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3 Big Risks Singapore Exchange Limited Is Facing and How It Is Addressing Them

Singapore Exchange Limited (SGX: S68) is the only stock exchange operator in Singapore.

Any company, big or small, faces risks that could damage its business. In Singapore Exchange’s annual report for its fiscal year ended 30 June 2016 (FY2016), the company discussed the risks it has to deal with.

I thought it’d be very useful to share Singapore Exchange’s discussion. Understanding Singapore Exchange’s risks and how it is addressing them will help investors better evaluate the company’s future profitability.

Credit risk

One part of Singapore Exchange’s business model deals with the matching of buyers with sellers. The company “acts as a buyer to every seller and a seller to every buyer.”

Under this business, Singapore Exchange is put at risk in the rare instance that a member defaults. If such an event occurs, the company’s clearing house will need to manage and close-out the open positions of the defaulted firm. Singapore Exchange and other members may need to absorb the losses from the resulting market risk.

To manage such risks, Singapore Exchange has taken a number of actions, including:

1. Screening members at admission and reviewing them regularly.

2. Collecting margins for trades, and actively monitoring members’ positions so that “risk does not concentrate on any particular member.”

3. Having a default fund at the clearing house. The default fund is a pool of resources contributed by Singapore Exchange and its members to buffer against any losses arising from a default.

Liquidity risks

This risk follows from credit risk. If a member defaults, Singapore Exchange “may have a need for liquidity in honouring payment obligations to other members. This is because it will no longer receive payments from the defaulted member.”

Furthermore, Singapore Exchange’s clearing house uses commercial banks to facilitate the “day-to-day settlement of payments and safekeeping of customer monies.” A default by such a commercial bank can also cause liquidity risk to flare up for Singapore Exchange.

To manage liquidity risks, Singapore Exchange does the following:

1. Set aside resources to cover the risks.

2. Perform stress testing to ensure that even under extreme but plausible scenarios, the company will have sufficient cash resources and credit lines.

3. Work only with financially strong commercial banks, in addition to constantly monitoring the credit quality of the banks.

Operational risks

This category of risk relates to the daily running of Singapore Exchange’s business. Here, the main risks revolve around interruption to its business arising from situations such as distress to its staff (from terrorist acts or pandemics, for instance), cyber-attacks on the company’s IT systems, and service breakdowns on its systems.

To manage operational risks, these are some of the actions taken by the company:

1. Continuous monitoring of systems to ensure that specific performance criteria – such as predictable response times for critical business transactions, latency, capacity, and expected current, future and peak load – are met.

2. Have its technology and operations personnel work from two locations that are supported by dual data centres. The backup systems are also “designed to be running all the time in active or fault tolerant conditions and have recovery time objectives in line with PFMI-IOSCO [Principles for Financial Market Infrastructures, International Organisation of Securities Commissions] standards.”

3. Continuously improve its operational resiliency and preparedness for business continuity by studying from its own experience and that of its peers around the world.

4. Increase staff training in dealing with cyber-attacks and investing in cyber defense capabilities.

A Foolish conclusion

The above are three important risks, and how they’re managed, that Singapore Exchange shared in its FY2016 annual report.

Given that risks and the management of risks are part and parcel of running a company successfully, it is important that investors understand them before investing in any company.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. The Motley Fool Singapore has recommended shares of Singapore Exchange. Motley Fool Singapore contributor Lawrence Nga doesn’t own shares in any companies mentioned.