Risk Management - Preventive & Corrective Measures
Capital Adequacy Requirements
The ability to identify and monitor risks on an ongoing basis is crucial for a clearing and settlement organisation. The strategy is to avoid, as much as possible, situations that can create unacceptable levels of risk for the clearing and settlement organisation and its participants. It is in this context that the CDS mandated international consultants to carry out a risk review and make recommendations on the risk management and monitoring policies of the CDS. One of the main recommendations of the consultants was the setting up of capital adequacy requirements for the CDS participants as a first line of defence against risk. The stability and financial health of participants in the clearing and settlement services is an important indication of potential trouble.
Since November 1999, the CDS has implemented a set of rules on conditions for participation called Financial Resource Requirements. These rules require each stock broking company to have sufficient adjusted liquid capital to cover its fixed expenditure base requirements and risk (position, counter party and foreign exchange) requirements. Stock broking companies are required to submit monthly returns to allow CDS to monitor compliance with the Financial Resource Requirements.
The Business Conduct Commitee
Since its inception in 1997 and in accordance with CDS Rule 1.4, the CDS has set up a Business Conduct Committee (BCC) with the following mandate:
1. Recommend the adoption of a risk management policy to the Board of Directors
2. Monitor the operations relating to risk management issues
2.1 Ensure enforcement of the risk management policy being adopted, at all levels of the organisation
2.2 Ensure compliance with the requirements of Rule 3.8.7 with regard to the review of internal control
3. Monitor the operations relating to the Guarantee Fund
4. Hear complaints from aggrieved Participants who claim to be adversely affected by any decision of CDS with respect to CDS operations in accordance with Rule 2.4
5. Make recommendations to the Board of Directors of CDS with respect to Participation Applications in accordance with Rule 2.2.4 and to Termination in accordance with Rule 2.3.3.
As per Rule 1.4.2, the Business Conduct Committee is composed of a majority of members who are not members of the Board of CDS, nor Participants or related to Participants, and not employed by a Participant.
In accordance with Section 3(8a) of the Securities (CDS) Act 1996, the CDS has set up a Guarantee Fund for the purpose of providing an indemnity against any default in respect of payments for or delivery of securities and of obligations of Participants towards CDS. The CDS Guarantee Fund is used to guarantee the settlement of transactions in the event of a default by a Participant. In such a situation, the Guarantee Fund steps into the net settlement mechanism and makes good the obligation of the defaulting Participant. The Guarantee Fund acts as a shock absorber in the event of a settlement failure and thus prevents the market from collapsing through systemic effect. The Guarantee Fund contributes to create confidence in the stock market. It is important to note that to date there has never been any failed trade in the CDS.
The Fund is constituted of cash contributions by investment dealers and CDS, as well as Letters of Credit provided by investment dealers. The CDS contributes part of the fees that it levies on transactions effected by investment dealers (as principal or on behalf of their clients) to the Fund. The assets of the Fund are segregated from those of the CDS (separate bank accounts) and are available only for the purpose of the Fund as required by law. The Fund is independently managed by the Business Conduct Committee. The size of the Fund as at 30th June 2012 was as follows:
Cash Rs 26,532,827
Standing Line of Credit Rs 50,000,000
Letters of Credit and Deposits (Collateral) Rs 25,107,500
Dealing with Funds Settlement Failures
Each stock broking company has a settlement limit that is based on the amount of collateral (cash and letters of credit) provided to the CDS. The minimum amount of the collateral required for each stock broking company is based on the moving average of its Cumulative Liability over the past 12 months.
CDS monitors the settlement obligation of each stock broking company on a daily basis. Stock broking companies are not allowed to trade beyond their settlement limits unless additional cover is provided.
If a stock broking company fails to meet its settlement obligations, the CDS will have recourse to the stock broking company’s letter of credit and to the Guarantee Fund to meet the defaulting stock broking company’s obligations.
Dealing with Securities Settlement Failures
The CDS system checks the securities balance each time a trade is allocated to a client’s account. Á trade cannot be allocated to a client’s account if there is an insufficient balance of securities in the account. In case of failure by the stock broking company to allocate the trade within the prescribed deadline or if a trade that has been allocated to the client of a custodian bank is not accepted by the latter, the trade is automatically posted to the account of the stock broking company. If the latter does not have the securities in its account, a negative balance will be shown. CDS monitors negative balances in the proprietary accounts of stock broking companies and applies a penalty on a daily basis. Any negative balance in the securities account of a stock broking company must be rectified before T+3, failing which buy-in procedures are initiated. To rectify the negative balance, the stock broking company may allocate the trade to another client or it may borrow the securities from a lender.
If the negative balance is not rectified before T+3, CDS initiates buy-in procedures against the defaulting stock broking company. The latter is requested to provide a cash deposit equal to 50% of the value of the failed transaction. If the buy-in is successful or the trade is subsequently confirmedor a loan transaction is reported to settle the trade, then CDS will return the cash deposit to the defaulting Participant.
When buy-in is completed, notwithstanding whether it is successful or not, the CDS will use the cash deposit to compensate all the buyers involved in each turnaround trade linked to the failed trade, except the buyers involved in the last transaction in each chain of turnaround trades, by paying them an amount equal to 50% of the difference between the price at which they bought the securities and the price at which they subsequently sold the securities.
If after 5 trading sessions the buy-in is unsuccessful, CDS will also use the cash deposit to compensate the buyers in the last transaction in each chain of turnaround trades linked to the failed trade, by paying them an amount equal to 15% of the value of the securities that remain undelivered after the buy-in and CDS will request the SEM to cancel the failed trade together will all turnaround trades linked to it.
In a situation where there is no turnaround trade linked to the failed trade, the failed trade will be treated as the last transaction in a chain of turnaround trades.
System of Internal Controls and Audits
The CDS has implemented a system of internal controls pertaining to:
1. The recording of transactions in securities accounts
2. The processing of transactions, including clearing and settlement, in accordance with CDS Rules and Procedures
3. The integrity and reliability of the data processing facilities
The suitability and effectiveness of the system of internal controls are verified by external independent auditors on an annual basis.
In addition, internal auditors perform monthly audits on the operations of the CDS. The results of these operational audits are reviewed by the Business Conduct Committee.
Securities lending to avoid delivery failures is available as from 11 th April 2008. The CDS Rules and Procedures have been amended with the approval of the Financial Services Commission (FSC) to cater for turnaround trading and securities lending. A loan transaction that is reported to CDS is settled on the next day by the transfer of securities from the lender’ securities account to the borrower’s account coinciding with the payment of the collateral and the premium by the borrower to the lender, through the settlement service of the CDS .