Why risk management in equity clearing and settlement is critical for market stability

In today’s dynamic world of equity markets, every trade represents an agreement between two parties to exchange of cash and securities on a future date. This agreement ensures that trade is not only executed but honoured, settled, and risk-free. In this context, the importance of risk management in equity clearing and settlement cannot be overstated. It is the unseen safeguard that ensures the visible trust investors place in the market. That’s why risk management in clearing and settlement plays a vital role in maintaining the safety and integrity of the financial system.

The risks associated in the trade to settlement process

In Sri Lanka every time equities are bought or sold; there’s a time gap between trade execution and final settlement of two days with T+2 settlement cycle. This gap might seem short, but it introduces several layers of risk:

• Counterparty risk: The risk that one party in a transaction default on its obligations.
• Market risk: The risk of market prices moves unfavourably prior to the settlement.
• Liquidity risk: The risk that parties may not have sufficient cash or securities to meet settlement obligations when due. 
• Operational risk: The risk of failure due to system errors, human mistakes, or processing delays.

If adequate controls are not in place, the consequences can be far-reaching and severe. Particularly when markets are in a growth stage and volumes increase exponentially, large-scale defaults can potentially trigger market instability, while liquidity crunches may cascade through the financial ecosystem, amplifying systemic risk. This makes strong risk management not merely an operational requirement, but a fundamental imperative for market integrity and resilience.

Why risk management matters in post-trade infrastructure

In absence of proper safeguards, a failure of a single market participant to meet its obligations could trigger a ripple effect, compromising other participants, straining liquidity, and ultimately shaking investor confidence.

Thus, a robust risk management system in post-trade operations not only contains these risks but also ensures that the market remains operational even when individual participants face stress. For a developing market like Sri Lanka, building such resilience is vital for both domestic market growth and attracting international participation.

The International Organisation of Securities Commissions (IOSCO) laid out Principles for Financial Market Infrastructures (PFMIs) that set clear expectations for post-trade institutions. These principles cover a wide range of areas, including governance, credit and liquidity risk management, default procedures, and operational reliability to emphasise transparency, accountability, and a proactive approach to managing the unexpected.

This is where the Central Counterparty (CCP) plays a vital role. A CCP is a specialised clearing entity that guarantees the completion of trades, even if one side defaults. As Sri Lanka prepares to enter a new phase in post-trade infrastructure with the CCP implementation, these reforms will not only strengthen operational resilience but also create the conditions necessary for a more vibrant, liquid, and internationally competitive market. For Sri Lanka, aligning with these global standards is more than a compliance requirement, it is a strategic step toward facilitating a new era of capital market development.