21st Century Liability – Legal Risk In Focus

challenged in courts to ensure certainty and eliminate liability for any injured party. The amount at risk in central clearing dwarfs the current day value of the risks at the time in the gilt market. And one can add to that toxic option of frozen settlement pending completion of legal process, the possibility that hedge funds see that event as an opportunity and adopt the same approach as they have in leveraging the Greek, Argentine or Venezuelan debt crises.

During my career, I have come up against two major horror stories on legal risk. The first was in 1991 when Hammersmith and Fulham, a UK municipality, argued that the swaps it had taken out were invalid as the municipality had acted ultra vires and, although the malfeasance was by the municipality, banks had to unwind this, and many other similar, swaps at great expense to themselves. The second came in 2008 with Lehman Brothers where the perils of rehypothecation were first identified at a potential cost of some billions to the industry.

Network managers should peruse carefully their legal documentation, including RFPs, side letters, operating manuals, emails and texts or notes and recordings on verbal communications. Are there potential pitfalls that could provide the third of my career horror stories on legal risk? Candidates for inclusion are multiple. Delivery versus payment are three simple words loaded with liability. Novation of contracts is a demanding concept especially where there could be conflict of cross border jurisdictions. The legal liability for safety of client assets is a pitfall for the unwary that has been born of the good intentions of AIFM and UCITS legislation. And overshadowing all of these are the concept of caveat venditor, regulatory ambiguity and post event hindsight.

DvP, or “Delivery versus Payment”, really worries me for it used so casually across multiple aspects of our business. The legal definition has to be simultaneous and final exchange of cash and stock on an irrevocable basis. Markets like T2S have the concepts hard wired into their platforms and any legal analysis would assume that is inviolate. But many other markets move cash and securities independently, linked by the concept of freezing one or another and a contractual arrangement that is written into the market rule books. We may be far from the days when markets with next day payment finality or the potential for payments (but not stock) to be unwound on default claimed this constituted DvP, but the reality is that many of the arrangements in markets are just that - arrangements - rather than certainty, especially when default may be cross border and occur during the processing runs of the impacted markets.

Novation of contracts is a splendid tool for risk reduction. But it is a tool that could come under scrutiny in the event of a default. Perhaps it will survive challenge but the sheer quantum of value that is novated makes me nervous. Imagine frozen settlement across multiple clearings, for that is, albeit remote, a possibility. I recall a conversation with the indigenous insolvency practitioners, as we introduced DvP into the UK gilt market in the late 1980’s. Quite simply, at a meeting where I represented the UK banking industry, the chairman of their august, if somewhat macabre, association explained that the legal structure we had put in place looked robust but would, in a default, need to be the client, especially if they represent the individual saver, the pension fund or another entity whose losses could hit compensation funds or state coffers. Regulatory ambiguity serves the same purpose and network managers are faced with the impossible task of identifying such pitfalls often in remote locations with untested legal systems. Overshadowing all this is that post event hindsight that now dictates that the network manager is the expert who should have realised in advance the fact that Hammersmith were acting ultra vires; or that Lehman were rehypothecating stock and that impaired the ownership chain. Welcome to liability twenty first century style!

Safety of client assets has become a buzzword but it is often ill defined. First of all, there remains a lack of clarity as to the boundaries between commercial liability, agent or counterparty performance and country or CSD risk. There is a potential legal challenge if ever a case impacts an investor, as distinct from an issuer, CSD or even one of the ICSDs where agents have a choice of CSD location. A further dangerous boundary is between assets held protected for AIFMD or UCIT purposes and all other assets. If they are held in the same manner, there is an illogicality in ever treating them differently. I assume it would be commercial suicide to do so, even if a legal challenge did not work.

John Gubert Chairman, GTL Associates

When I started in business the mantra was caveat emptor or buyer beware. Contractual agreements, at that time flimsy documents of 6-8 pages, were mainly about codifying the absence of liability for the seller. Regulation has changed that and the pendulum has moved to seller beware or caveat venditor. Those carefully crafted areas of ambiguity in legal documents or those casual comments on related papers, will in this day and age more likely be interpreted to favour

Risk Management

The cascading effect of a default on contracts between institutions could have heavy repercussions for the whole financial community. The underlying risk behind this kind of default is a counterparty risk and has to be considered as a credit risk that financial banks have to face when entering into contractual relationships with each of their peers.

During the last ten years, central banks, clearing houses, banks and many other financial institutions successfully implemented new practices to mitigate risks. In 2017, the European Central Bank (ECB) published its ECB Guide on Materiality Assessment (EGMA) related to changes or extensions in counterparty credit risk models in order to promote a day-to-day supervisory dialogue with banks.

In parallel, during the last ten years technology was able to manage more data close to real-time with a more pragmatic and efficient level of risk management, on a worldwide basis. One of the key focuses of the industry was to ease changes and extensions to internal models used to calculate counterparty credit and credit valuation adjustment risks of internal representatives of the banks and business partners.

The aim is to reinforce the capability of the systems supporting counterparty risk for any type of institution: Banks, Government Entities, Financial Institutions, Insurers, Securities Firms, Fund Managers. In this area, technology will be key to providing more flexibility and more predictive information.

SLIB has been a recognised software provider in the risk management space for more than fifteen years with a strong focus on counterparty risk.

SLIB is now launching its new risk management solution - a multi-layer framework to aggregate information from multiple sources in different ways to support a high capacity of analysis.

Basically, SLIB system provides extensive and easy connectivity to European and Asian markets, enabling multi-activity risk steering, either by running SLIB’s cross-market algorithm based on VaR, replicating external risk algorithms, or even connecting to a client’s private ones.

Running continuous exposure re-assessment on consolidated portfolios against a flexible scale of alerts, this new risk management platform provides centralized and reactive monitoring ability.

The software embeds datalake technology to support multi-axis data analytics, drill-down research to detect anomalies, long-term trends to adjust credit limits and margin requirements.

Closer to business. Clear and sharp.

You already trust BBVA, as service leaders in Spain and Latin America, for transactional banking. What about your longer term requirements? BBVA provides a wide range of custody and securities servicing solutions to clients around the world. It’s in-depth market knowledge, highly quali ed teams and ability to match client needs with customised solutions, make BBVA the perfect partner for securities services in Spain.

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