The Colombo Stock Exchange (CSE) yesterday announced the proposed establishment of an Institution to act as a Central Counterparty (CCP) for all secondary market transactions on the CSE. This institution which is a 100% owned company of the CSE will act as a Central Counter Party and guarantee settlement of cash and delivery of securities for all secondary market transactions on the CSE. The CSE said it therefore expects to launch the CCP in January 2017 provided all the necessary regulations are in place.
“This is a ground breaking initiative launched with the approval of the Securities and Exchange Commission of Sri Lanka (SEC) to set up Clearing Company to act as a Central Counterparty to guarantee settlement of Equity and Corporate Debt securities traded on the CSE to address a key risk prevalent in the Colombo Stock Market,” the CSE said in a statement.
Presently for equity securities, 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 3 market days from the transaction date (T+3), thus exposing the seller to a 3 day settlement risk
In guaranteeing the settlement of a transaction, the CCP would act as a buyer to the seller and the seller to the buyer in all secondary market transactions. 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, i.e. the CCP substitutes itself as a counterparty to the transaction.
The initial steps prior to the CCP project which commenced in 2014 with the commissioning of the state of the art new generation Central Depository System moved to its second phase in 2015 with the development of new Broker Back Office (BBO) systems and Order Management Systems (OMS) which will be commissioned in full by March 2016.
The CCP project will now move into its third phase in December 2015 with the incorporation of a separate institution for the purpose of guaranteeing settlement and commence procurement of the necessary IT infrastructure and systems and the formulation of the rules and regulations and legislation to enable CCP.
The statement by CSE noted that although certain stringent measures have been imposed by the CSE over the years to minimize the settlement risk and none of the Stock Brokers and Custodian Banks have defaulted payments, the globally accepted mechanism for minimizing the settlement risk is through a Central Counter Party 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.
“This initiative to set up a Central Counter Party (CCP) system would bring the CSE closer to its goal of achieving a world class status. This is a major development of the post trade market infrastructure of the CSE and would be the most significant development of market infrastructure at the CSE since the Automation of Trading in 1997,” the CSE said.
This does not mean that a CCP 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 system has been identified and recommended by International Organization of Securities Commissions (IOSCO) as the best practice to adhere for clearing and settlement.
A Central counterparty will strengthen the overall market integrity. Having a central counterparty in place is a requirement for CSE to be categorized as an emerging market exchange. In addition, to expand to other tradable derivative products such as a Futures and Options, a CCP is a necessity as the risks associated with the trading of such instruments are relatively high.
Apart from the benefit of significantly minimizing the settlement risk in the stock market the establishment of a CCP will enable the CSE to commence the next ground breaking initiative of establishing a derivatives market in Sri Lanka.
The regulatory approvals from the SEC for the project have been obtained. The new Company which will act as a CCP which will be incorporated shortly will formally seek a license from the SEC.
The Consultants selected for the project are BTA Consulting (BTA) of the United Kingdom who are providing Consultancy and Project Management services to set up the Clearing House. BTA Consulting is a UK based consultancy firm specializing in capital market related assignments globally having specialists with exposure to most global capital markets.
The consultancy is being jointly funded by the CSE and SEC and the Central Bank of Sri Lanka also funded 1/3 of the consultancy fees of the initial phase. The infrastructure and IT systems would be made by the CSE.
The project to establish a CCP will be completed in the following 5 phases:
1 Requirement gathering & Inception Report
2 Procurement & Vendor Management
3 Legal, Regulatory & Operational Documentation
4 Operationalize CCP & Go Live
5 Post Live Period
Phase 1 of the project has been completed and the Inception Report was approved by CSE and SEC.
Phases 2 and 3 will run in parallel and is scheduled to start in December 2015.