Are Indian CCPs prepared for high impact NDLs?

Other than broker default, a CCP can also confront non-default losses (NDLs). These NDLs can arise due to its business or operational failures (which can occur due to cyber-attacks, employee frauds, IT system failures, etc.), investment risks, custodial failure, and legal and regulatory risks. As of now, there has been no such episode which can help to ascertain the magnitude of such NDLs. Nevertheless, research suggests that the amount of money could be large enough to impact the survival of a CCP and could be more serious than the risks posed by a broker default. A severe NDL calamity can result in insufficient financial resources held by the CCPs, leading to systemic failure.

Of late, such NDLs have gained traction and this has become a debatable issue. There are a few associations and market infrastructure institutions (MIIs) that advocate the recognition of NDLs and suggest that it is critical for CCPs to quantify losses arising from such NDLs by analysing various scenarios. For instance, some CCPs, during their stress tests, take into account extreme adverse business and operation situations wherein they experience financial losses from system outages and cyber-attacks. This helps them to pre-empt risks from NDLs and allocate resources to meet the risk. Some CCPs have also deployed the Basel II framework for quantifying the level of risks. However, there cannot be a fixed template as each CCP differs as per its ownership structure, business strategy, and technology and face different risks and have different loss allocation mechanisms. For instance, some world class CCPs do not allow the spillover of the business and operational risk to clearing members while sharing investment and custodial losses.

The world’s largest clearing members apprehend that losses arising from NDLs will easily percolate down to the clearing members by CCPs. They advocate CCPs taking full-responsibility for NDLs and suggest supervisory authorities to establish clear standards for dealing with such risks. External insurance is another measure prescribed by many of these members.

In India, at the regulatory level, Sebi has prescribed risk-based capital and net worth requirements for clearing corporations to ensure that CCPs adequately capture the risks faced by them . Granular norms have been issued to fortify against credit risks, business risks, and legal and operational risks. Further, critical frameworks have been laid down to aid cybersecurity, orderly winding down of critical operations/services of clearing corporation. Accordingly, the Indian CCPs have developed world class robust risk management framework and are highly capitalized to mitigate business risk. They also have well defined policies for managing custody and investment risk. However, a few questions need to be addressed: Are CCPs conducting analysis of specific non-default risks to quantify losses? Quantification is the key here. Is the level of stress testing for NDLs as rigorous as in the case of broker defaults? Are CCPs assessing resource sufficiency for NDLs? Is mere fulfilment of regulatory requirements enough to tide over the NDL challenge? Talking about business risk, one can never pre-empt the severity of a cyber-attack, therefore it is best to be armed for the worst.

The CCPs need to be nudged further for gauging their preparedness for any kind of NDL. CCPs can face one NDL event or multiple NDLs together or simultaneously with broker default. Having an explicit NDL management is therefore fundamental. The CCPs should explicitly disclose their methodologies for identifying potential NDL scenarios and the resources and tools employed for averting NDL crisis of any magnitude in their rule books. Overall, it would foster confidence, promote operational effectiveness, result in best governance practices and transparency in Indian securities market ecosystem.

The author is working with the National Institute of Securities Markets. The views expressed in this article are personal.

Updated: 04 Sep 2023, 11:16 PM IST