Every financial institution knows the essential importance of legal data – it underpins everything from regulatory compliance and the management/optimisation of capital, liquidity, collateral and many of the operational logistics of doing business. Yet, despite the increased regulation and better understanding within the industry of the value of accurate and usable legal reference data for downstream business users, too few organisations have adequately addressed their legal data management. The consequences, particularly within the complex and increasingly regulated capital markets, are significant.
One of the key problems is that the governance of legal data is rarely adequately considered and defined within an organisation. Historically, in-house legal teams have existed in a different world to the business and reference data teams. The in-house legal role traditionally has been restricted to advisory guidance, both transactional and non-transactional, but has not touched on the realm of documentation storage and even less so the classification of associated meta-data of contracts and how best to collate, manage and distribute this information as required by the wider institution.
Where, therefore, does the responsibility lie for ensuring legal contract data is accurate and usable downstream, both internally and externally? Is the data owned by individual business data consumers; the trading desk that first trades under the legal contract; the IT team that owns the database; or the first system that receives and processes that data? How should legal team who created the contracts be involved in the management of the legal data they contain? Who is responsible for what when there is a change to the documentation templates and the required legal data terms require updating? According to an industry survey, 67% of financial firms reported that the question of who owns and is responsible for the accuracy of legal contract data was not clearly defined.
The traditional roles of data owner, steward and consumer have simply not been considered and applied in this critical area. This blind spot was highlighted by the financial crisis with the result that the regulators have found management of legal contracts within the industry to be not fit for purpose, particularly in respect of OTC derivatives contracts.
One of the most complex types of documentation entered into by capital market participants is the International Swaps and Derivatives Association (ISDA) Master Agreement and its related annexes. Most OTC derivatives are documented under this documentation, although there are a number of slightly simpler local domestic master agreements. Derivatives documentation is highly complex and technical, often more so than loan documentation. This is primarily a result of the key close- out netting treatment these master agreements seek to achieve and the fact that both parties take on credit exposure with each other, so many of the provisions need to contain mutual protection for those
parties. (Close-out netting is a credit risk mitigating technique based on the cancellation of a series of open executory contracts between two parties on the default of the counterparty and the set-off of the resulting gains and losses.)
A major reason behind the successes and exponential growth of the over- the-counter(OTC) derivatives industry over the past 25 years has been the publication of industry templates to help standardise documentation. A wide range of related documentation materials has been published by the ISDA trade association to ensure the enforceability of netting and collateral provisions, helping to significantly reduce credit and legal risk. The close-out netting facilitated by the documentation architecture has reduced the OTC derivatives’ credit exposure by over 85% — without the benefit of netting, banks worldwide might face a capital shortfall of over US$500bn.
The documentation is split into modular components, which can be easily combined as required by the contracting parties to achieve the desired commercial and legal effect. The master agreement sits at the heart of the relationship, governing the main commercial and credit terms between the parties, with annexes to deal with specific requirements — such as a credit support annex (CSA) to mitigate credit risk through collateralisation — as well as numerous trade confirmations (which contain the economic terms of each specific transaction between the parties).
Although successful from a traditional legal perspective (i.e. putting adequate documentation in place), this modular architecture is now causing major data challenges.
Architectural & Content Complexity
The modular architecture proliferates the number of key documents a firm needs to track and maintain, as well as needing to sew up the various modules in a manner that preserves the meaning of the contract as a whole. The historical lack of importance placed on the legal data meant that, in many institutions, storage and collation of the legal documentation data was performed not by those who understood the documents and the way in which the modules combined, but by paralegals or temps. Or, indeed, where consumers who needed that data found shortcomings, by downstream operational teams, typically creating another silo of legal contract data. Collateral management teams are a good example of this. Of course, the legal data held within the collateral systems are purely for the benefit of the collateral management team and therefore the wider, non-collateral context to the data is lost. Given that the context of the data can completely change its meaning, this is, in the context of mandated regulatory reporting, causing significant data accuracy issues. But that is where one can even find the documents!
Many firms are simply oblivious to the important nuances of the different modules and how they combine, as well as the contractual wording they contain. For regulated financial firms, the consequences of this have been beyond a simple contractual breach, ranging from large regulator fines and sanctions (e.g. breaches of client asset and segregation regulation, incorrect liquidity and regulatory capital calculations (and regulatory reporting)) and significant incorrect assessment of risks and therefore pricing of portfolios — all carrying significant reputational and financial consequences.
Fixing The Problem
Many of the issues detailed are the simple product of a lack of engagement from those with a sufficient grasp of the legal detail with the processes and systems which are reliant on legal contract data.
Industry-wide there is a lack of ownership, accountability and responsibility regarding:
• storage of legal contracts, terms and conditions; and
• key legal terms required by an institution’s internal and external consumers (both in terms of what these terms are and the accuracy of the data captured).
Data governance is the key starting point for curing these issues. For this to occur, firms must internally reach a collective understanding that legal data is a common asset of their firm, requiring adequate rigour and governance to be applied to it. It is important, therefore, that in-house legal teams recognise their role in curating the legal data.
Legal data forms an essential part of risk data aggregation and its reporting, key business optimisation data and operational data required to be regulation compliant. The regulatory requirements following from the financial crisis need a holistic approach to data governance, not a silo-based approach targeted at specific datasets and domains, and the legal data domain is perhaps one of the ones in most urgent need of attention. The banking industry is finally awakening to the cultural change required in order to maximise the value of legal data as an asset, which requires a far more focused, reference data approach to allow it to be fully exploited.