Systemic risk
Also written System-wide risk · Contagion risk
The risk that one participant's default triggers defaults by others until the settlement system itself fails — the domino risk, not the market risk.
In plain language
Read this first if you were looking for systematic risk. The two words differ by three letters and mean entirely different things:
| What it is | Who carries it | |
|---|---|---|
| Systematic risk | Undiversifiable market risk — the part of a price move that hits every position at once | Every investor, always |
| Systemic risk | The risk that the financial system itself stops working, because one default causes the next | The market infrastructure, and ultimately everyone in it |
Systematic risk is why your portfolio falls when the market falls. Systemic risk is why, in a bad enough default, there might be no market to fall.
The workbook's definition is the domino one: systemic risk arises when the default by one of the parties leads to the default of other parties too — the multiplier effect of one significant failure cascading into a failure of the system.
How it works
Chapter 7 sets systemic risk alongside the other risks a commodity exchange manages — replacement-cost risk, principal risk, market integrity risk, operational risk and legal risk. It is the one that is different in kind, because it is not a risk to one participant but to the mechanism they all clear through.
The defences are all pre-emptive, because a cascade cannot be stopped once it starts. The workbook names five:
- Stricter margining — collect the loss before it becomes a default
- Capital adequacy standards for members
- Settlement Guarantee Funds — a pool that absorbs a default rather than passing it on
- Legal backing for settlement activity, so netting and novation survive an insolvency
- Limits on exposure to the bank guarantees of any single bank — so that one bank's trouble cannot become the exchange's trouble
That fifth one is the clearest illustration of what systemic risk means in practice: the exchange is not worried about a bank's credit as such, it is worried about a channel through which one institution's failure reaches all its members at once.
A worked example
Work the cascade with the workbook's own gold numbers.
Client X is long one gold contract of 1 kilogram bought from Client Y at Rs 50,000 per 10 grams — a contract value of 50,000 x 100 = Rs 50,00,000. A hundred more members carry positions of the same size.
Gold gaps Rs 1,000 per 10 grams overnight. Each contract throws up an MTM of 1,000 x 100 = Rs 1,00,000.
- No infrastructure. Losing members owe winning members directly. A member who cannot pay leaves his counterparties short Rs 1 lakh per contract; they in turn cannot pay theirs. One failure becomes twenty. That is systemic risk.
- With infrastructure. The clearing corporation has already novated every trade and become the counterparty to both sides. It collected initial margin before the position opened, calls the Rs 1,00,000 MTM by the next morning, and if the member still fails, meets the obligation from the Settlement Guarantee Fund. The winning members are paid on time and the chain stops at one default.
The difference between the two paragraphs is the entire case for a clearing corporation — and it is why the workbook limits any single bank's guarantees, so that a hundred members' collateral is not all sitting behind one balance sheet.
Why NISM asks about it
Chapter 7 (Clearing, Settlement and Risk Management), section 7.8.6, which is the shortest of the risk sub-sections and one of the most examined, because it is a definition with a list of mitigants attached. Chapter 8 reinforces it by describing market infrastructure institutions as performing systemically critical functions. Expect a definition question, a "which of these is not a measure against systemic risk" item, and questions on the role of the Settlement Guarantee Fund.
Common exam traps
- Systemic is not systematic. Systematic risk is undiversifiable market risk that every portfolio carries; systemic risk is the failure of the financial system itself. Read the word twice before answering — the exam relies on the misread.
- Diversification does nothing for systemic risk. It cannot: the whole system is the thing failing. Diversification is the wrong answer to both, but for different reasons.
- It is not the same as principal risk or replacement-cost risk. Those are a single counterparty's default hitting a single participant; systemic risk is that default spreading.
- Novation and the clearing corporation do not remove it, they contain it — the workbook notes that exchanges guarantee financial settlement, not gross delivery settlement.
- The bank guarantee concentration limit is a systemic-risk measure, not a liquidity measure. It is a favourite distractor.
- Margining is a systemic-risk control as much as a credit control, because uncollected losses are what turns one default into many.
Check yourself
1.Which risk refers to the cost of substituting an original trade with a new trade, as the new trade may be done at a different and probably adverse price to the aggrieved party?
- a)Rollover risk
- b)Principal risk
- c)Replacement-cost risk
- d)Systemic risk
Show the answer
Answer: (c) Replacement-cost risk
(This is a sample question from the NISM workbook.)
"REPLACEMENT-COST RISK refers to THE COST ASSOCIATED WITH REPLACING THE ORIGINAL TRADE, as the new trade MAY GENERALLY BE DONE AT A PRICE DIFFERENT FROM THE ORIGINAL PRICES AND PROBABLY AT AN ADVERSE PRICE TO THE AGGRIEVED PARTY."
It is also called pre-settlement risk, and it is one of the two components of counterparty risk:
Component When it bites ⚠️ Replacement-cost (pre-settlement) Before settlement — the trade fails and must be redone at a worse price ⚠️ Principal ⚠️ During settlement — "arises when the buyer/seller HAS NOT RECEIVED THE GOODS/FUNDS BUT HAS FULFILLED HIS OBLIGATION" Option (b) principal risk is therefore the near-miss — and it is the one the market has genuinely solved: "ELIMINATED BY HAVING A CENTRAL COUNTERPARTY such as clearing corporation and through the principle of NOVATION." Replacement-cost risk cannot be eliminated the same way; it is instead compensated, through the replacement cost component of the delivery default penalty.
Option (d) systemic risk is broader — "the default by one of the parties LEADS TO THE DEFAULT OF OTHER PARTIES TOO... THE MULTIPLIER EFFECT."
2.The regulatory framework for commodity markets in India consists of three tiers. Which of the following is NOT one of them?
- a)Government of India
- b)Securities and Exchange Board of India
- c)Exchanges
- d)Forward Markets Commission
Show the answer
Answer: (d) Forward Markets Commission
(This is a sample question from the NISM workbook.)
"The THREE-TIERED REGULATORY FRAMEWORK for commodity markets comprises GOVERNMENT OF INDIA, SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI) AND EXCHANGES."
The Forward Markets Commission was the commodity regulator under the Forward Contracts (Regulation) Act, 1952 — and that Act "WAS REPEALED BY THE GOVERNMENT WITH EFFECT FROM SEPTEMBER 28, 2015."
The FMC appears as a distractor precisely because so much older literature on Indian commodity markets refers to it throughout. Anyone studying from a pre-2015 text will find it named as the regulator on every page.
What each surviving tier does:
Tier Role Central Government "FORMULATES THE BROAD POLICY with regard to THE RECOGNITION OF COMMODITY EXCHANGES AND THE LIST OF COMMODITIES PERMITTED FOR TRADING" SEBI "THE REGULATOR", with "TWIN OBJECTIVES OF PROTECTING THE INTERESTS OF THE INVESTORS AND TO PROMOTE THE DEVELOPMENT OF THE MARKETS" Exchanges Frame their own bye-laws, but "SUBJECT TO PRIOR APPROVAL BY SEBI" The chapter's stated purpose of regulation is worth remembering alongside: "to MAINTAIN AND PROMOTE THE FAIRNESS, EFFICIENCY, TRANSPARENCY AND GROWTH of commodity markets, PROTECT THE INTERESTS of stakeholders, REDUCE SYSTEMIC RISKS AND ENSURE FINANCIAL STABILITY."
Where this is taught
- Series XIX-D · Chapter 12: Fund Monitoring, Reporting and Exitintroduced here
- Series XVI · Chapter 7: Clearing, Settlement and Risk Managementintroduced here
- Series IV · Chapter 6: Trading Mechanism in Exchange Traded IRDintroduced here
- Series XIX-A · Chapter 10: Fund Monitoring, Reporting and Exitintroduced here
- Series XIX-C · Chapter 15: Fund Monitoring, Reporting and Exitintroduced here
Related terms
- NovationThe clearing corporation stepping into the middle of every trade — becoming the buyer to every seller and the seller to every buyer — so that neither side carries the other's default risk.
- Systematic riskThe part of an investment's risk that comes from economy-wide forces moving every asset at once — it cannot be diversified away, and it is the only risk the market pays you to carry.
- Clearing corporationThe entity that steps between every buyer and seller in the derivatives segment by novation, becoming the counterparty to both sides and guaranteeing that the trade settles.
- Initial marginThe deposit both the buyer and the seller of a futures contract must place before the position is accepted, sized to cover a 99% worst-case one-day loss on that position.
- Principal riskThe risk of having paid or delivered without receiving.
- Replacement-cost riskAlso called pre-settlement risk — the cost of substituting the original trade with a new one at a different and probably adverse price.
- Settlement Guarantee FundThe buffer held with the clearing corporation, funded by the exchange, clearing corporation, clearing members and settlement-related penalties, and drawn on through a default waterfall.
- Market riskThe risk of loss from movements in market prices — one named category in a manager's risk framework, alongside credit, liquidity and operational risk, and the one measured with VaR and stress tests.
- Unsystematic riskThe part of an investment's risk that belongs to one company or one issuer — a strike, a fraud, a downgrade — and which diversification can remove, unlike market-wide systematic risk.
- Central counterpartyThe clearing corporation that interposes itself in every exchange trade, becoming buyer to every seller and seller to every buyer, so neither side carries the other's credit risk.
- DiversificationSpreading an exposure across holdings that do not move together, so that total risk falls by more than total return does — minimising risk per unit of return.
- Credit Default SwapA contract in which a protection buyer pays a regular premium to a protection seller, who agrees to pay any loss in value on a specified reference obligation if a credit event such as default occurs.