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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
A practical, informative guide to banks' major weakness Legal Data for Banking defines the legal data domain in the context of financial institutions, and describes how banks can leverage these assets to optimise business lines and effectively manage risk. Legal data is at the heart of post-2009 regulatory reform, and practitioners need to deepen their grasp of legal data management in order to remain compliant with new rules focusing on transparency in trade and risk reporting. This book provides essential information for IT, project management and data governance leaders, with detailed discussion of current and best practices. Many banks are experiencing recurrent pain points related to legal data management issues, so clear explanations of the required processes, systems and strategic governance provide immediately-relevant relief. The recent financial crisis following the collapse of major banks had roots in poor risk data management, and the regulators' unawareness of accumulated systemic risk stemming from contractual obligations between firms. To avoid repeating history, today's banks must be proactive in legal data management; this book provides the critical knowledge practitioners need to put the necessary systems and practices in place. * Learn how current legal data management practices are hurting banks * Understand the systems, structures and strategies required to manage risk and optimise business lines * Delve into the regulations surrounding risk aggregation, netting, collateral enforceability and more * Gain practical insight on legal data technology, systems and migration The legal contracts between firms contain significant obligations that underpin the financial markets; failing to recognise these terms as valuable data assets means increased risk exposure and untapped business lines. Legal Data for Banking provides critical information for the banking industry, with actionable guidance for implementation.
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Veröffentlichungsjahr: 2019
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Table of Contents
Cover
Preface
Acknowledgements
1 The Role of Data in a Financial Crisis
The Financial Crisis – Looking Back
Causes of the Financial Crisis
Systemic Financial Contagion
The Legal Data Consequence
Bibliography
Notes
2 The Law, Legal System and Basics of Contract Law
Legal Systems and Traditions
Governing Law
Contract Formation
Guarantees and Indemnities
Enforceability of Contracts
Battle of the Forms
Principal and Agent
Contract Law and Important Overlaps
Bibliography
Notes
3 Structured Finance and Financial Products – Derivatives
Derivatives
Derivatives – Product Families
Derivatives – Asset Classes
Documentation of OTC Derivative Contracts
Close‐Out Netting
Single Agreement Concept
Flawed Asset Provisions
Close‐Out Mechanics
Trade Confirmations
Protocols
Brief Guide to the 1992 ISDA Master Agreement (Multicurrency – Cross Border)
Bibliography
Notes
4 Data, Data Modelling and Governance
What is Data?
Legal Data Governance
Contractual Taxonomies
Bibliography
Notes
5 BCBS 239 – Legal Data in Risk Aggregation
What is the Basel Committee on Banking Supervision and BCBS 239?
Typical Implementation Issues to Achieve Compliance
Bibliography
6 Capital and Netting
What is Regulatory Capital?
Bibliography
Notes
7 Collateral – Enforceability, Reform and Optimisation
What is Collateral?
Credit Risk Mitigation
Collateral in the OTC Derivatives Context
Collateral Documentation – OTC Derivatives
Brief Guide to the 1995 English Law Credit Support Annex (Transfer – English Law)
MR Collateral Documentation
2016 ISDA Credit Support Annex for Variation Margin (VM) – English Law
IM Documentation
2016 Phase One Credit Support Annex for Initial Margin (IM) – New York Law
Bibliography
Notes
8 CASS – Client Assets and Client Money
The Collapse of Lehman Brothers
FCA Enforcement of CASS
The Current CASS Rules
CASS and Collateral
CASS and Prime Brokerage
CASS Resolution Packs
CASS and Legal Data
Bibliography
9 Liquidity Risk Management and Reporting
Bank Liquidity
How Much Liquidity Should be Required?
OTC Derivatives and the NSFR
Data and Systems Requirements
Bibliography
Notes
10 Contractual Impediments – Recovery and Resolution Planning
The Context Behind Recovery and Resolution Planning
Recovery vs Resolution
Normal Insolvency vs Resolution
Main Differences Between EU and Recovery and Resolution Regimes
Single and Multiple Point of Entry Strategies
What Does a Recovery and Resolution Plan, a Living Will, Need to Contain?
US Recovery Plans
US Resolution and Recovery Plans
EU Recovery Plans
Data Requirements of Living Wills
Resolution After Failure of Preventative Tools
The BRRD A55 Contractual Recognition Requirement
Initiatives to Assist with Article 55 BRRD Compliance
Stay Termination Rights
Financial Contract Record‐Keeping Requirements
The QFC Record‐Keeping Rule
Article 71(7) BRRD
Bibliography
Notes
11 Document Generation/Data‐Driven Contracts
Contract Lifecycle Management
Lifecycle of a Contract and Associated Processes
ECM Solutions Overview
Data‐Orientated Contracts
Further Consideration of the Benefits of Data‐Orientated Contracts
Contract Negotiation Platforms
Standardising Contracts for Document Assembly/Generation Purposes
Legal Agreement Data Extraction
Optical Character Recognition
Artificial Intelligence
Bibliography
Note
12 Smart Contracts
What is a Smart Contract?
Further Misunderstanding – Ricardian Contracts
How Does a Smart Contract Work?
Distributed Ledger Technology and Blockchain
Centralised, Decentralised and Distributed Networks
Transactions, Blocks, Merkle Trees and Mining
Merkle Trees
Consensus Algorithms
Blockchain Protocols
An Alternative Future for DLT – Hashgraph?
DLT and Smart Contracts
Smart Contracts – Legally Binding?
Benefits, Limits and Risks of Using Smart Contract Technology
Legal Issues
Operational Issues
Learn to Walk, Before You Can Run
Bibliography
Notes
13 Electronic and Digital Signatures
Wet‐Ink Signatures
Bridging the Gap to Computational and Smart Contracts
Distinguishing Electronic and Digital Signatures
How Do Digital Signatures Work?
Which Law Applies in Respect of the Formal Validity of an Electronic and/or Digitally Signed Contract?
International Legislative Approaches to Digital Signatures
England and Wales – Legislation Regarding Enforceability of Electronic and Digital Signatures
Bibliography
Notes
Appendix A
Appendix B
Appendix C
Index
End User License Agreement
List of Illustrations
Chapter 1
Figure 1.1 The impact of the 2007–2008 Financial Crisis on global GDP ...
Chapter 2
Figure 2.1 A principal entering into a contract via an agent
Chapter 3
Figure 3.1 The division of the derivatives market between OTC and listed deriva...
Figure 3.2 Outstanding gross market value in trillions of US dollars [adapted f...
Figure 3.3 The continuum of complexity across the derivatives market
Figure 3.4 Interest rate swap cash flows, hedging interest rate risk that a loa...
Figure 3.5 Managing the business process in relation to protocols
Chapter 4
Figure 4.3 Example legal opinion relational database structure
Figure 4.4 Example database table records
Figure 4.8 An example conceptual data model
Figure 4.9 An example logical data model
Figure 4.10 An example physical data model
Figure 4.11 The use of primary and foreign keys, shown in an entity relationshi...
Figure 4.12 Symbols used to express relationships in an entity relationship dia...
Figure 4.13 An example of a ‘one‐to‐one’ relationship
Figure 4.14 An example of a ‘many‐to‐many’ relationship
Figure 4.15 Adding extra entities to convert a ‘many-to-many’ ...
Figure 4.18 Illustrating the extract, transform, load process
Figure 4.19 Applications and Benefits of the Taxonomy and Clause library
Chapter 5
Figure 5.1 Basel implementation summary (adapted from 2018 ISDA Annual Europe C...
Chapter 6
Figure 6.1 Overview of Basel III standardised approach to credit risk (reproduc...
Figure 6.3 Illustration of payment netting
Figure 6.4 Why is close-out netting important?
Chapter 7
Figure 7.4 The LIBOR–OIS spread (1m/3m/6m) (2006–2009)
Figure 7.5 Margin for uncleared derivatives compliance phase-in schedule. N...
Figure 7.6 Title transfer mechanism under the 1995 English Law ISDA Credit Supp...
Figure 7.7 A Delivery Amount is due from the Transferor if the Transferee has C...
Figure 7.8 A Return Amount is due from the Transferee if the Transferor has Cre...
Figure 7.9 A comparison of the ISDA collateral documentation architecture befor...
Figure 7.10 The explosion of ISDA pre-print forms post-margin reform regulation
Figure 7.11 Two-way margining of initial margin
Figure 7.12 The mechanics of IM segregation
Figure 7.13 How the documentation architecture looks in practice for initial ma...
Chapter 8
Figure 8.1 Defining moments resulting in the CASS regulatory focus
Figure 8.2 The typical prime broker relationships
Figure 8.3 Application of CASS and banking regulation to cash and securities
Chapter 9
Figure 9.1 A simplified view of the ‘Sound Principles’ guidelines ...
Figure 9.7 Illustration of the NSFR treatment of derivatives
Figure 9.8 A comparison of the NSFR requirements for derivatives under the EC pr...
Figure 9.10 Credit Rating Agency Scales Compared
Chapter 10
Figure 10.1 What is a Recovery and Resolution Plan (RPP)?
Figure 10.2 Recovery and resolution stages as capital and liquidity ratios decr...
Figure 10.3 Usage of recovery and resolution plans
Figure 10.4 Timeline of events leading up to a bank entering resolution
Figure 10.5 The Lehman Brothers failure problem: sudden termination of Lehm...
Figure 10.6 An example of a counterparty exercising their cross-default ...
Chapter 11
Figure 11.1 The lifecycle of a contract
Figure 11.2 Organisation of the FpML standard and the anatomy of an FpML messag...
Figure 11.3 Feature extraction on the letter ‘A’, which can be th...
Figure 11.4 An example of OCR pre-processing techniques
Figure 11.5 End-to-end OCR process and matching of the transcribed text to ...
Figure 11.6 Problematic multi-column page setup
Chapter 12
Figure 12.1 The process involved in the creation of a Ricardian contract known ...
Figure 12.2 The core logic code for the Fizzy smart contract application
Figure 12.3 An example of the Solidity smart contract coding language (tak...
Figure 12.4 A comparison of centralised, decentralised and distributed networks
Figure 12.5 A representation of individual blocks (in this case, blocks 1 and 2...
Figure 12.6 A Merkle tree condensing previous transaction hashes into a single ...
Figure 12.7 A comparison of blockchain types and differences in governance
Figure 12.8 The Hashgraph data structure organises data into events rather than...
Figure 12.9 A graph representing how the number of transistors on integrated ci...
Figure 12.10 A model showing how a smart contract operates on a blockchain netw...
Figure 12.12 Sample use cases for smart contracts
Figure 12.13 The uptake of blockchain technologies by companies (from Gartner's...
Chapter 13
Figure 13.1 An example of a digital signature with an associated pictorial rep...
Figure 13.2 An example of both how a digital signature is converted into a fixe...
Figure 13.3 The process involved in the encryption and decryption of data throu...
Figure 13.4 An example of how asymmetric cryptography can be used to verify if ...
Guide
Cover
Table of Contents
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Legal Data for Banking
Business Optimisation and Regulatory Compliance
Akber Datoo
This edition first published 2019
© 2019 Akber Datoo
Registered office
John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom
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Library of Congress Cataloging‐in‐Publication Data
Names: Datoo, Akber, 1978‐
Title: Legal data for banking : business optimisation and regulatory compliance / Akber Datoo.
Description: Chichester, West Suxxex, United Kingdom ; Hoboken : Wiley, 2019. | Includes index. |
Identifiers: LCCN 2018061435 (print) | LCCN 2019005061 (ebook) | ISBN 9781119357209 (ePDF) | ISBN 9781119357223 (ePub) | ISBN 9781119357162 (hardback)
Subjects: LCSH: Financial services industry—Law and legislation—Data processing. | Law offices‐‐Automation. | BISAC: BUSINESS & ECONOMICS / Finance.
Classification: LCC K1066 (ebook) | LCC K1066 .D38 2019 (print) | DDC 346/.082—dc23
LC record available at https://lccn.loc.gov/2018061435
Cover Design: Wiley
Cover Images: © T33kid/Shutterstock,
© Titima Ongkantong/Shutterstock, © Akber Datoo
Preface
I first encountered the capital markets and investment banks in the late 1990s. Thrust into a trading floor environment straight from a computer science degree at Cambridge University, there was a lovely mix of mathematics, business and adrenaline on that Fixed Income Derivatives Trading floor that I fell in love with and which set the path for derivatives to be the one constant in my future professional career.
During my lifetime, technology has been a game changer in every aspect of our lives, not least the workplace and business, with the increasing reliance on computers, the internet and smartphones, to the increasing data‐enabled world and digital economy.
The investment banking and finance industry recognised this in the late 1990s and early 2000s, using technology to scale and grow business. But amongst the innovation and embracing of change, I encountered in‐house legal teams and external lawyers who were seemingly oblivious to the empowerment offered by process refinement, systems and data. The legal profession is quite rightly a conservative one in approach – one certainly does not want lawyers to be overt risk takers, rather trusted advisers and counsel through the risks that are taken in order to succeed in business, and to balance legal and commercial risks as required. However, I felt the balance was wrong, and resulted in far too many missed opportunities to unlock business value through legal change.
After wonderful years at Warburg Dillon Read (UBS by the time I had left!), including meeting my lovely and dear wife Naila during my time in New York, I decided to go back to study, curious through my engagement with in‐house lawyers at UBS, particularly through industry initiatives such as FpML and Swapswire (now Markitwire). There surely had to be a way to optimise business operations and achieve through the medium of legal data, and I was hoping to find this out via a journey through the legal profession.
I was fortunate to practise law at Allen & Overy LLP, a magic circle law firm, with an outstanding derivatives and capital markets practice. I worked alongside some of the brightest minds, many of whom had worked on key foundational industry documentation, such as drafting the original ISDA Master Agreement in a mythically smoky room in 1987.
It was only, however, during my secondments to the legal teams of Royal Bank of Scotland (RBS) and Credit Suisse, the latter during the midst of the Financial Crisis and the Lehman Brothers collapse, that the importance of the legal data really struck home.
Deciding that the time was right, with the regulatory impetus in many ways forcing the financial industry to recognise the importance of legal data and systems – especially given that the financial instruments at the heart of the Financial Crisis were, in many ways, nothing more than contractual obligations – I decided to pull the two strings together, legal and data, founding D2 Legal Technology (D2LT) in October 2011.
Over eight years later, we are truly seeing legal data come to the fore, through the intersection of Fintech, Regtech and Legaltech. It may be over a decade since Richard Susskind raised the spectre of technology replacing lawyers, with his sensitively titled book The End of Lawyers, but the arrival of commercially viable artificial intelligence solutions has, quite suddenly, begun to make the vision look ever more real. The question arises, though: Have organisations truly understood the new digital agenda – or how to respond to digital disruption? This is not just about the use of automation to reduce headcount or drastically minimise fees. It is about delivering business value and, critically, bringing legal teams out of the ivory towers and fundamentally into the business mix. This requires not only the use of technology, but also a critical examination of the business need, and the current processes used to try and meet that need. Legal data is at the heart of this.
The new model should be about using digitisation to become data driven in order to add business context to legal activity. Particularly within the specialism of financial services, the new legal digital agenda is a chance to bring legal counsel further into business and use digitisation and data connectivity to achieve hyper‐awareness both pre‐ and post‐trade. With real‐time recognition of key events and how they may affect a position, an empowered legal team can drive new and measurable value. The greatest risk is inaction.
This book is my humble attempt to bring together some of the foundational building blocks required to empower the capital markets business through legal data. As a result, both technologists and lawyers will find some sections in the book basic for them and so they are probably best skipped over. However, I hope all readers, be they students, legal practitioners, technologists, business analysts, traders, risk professionals, regulators or academics, will find something of use in this journey on the digitisation of the law.
Akber Datoo, London – 20 February 2019
Acknowledgements
First and foremost, a special thank you to my parents for their continual support and encouragement in every walk of life. Without you, I would not have been able to finish this book, especially without the recent trip to France when it finally took proper shape. No thank you can ever be complete enough to acknowledge your role as the best parents a son could ask for.
I would also like to thank my dear wife Naila for her love, patience and support as I have been writing this book, together with my wonderful son and daughter, Abbas Hassan and Fatema Zahra (who have convinced me that I have missed many a trick in failing to cover the more important topics of football and fairies in the chapters to follow). Abbas Hassan and Fatema Zahra really are the best children a father could have – fun, loving and caring – and I have missed out on so much whilst writing!
I would like to thank all of the staff at D2LT, especially Jessica Bryant, Katie Oliver, Peter Newton, Jason Pugh, Michael Wood, Subhankar Ghosh, Carol Lance and Adrian Jenks, who have endlessly reviewed and assisted with various parts of the book, providing their expert views and feedback, as well as checking for accuracy and correctness. Many thanks to Emma Patient, Senior Counsel at HSBC, for her meticulous review and comment on Chapter 7.
I have been fortunate in the time invested in me by a number of managers and colleagues, such as Jeffrey Golden at Allen & Overy, Ulku Rowe and Kirren Basavaraj at UBS. Your time and effort to guide and develop my knowledge has been invaluable.
My colleagues and clients, including Colin Hall Nicholas Sainsbury and Vasan Siva (Credit Suisse), Amir Mehdi, David Todd and Laura Muir (Barclays), Sam Hooker, Vivienne Chan and Jillian Melton (HSBC), Simon Berkett (Macquarie), George Simonetti, Lee Cummins, Richard Paolini and Josh Luber (Wells Fargo) and Ciarán McGonangle (ISDA) – thank you for all the legal data adventures we have been through, many of which form the foundation of parts of this book.
Finally, but not least, thank you to Wiley for making this book a reality. In particular, thank you to Thomas Hykiel (with whom I shared the initial idea – I am grateful for his enthusiasm and support), Kari Capone (Manager), Elisha Benjamin (Project Editor), Banurekha Venkatesan (Production Editor) and Gemma Valler (Commissioning Editor).
1The Role of Data in a Financial Crisis
This first chapter serves to provide context for the rest of the book – setting out the causes of the 2007–2008 Financial Crisis (the Financial Crisis) that swept the global financial markets well over a decade ago and has substantially impacted the banking and finance industry as we know it today. It was this turbulent period that provided the impetus for the substantial body of financial regulation that has been introduced over the last 10 years, as well as the enhanced legal data requirements that this body of regulation imposes, extending beyond the business and operational needs for such legal data.
In subsequent chapters we will further examine the Financial Crisis through various lenses, as some of the more pertinent aspects of recent financial regulation (such as regulatory capital requirements, margin for uncleared derivatives and recovery and resolution planning) are considered in detail. It is impossible to adequately consider legal data within the banking industry without reference to the Financial Crisis. The substantial regulatory change that has occurred affects how banks conduct business; therefore, legal data, once initially important for business optimisation and business processes, is now mandated for regulatory compliance.
For the purpose of this book, any reference made to the ‘Financial Crisis’ should be taken to mean the financial crisis of 2007–2008 and its subsequent impact. In the context of this book, by legal data, we are usually referring to legal agreement and/or legal opinion data, or that representing financial rules and regulations.
The Financial Crisis – Looking Back
The world of finance has undergone a tremendous period of change, including much retrospective questioning and attempted diagnoses, since the Financial Crisis. Albeit with the benefit of hindsight, the seeds and signs of impending trouble were undoubtedly present and grew in the build‐up to the dramatic events of 2007. Many of the effects of the issues that came to light during the Financial Crisis unexpectedly compounded each other, catching out investors, dealers, banks, regulators and politicians.
Most put the cause of the Financial Crisis down to the rapid expansion of the securitisation markets and a backdrop of accommodative monetary policies serving to heighten the value of the housing market prior to 2007. Sub‐prime borrowers were encouraged to take out more and bigger mortgages – in effect, creating an inflated ‘housing bubble’.
Some also attribute the Financial Crisis to finance professionals who lost track of the risks they were generating by entering into securitised deals, compounded by a lack of regulation. Bank regulation in respect of the level of capital that banks need to hold based on the Basel Accords played a part in encouraging unconventional banking practices to optimise regulatory capital treatment, contributing to the Financial Crisis. The repeal of the Glass‐Steagall Act removed the previously mandated separation of investment banks and depository banks, effectively providing a stamp of approval for a universal risk‐taking bank model. Financial firms were allowed to move significant amounts of assets and liabilities off‐balance sheet, into complex structures such as structured investment vehicles (SIVs), having the effect of masking the real risks, in particular, capital and leverage involved, only to be unmasked and unravelled during the full force of the Financial Crisis. Furthermore, the over‐the‐counter (OTC) derivatives market was substantially unregulated, however, it increased exponentially in volume and complexity. From supposedly being a risk‐mitigant tool at heart, their usage quickly became a significant source of systemic risk in the midst of the Financial Crisis.
Overall, the explanations given for the Financial Crisis are still hugely contested. Perhaps this is because of the undeniable complexities of the subject and the banking system as a whole, leading to an oversimplification of its causative features, or maybe it is because of the tendency to lay blame or scapegoat on particular actors in the financial markets.
It is crucial, however, to remember that banking is ultimately about taking risks. Without the assumption of risk by those financial firms best placed to assume and manage the risk, there is no banking business and therefore no financial intermediation system. The issue was the inability to identify activities that were too risky for the banks to undertake, both by the banks themselves and by their regulators.
Within the financial markets, there was a natural incentive for the underpricing of systemic risk by financial institutions. Absent regulation, they were not commensurately burdened with the costs of the broader systemic risks, fostering and, in many cases, rewarding risky behaviour. Through the Financial Crisis, the public at large ultimately bore the burden of the market failure, due to the ‘too big to fail’ view of the largest financial firms.
Regulators' forecasts of serious problems and ‘dire prophesies’ years in advance of the Financial Crisis were largely ignored, partly because of the successful lobbying by the very financial institutions that are today either bankrupt or had to be rescued with government funding. For instance, the failures of the two federal agencies (Fannie Mae and Freddie Mac) were preceded in 2005 by a successful $2 million campaign by Freddie Mac to lobby Congress from restricting their own investments in higher‐risk mortgages. These same agencies, banks and other institutions provided assurances that their lending practices (including those enabling loans without adequate documentation) were ‘safe’ based on evaluations of past data.
Data played a significant role through a failure to provide business intelligence on the underlying causes of the Financial Crisis, occurring not only at the individual firm level but also at the broader industry and supervisory level, and being unable to aggregate and derive the required intelligence in relation to the rising systemic risk beforehand. At the individual firm level, it is a significant failure that the data available and used to supposedly optimise the business decisions, in fact, could not even ensure survival in many cases.
Given this, it is welcome, and not surprising, that a number of the regulatory responses to the Financial Crisis have been to increase the banking data requirements, from transaction to trade and legal agreement‐level reporting.
There have been issues identified concerning:
the scope of data available (i.e. that within the shadow banking system, such as hedge funds and the OTC derivatives market);
the understanding and governance of the data available;
the quality of the data; and
the way in which the data was used to derive the required business intelligence.
To better understand the role data should have played prior to the Financial Crisis, and needs to play going forward, from both business optimisation and regulatory perspectives, it is worth considering in more detail some of the causes of the Financial Crisis.
Causes of the Financial Crisis
The economic backdrop of the financial system is particularly crucial to explaining the onset of the Financial Crisis. Some commentators attribute the start of the Financial Crisis to the American Federal Reserve's change of policy post‐2001. In the wake of the dot‐com bubble bursting, the American Federal Reserve lowered their interest rates to 1% in an attempt to keep the economy strong. The implication of this low rate was a low return on investment for investors, causing them to limit their investment activities, but also an increase in borrowing. Many banks used this abundance of cheap credit as leverage. Essentially, this involved borrowing to amplify the outcome of a deal; using debt to, for example, buy larger quantities of a product than cash flow would otherwise allow and then selling that product for a huge profit, even after the cost of interest (see Figure 1.1).
Figure 1.1 The impact of the 2007–2008 Financial Crisis on global GDP growth
The monetary policy increased financial institutions' willingness to take on risky assets, driving the demand for collateralised debt obligations (CDOs) and collateralised loan obligations (CLOs). These combined risky mortgages together with other financial assets before slicing them into different tiers, or tranches. Each slice – or tranche – would be made up of securities with different financial terms, meaning that they could then be marketed to investors based on the presumed level of risk. These tranches were prioritised such that the most senior tranche related to the lowest risk assets – offering safer assets, but a lower return. The most junior tranches would relate to the riskiest assets (and offer the highest returns), and if underlying assets defaulted, the tranches affected first would be the most junior ones, rising to more senior tranches as the level of losses increased. The aim was to construct a portfolio of well‐diversified assets and reduce risk through diversification. However, the quality of the CDO/CLO depends on the quality of the assets in the portfolio and most importantly, on the correlation of different tranches, which is managed by a CDO/CLO manager.
Furthermore, there was an increased use of synthetic products – for example, a synthetic CDO where the underlying asset, such as a mortgage, is instead replaced with a synthetic equivalent, such as a credit default swap (or other derivatives). With a limited number of actual assets to meet the demand of these products (surely another data metric of note in assessing the build‐up of systemic risk), these synthetic products thrived, being cheap and easy to create. In fact, synthetic issuance jumped from some $15 to $60 billion in the space of a single year in 2005, valued notionally at around $5 trillion. For example, the value and payment stream of a CDO would be replaced with premiums paying for ‘insurance‐like’1 credit default swap protection on an underlying reference asset(s) from defaulting. This allowed speculative views to be taken on the underlying assets, even when they didn't ultimately exist. These assets hence offered a way to obfuscate the true risks being introduced into the global financial system and amplified, for example, the sub‐prime mortgage bubble. The data available – used by the regulators and market participants – was incomplete, inaccurate or simply not fully understood in terms of the caveats to it (partly due to the sheer complexity of financial products and engineering).
In 2006, interest rates in the USA started to rise in an attempt to control inflationary pressures. This meant that homeowners began to struggle to make mortgage payments, especially in respect of sub‐prime mortgages that had grown in the previously easy credit/low‐interest‐rate environment. Bank traders started to feel the impact of declining interest in CDOs/CLOs based on the growing issues with the underlying assets. There was therefore a repackaging of this risk by splitting out the problematic parts and creating new CDOs/CLOs with them – with large commissions and fees continuing to be paid both to traders and the CDO/CLO managers. Ironically, in many cases, the banks selling the CDOs were actually the investor, lending most of the funds to their clients in order to purchase them. This was a clear failing in the data aggregation to understand the vicious circle being created, partly driven by the opacity of the inherent synthetic derivatives in these products, which increasingly formed a part of the more and more complex financial product engineering. Consider the CDO‐cubeds that were created, a CDO that invested in CDO‐squareds (which are CDOs that invested in other CDOs). As Les Leopold states in his 2009 book The Looting of America: How Wall Street's Game of Fantasy Finance Destroyed our Jobs, Pensions, and Prosperity and What We Can DO About It:
But what if you can't sell all the bottom tranches of the CDO‐squared securities? You guessed it. You form another pool of these untouchables … and tranche away again.
The modelling assumptions that had been used to manage the risk and diversify it ultimately failed in the Financial Crisis and could not sustain the plummeting asset prices at the very heart of these products. This left financial firms holding boxes of worthless (or close to!) CDOs/CLOs that could not be sold or used as collateral, despite rating agencies' seals of approval (yet another data shortcoming exposed in the Financial Crisis). This undermined the credit rating agencies' data, relied upon by investors to determine the level of risk, leading to a loss of confidence in the market. The Financial Crisis also exposed the potential effect of conflicts of interest, with the very same credit rating agencies that the banks relied upon to create the CDOs/CLOs being paid by the banks to provide the credit ratings that acted as a seal of approval to investors.
As the Financial Crisis started to unfold, financial institution traders, finding it harder to shift the CDOs/CLOs containing elements backed by riskier assets, would split these elements out and create new ones that effectively bought these ‘toxic parts’. By creating new CDOs/CLOs, they were able to earn their commissions, with the CDO/CLO managers buying these new CDOs/CLOs with the traders' banks themselves lending most of the money to buy them. Effectively, the bank selling the CDOs/CLOs was itself the customer. As a higher and higher proportion of these CDOs/CLOs failed to sell, again they would be sliced up and the worst bits sold into new CDOs that the traders created, recursively self‐dealing.
The OTC derivatives market was identified as one of the chief villains in the global crisis (Warren Buffet had famously previously labelled them as ‘financial weapons of mass destruction’ in 2003). As largely unregulated, bilateral arrangements, OTC derivatives were somewhat of a black‐box to regulators. Their complexity resulted in significant information asymmetry between those using such products and the regulators. The well‐documented derivatives troubles of Bear Stearns, AIG and investment banks post‐crisis ultimately showed the lack of understanding of their inherent risks for even the supposedly most sophisticated of users. Derivatives originally came into being as a means to manage risk, as a protection against a possible catastrophe or market event. For example, farmers would enter into a contract where they would agree to sell their crops at a certain time in the future for a predetermined price. This meant that should the crops be negatively affected by bad weather or disease, the farmer could ensure he or she would still make money and a good living. But what started as a way to hedge risk could also be used as a speculative tool. The issue is that when packaged products become so complex that no one truly understands their underlying level of risk, they cannot be reliably used for the purposes of safely generating returns. Many banks who entered into derivative contracts did not know or understand the full extent of their liabilities. Moreover, the number of derivative contracts that were entered into, accumulating these risks, was huge and sufficient to cause financial disruption with the backdrop of the other market stresses developing.
An underlying problem at the heart of the Financial Crisis was that new instruments in structured finance (including derivatives and securitised and collateralised debt instruments such as syndicated loans, collateralised mortgage obligations and credit default swaps) developed so rapidly that the market infrastructure was not prepared when those instruments came under stress. Because of the complexity of many of these products, investors were unable to make independent judgments on the merits of investments, and the risks of aggregate effect market transactions were obscured. Moreover, regulatory requirements such as record‐keeping and reporting were insufficient and fragmented, as they had not had time to be developed, nor did regulators ever realise the seriousness of the situation. Many commentators argue that regulators mishandled the Financial Crisis. They failed to exercise proper oversight of financial institutions and were unable to keep economic balances in check. According to The Economist, lax capital ratios proved to be the most significant regulatory shortcoming: regulatory rules prior to the Financial Crisis failed to define capital strictly enough, enabling banks to smuggle in forms of debt that did not have the same loss‐absorbing capacity as equity. Essentially, banks were too highly leveraged and operated with insufficient equity to protect themselves in the event of disaster. Had they been in place, regulators could have been made aware that systemically vital institutions were without adequate capital and that the market was at risk of collapse. The problem is that, as explained by the economist Brian Wesbury, the onus could never have been on the dealers trading with these instruments. He describes the financial climate in the run‐up to the recession as being like a system of traffic lights and argues that when a traffic light is green, you will never see a driver get out of their car to check the traffic light at the adjoining junction is red so that it is safe to cross the intersection. Likewise, when interest rates are down to as low as they were, it is only natural that banks and investors will leverage and make the most of seemingly good opportunities. The onus should have been and – even more so – is now on the regulators to ensure that the system and its inherent risks are properly managed.
The chasing of short‐term profits and individual incentivisation schemes encouraged an unsustainable level of short‐term risk‐taking and reliance on financial modelling. Simply consider AIG. This major insurer of debts via credit default swaps placed ‘blind faith in financial risk models’ and for a few years their small elite staff of financial modellers generated large incomes for the firm (and equally large bonuses for individuals). However, that later turned into decimating losses for AIG as the mathematical credit risk models developed, and the data they provided, were ultimately incorrect. There was significant underestimation of the likelihood of sudden large events, which are especially important in the credit markets as the tail of a distribution is key in predicting the defaults that typically have a low probability of occurrence and a failure to consider inter‐related systematic risks.
In fact, the regulatory community had itself not been alert to the growing systemic risks and if anything was misled by the data, in terms of scope, timeliness, accuracy and aggregation. In an article entitled ‘Market‐based risk is changing banking’, the then leaders of the banking and capital markets sector of the FSA claimed:
From ‘hold what you originate’ the business model of banking is shifting to ‘underwrite to distribute, and buy what makes sense to hold.’ Banks are shifting to market‐based risk management […]. Traditionally, banks originated loans to customers, which they held on their balance sheet until maturity. Banks still originate loans, but aim to reduce their exposure, either by selling participations in the loan to other investors – not all of them necessarily banks – by securitising the loans, or by buying credit protection in the derivatives market.
At the same time, banks are buying exposures to credits not only through purchases of participations in loans originated by others, but also through selling credit protection and buying collateralised debt and loan obligations (CDOs and CLOs) […].
Regulation supports this move towards market‐based risk management. Under Basel 2 and the Capital Requirements Directive, capital regulation is moving in the direction of economic capital. Capital is now assessed in line with risk, and the new capital regulation framework gives much more adequate recognition for credit mitigation factors such as derivatives and securitisation. (Financial Times 2007)
Ultimately, of course, it is hard to argue, post‐crisis, that the recognition of these factors was, in fact, misled. In most cases, the data available did not allow recognition that, rather than dispersing the risks, many turned out to be concentrated in entities that were unable to bear them. For example:
Conduits and SIVs held the assets with substantial leverage coupled with maturity and liquidity risk – therefore very vulnerable to classic bank ‘runs’.
Banks ended up with indirect exposures (through contingent credit lines, reputational risks and counterparty credit exposures) to many of these vehicles (despite assuming, from their knowledge of the risks and supporting data, that the risks had been transferred away).
Systemic Financial Contagion
The seriousness of the onset of financial contagion demonstrates the importance of the regulatory landscape in avoiding future systemic failures in the financial sector. Once the Financial Crisis had fully started to take hold, the market was overwhelmed with firms trying close‐out trades at the same time. However, different financial institutions were also inter‐related and dependent on each other, as they had all been borrowing from and transacting with each other. Cross‐default clauses in financial contracts, which will be discussed later within this text in detail, demonstrate part of the problem when it comes to the interconnectedness of financial institutions. Standard default and termination clauses in financial contracts mean that if a party to the contract fails to perform its financial obligations, the other party can terminate the arrangement. Cross‐default clauses put a party into default if they default on another obligation under a separate contract with a third party. This can have a domino effect; if one party defaults under one relationship, other defaults are triggered elsewhere.
Additionally, when – during the Financial Crisis – counterparties started to default and could no longer rely on failed institutions' promises to fulfil their commitments, financial institutions began to lose trust in one another, causing them to withhold short‐term credit. This became known as the credit crunch – a crisis caused by a sudden reduction in the availability of liquidity in the financial markets. Gokay (2009) describes the credit crisis as being comparable to a heart attack:
Every modern economic activity depends for their day‐to‐day activities on continuous borrowing and lending. […] If it is not dealt with properly, the whole system immobilizes. That is why all those governments rushed to interfere, pouring billions of dollars into private banks, hoping the recipients will use the cash to start lending and borrowing again.
Financial contagion can occur on both a domestic and an international level and can be observed via co‐movements in exchange rates, stock prices and capital flows. However, this is not a problem that can be resolved purely by the inflow of more capital into the market. It is not likely that the financial sector will ever start trading or lending again with the same relaxed attitude, even once liquidity has fully improved. Moreover, the influx of regulatory requirements is now seemingly a thing of permanence.
The Legal Data Consequence
Each of the identified vulnerabilities that helped cause the Financial Crisis or increase its intensity (lack of capital, liquidity risk and so on) catalysed banking regulatory reform. Such regulatory reform has included the introduction of:2
The US Dodd–Frank Act
The Basel Committee's Third Accord
The European Market Infrastructure Regulation (EMIR)
The Alternative Investment Fund Managers Directive (AIFMD)
The Market Abuse Regulation (MAR)
The Markets in Financial Instruments Regulation (MiFIR)
The Foreign Account Tax Compliance Act (FATCA)
Client Assets Sourcebook – Client Money and Assets Rules (CASS)
Margin for Uncleared Derivatives Regulation
Securities Financing Transaction Regulation (SFTR)
Recovery & Resolution Regulation [such as Recordkeeping Requirements on Qualified Financial Contracts (QFC) and the Bank Recovery and Resolution Directive (BRRD)]
Accordingly, the sector has been hit by a torrent of new regulatory requirements. Many of the above regulations mandate, or indirectly require, a number of data reporting requirements, from the reporting of transactions to that of key contractual terms. Ultimately, many financial instruments, and therefore their consequences that need to be better understood, managed and regulated, simply consist of a series of complex contractual obligations – or legal data. It is this legal data that is the subject of this book, seeking to demystify and provide guidance on some of the challenges that exist in ensuring this data on the contractual obligations is complete, accurate and ultimately useful, from the perspective of business optimisation, operational management or regulatory compliance. Increasingly, there is criminal liability attached to ensuring operational effect is given to meeting regulatory mandates, significantly increasing the burden of reliance on legal data by senior management at financial institutions, such as in the context of the treatment of client assets and money.
It should be noted that the post‐crisis regulatory response, whilst large‐scale in the changes made to the fundamental banking infrastructure in many parts, has also brought out and increased differences in standards and expectations globally. There is also an increasing need to maintain data on the regulations themselves and to be able to understand the cumulative impact for an impacted firm – yet again, a significant data challenge. In an ever‐increasingly globalised world, this also, with the prospect of regulatory arbitrage it brings, raises the challenge for supervisory bodies utilising data to be on top of the consequences of regulation.
Bibliography
Associated Press (2008) ‘Bush administration ignored clear warnings’,
Associated Press
, 12th January 2008
Berkshire Hathaway Inc. (2003) 2002 Annual Report
Dewar, Sally and Huertas, Thomas (2007) ‘Market‐based risk is changing banks’,
The Financial Times
, 8th May 2007
Gokay, B. (2009) ‘The 2008 world economic crisis: Global shifts and faultlines’,
Global Research
, 15th February 2009
Greenberger, M. (2010) ‘The role of derivatives in the financial crisis’, Financial Crisis Inquiry Commission Hearing, Washington, DC
Jameson, R. (2008) ‘The blunders that led to the banking crisis’,
New Scientist
, 27th September 2008
Morgenson, G. (2008) ‘Behind insurer's crisis, blink eye to a web of risk’,
The New York Times
, 27th September 2008
Murphy, A. (2000)
Scientific Investment Analysis
, 2nd edn. Quorum Books: Westport, CT
Murphy, A. (2008) ‘An analysis of the financial crisis of 2008: Causes and solutions’ (
http://dx.doi.org/10.2139/ssrn.1295344
)
The Economist (2013) ‘The origins of the financial crisis: Crash course’,
The Economist
, 7th September 2013
United Nations Organisation (2017) ‘Global context for achieving the 2030 agenda for sustainable development: Sustained global economic growth’, Development Issues No. 8 (
www.un.org/development/desa/dpad/publication/development-issues-no-8-global-context-for-achieving-the-2030-agenda-for-sustainable-development-sustained-global-economic-growth/
)
Wesbury, B. (2014) ‘The real truth about the 2008 financial crisis’,
TEDxCountyLineRoad
(YouTube video)
Yost, P. (2008) ‘AP IMPACT: Mortgage firm arranged stealth impact’,
Associated Press
, 20th October 2008
Zuckerman, G. (2009)
The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History
. Broadway Books: New York
Notes
1
With apologies to the legal and regulatory correctness of this statement!
2
This list contains a number of overlaps and inconsistencies, and has a focus on US and EU regulation, but is intended to present a good picture of the coverage of regulated themes, rather than anything remotely approaching a comprehensive list.
2The Law, Legal System and Basics of Contract Law
This chapter will be trite for any legal student or practitioner, however, we hope invaluable for those approaching this text without formal legal training or experience. In order to fully appreciate and ensure legal data helps to ultimately unlock business value, one needs to understand the context of the law, the legal system and – of particular relevance in respect of the banking and finance industry – the basics of contract law (given that financial instruments are at heart, simply a series of contractual obligations).
This chapter starts with a discussion of the differences between civil and common law systems concerning choice of governing law, before explaining the different requisite elements of valid and enforceable legal contracts, followed by a discussion of how contract law sits alongside other relevant areas of law.
Chapter 3 will provide details of financial instruments themselves, before considering the fundamentals of ‘data’ in Chapter 4.
Legal Systems and Traditions
We will begin by outlining some of the most major legal traditions before delving into the legal systems most commonly used in the world of international finance, namely English and New York law. The term ‘legal system’ refers to the content or body of the law generally, along with the means by which it is enacted and adjudicated. A ‘legal tradition’, on the other hand, is a less specific term, referring to the general similarities shared between a family of legal systems. Contemporary legal systems that exist around the world today can be primarily categorised into a number of different traditions: civil, common, religious or even a combination of these. The legal system of a jurisdiction is resultant of its individual history and the legal evolution it has undergone over a period of time. As a result, all jurisdictions encompass unique variations. So, it is important to bear in mind that, whilst legal systems are capable of being broadly categorised into one or more of a number of legal traditions, any categorisation does not promise to describe the intricacies individual to a particular jurisdiction entirely. It is useful to understand the main legal traditions to achieve an overall feel of how the law works as a whole, before considering the more particular elements of an individual legal system.
A key example is the British common law tradition. Many British colonies replicated the British legal system at the time (major legal traditions tend to be associated with the original legal system as it then existed rather than as it exists today). As such, the legal systems used in countries such as Australia, India, Canada and the USA – although now individually unique – follow the same legal tradition due to their Anglo‐Saxon roots. The English common law is now the most widespread legal system in the world, with 30% of the world's population living under it, according to Professor Philip Wood.
Common and Civil Law Traditions
Although legal systems can vary greatly, most jurisdictions mainly follow one of two major legal traditions: common or civil law. In common law systems, judicial decisions previously made in similar cases are of primary importance. These judicial decisions, which collectively form a body of case law, are used as precedents to be applied in the decisions of new cases. In contrast to civil law systems hold case law to be of secondary importance, subordinate to statutes. Statutes are written laws passed by the relevant legislative body of the jurisdiction in question and will specify matters capable of being brought before a court, the procedure by which this should be done and the appropriate consequences. As such, judicial decisions in civil law systems are primarily made from codified compilations of statutes. To fully understand the differences and similarities between common and civil law traditions, it is beneficial to start by tracing back the historical context of both.
The common law emerged during the Middle Ages in Anglo‐Saxon England. At the time, the English monarchy would issue ‘writs’. A writ was essentially a royal order commanding an individual to act or abstain from acting in a particular way. Each writ provided a specific remedy to a specific wrong. However, writs were limited in their ability to cover all situations and achieve justice, because they were so rigid in their application. In an attempt to overcome this issue, further appeals to justice could be made directly to the King. While originally exceptional in nature, by the time of King Henry II (in the latter part of the 12th century), the use of writs had become a regular part of the system of royal justice in England, evolving into the establishment of the courts of equity (also known as the ‘Court of Chancery’, because it was the court of the King's Chancellor). The function of the court of equity was to hear complaints and formulate appropriate remedies based on the equitable principles of fairness. These equitable principles were founded on many sources of authority, including Roman law and the philosophy of ‘natural’ law. These decisions were collected and published, making it possible for courts to apply past decisions to current cases to achieve a degree of consistency, impartiality, transparency and therefore fairness.
Today, the common law and equity are now administered by the same court. Equity is only applied at the discretion of the court and is used on the basis of a number of general principles known as equitable maxims. Some key examples include the maxims: ‘Equity follows the law’, meaning that equity cannot override the common law or statute; ‘Equity looks at the substance, not the form’, meaning that equity will look at what something is rather than what something is called; ‘He who seeks equity must do equity’ or ‘He who comes to equity must come with clean hands’, meaning that a party wanting to use equity must act fairly towards their opponent for it to apply; and ‘Delay defeats equity’, meaning that failing to claim equitable rights within a reasonable period of time will prevent a party from using equity.
Historically, the courts of equity have shown a greater concern to enforce promises than to uphold a bargain. One significant difference between contract and equity are the remedies available. Unlike legal remedies such as damages, which are granted to a successful claimant by right, equitable remedies are given at the discretion of the court and can include an injunction, specific performance, rescission, rectification and so on.
The civil law tradition started to emerge at the same time as the common law. Originating in Roman law (which required codification due to its intricacy), the civil law tradition later spread into continental Europe, where it was applied in the colonies of imperial powers such as Spain and Portugal. Due to the codified nature of a civil law system, its uniformity promised a higher degree of certainty for citizens and judges than that offered by the common law. The political and social climate required such certainty in those regions in respect of the protection of property and the rule of law.
Whereas the common law operates as an adversarial system, the civil law operates as an inquisitorial one. This distinction is important because it assists in explaining the different approach of each system in the event of a case being brought before a judge. Under an ‘adversarial’ system, each side to a dispute presents its opinion. The judge – who acts as an arbiter or referee between each side – then analyses the case law that presents similar (but not identical) fact patterns. By doing this, the judge can apply the law in light of the arguments presented by both sides to deduce a result. This means making inferences by reference to general principles. The legal premise that underpins this system is that the argumentation between two opposing sides will lead to the best determination of the truth. Importantly, common law judges are also able to propose new rules to cover facts that have not yet presented themselves. Under an ‘inquisitorial’ system, in contrast, a judge or the court is actively involved in investigating the facts of the case. The premise underpinning this system is that the truth is best discovered through an impartial inquiry. Though the judge plays an active part in investigating the facts of the case, the judge must still work within a framework established by the codified laws that have been put in place. So, because the law within a civil system is designed to cover all eventualities, the implication is that the judges have a more limited role. Instead, they take a more investigative role. Consequently, judges have less scope to shape the law than the legislators who draft it.
In practice, many legal systems use a mixture of features from both traditions. After all, both systems utilise similar sources of law – both employ statute and case law, neither rely on one instead of the other. The central distinction is that they approach regulation and resolve issues in different ways. As already outlined above, although statute is of importance to both, civil law codes systematically and exhaustively consider statute before turning to jurisprudence, whereas common law uses case law as its core set of rules and uses statute to complete it. As such, the English legal system is comprised of a combination of both common law and statutory law (albeit the latter operating at a more substantive, prescriptive level).
Within banking and finance, new codified laws are intermittently issued by various government agencies in the UK. For example, the Bank of England Prudential Regulation Authority (PRA) has issued EU prudential rules for banks, building societies and investment firms, including the EU Capital Requirements Directive IV (CRD IV) – an EU legislative package in accordance with Basel III. It is these rules and regulations that will be discussed later in this book.
Governing Law
As we have already established, different jurisdictions have different and unique sets of laws, although we can trace some similarities between them due to broader legal traditions. When parties enter into a contractual relationship – especially in the context of an international transaction where a contract is likely to be connected with more than one jurisdiction – it is commonplace to decide which laws will apply via a ‘governing law’ clause.
