ which refers to the legal act of replacing the original contract between the buyer and the seller with two contracts between the buyer and the CCP and the seller and the CCP.
“This is a major development of the post trade market infrastructure of the CSE and would be the most significant development of market infrastructure since the Automation of Trading in 1997.”He said establishing a ccp does not mean that it eliminates the default risk altogether,
but will guarantee settlement by ensuring that it has sufficient resources to handle this risk through a range of ‘exception handling mechanisms’ such as collateral in the form of margins and the ability to cover the delivery failures of securities through a ‘Buy in’ mechanism, stock borrowing and lending and, as a last resort, by way of a cash settlement. “A CCP helps to attract international capital and recognition and increases liquidity due to reduced counterparty risk, netting/capital compression, collateralisation, anonymity, reduced principal and agency risk,” he said, adding that in a country with scarce capital a CCP is essential for capital market development.