Why Derivatives Contracts Are Threatening Your Business

Risk mitigation is one of the C-suite’s most important responsibilities in the financial sector. But increased regulation and the complexity of OTC derivatives contracts have made it even more difficult for financial organizations to manage the risks associated with ISDA contracts and the derivatives trading process.

Like it or not, derivatives contracts present a huge risk to your business—and unless you understand your company’s vulnerabilities and implement strategies to mitigate those risks, it’s only a matter of time before disaster lands on your doorstep.

Understanding Derivatives Contract Risks

The trading of OTC derivatives is governed by complex, bespoke ISDA (International Swaps and Derivatives Association) contracts. These documents detail the terms and conditions of transactions, and are designed to protect both trading organizations from pre-defined future events (e.g. the bankruptcy of one of the parties). Although conceptually “standard”, the ISDA Master is almost always customized through negotiated terms in the ISDA Schedule. These non-standard terms are the source of significant uncertainty and risk.

In theory, ISDA contracts reduce risk—they are extremely flexible trading agreements that can protect your organization from specific threats. Market participants on the buy and sell side routinely mold and leverage ISDA agreements to match their organizations’ goals and objectives.

But here’s the catch: the complex and tailored nature of ISDA agreements means that they must be meticulously crafted and carefully monitored. The simple omission of an essential clause or condition, due to manual contract management errors or inadequate oversight, can significantly raise your company’s risk profile. Or the failure to track an important non-standard term could leave your organization blind to contract-based threats.

Additionally, in today’s Dodd-Frank world, there is increasing regulatory pressure for improved oversight and management of derivatives contracts. Financial organizations that perform poorly on mandated stress tests or exhibit inferior risk management processes are likely to be hit with regulatory sanctions that jeopardize profitability.

For savvy financial executives, the bottom line is clear: increasingly, risk mitigation in derivatives trading means finding new ways to improve visibility into the terms of master trading agreements, and to automate contract management routines.

How to Reduce Risk in Derivatives Contracts

For financial organizations, improved contract management requires the implementation of strategies that reduce risk by monitoring the impact specific events have on your own business, as well as (in the case of very large players) potential systemic impacts on other stakeholders in the financial system.

What does that mean for your organization? More than ever, you need to show regulators that you are implementing strategies that reduce contract-based risk and increase compliance with sound business practices.

1. Understanding Your “Known” Risks in Real Time

The first priority in any contract management initiative is to fully understand known potential risks and how your contracts deal with those risks. If you don’t know something, you can’t manage it. By gaining a genuine, immediate and comprehensive understanding of known, day-to-day, operational risks, organizations are better equipped to roll out strategies that protect the organization as well as the financial system.

To accomplish this, you need contractual data you can trust, to a level of granularity that supports real-time decision-making and action, based on internal events, events that occur with trading partners, or market events.

 2. Improving Contract Visibility for “Unknown” Risks

The complex and customized nature of ISDA contracts means that even minor changes or concessions can significantly increase your organization’s risk with a trading partner. With so much riding on the details, it’s almost impossible to build structured, real-time reporting models for every future risk scenario. But there are still steps you can take to manage derivatives contracts in a way that supports rapid analysis of “unknown” future risks.

Considering that a typical financial organization may be required to simultaneously manage hundreds or even thousands of contractual relationships, the secret is to organize your contractual documents and data so that when unexpected events happen, your legal and risk experts need only read five critical documents, not five hundred or five thousand.

3. Pursuing Risk Management at the Time of Creation

Simply knowing about your contractual risks is not enough to satisfy regulators or to protect your organization—you also need a comprehensive strategy for optimizing contractual terms and conditions at the time of negotiation and execution.

By using modern contract drafting and negotiation tools, banks and buy-side players can nip many risks in the bud by eliminating problem clauses and by controlling deviations from standard. Automated contract drafting can also ensure that compliance rules are baked into the process, which is essential as the volume and complexity of regulation continues to grow.

ISDA agreements provide an example of one convenient focus for risk mitigation strategies. By proactively targeting the creation and management of ISDA agreements, your organization can showcase increased understanding of risk and demonstrate proactive measures to mitigate derivatives trading risk.

In the current financial climate, manual management processes are dangerous and impractical. To demonstrate serious improvement in ISDA contract management, financial organizations are turning to advanced contract management solutions.

There are several factors to consider when selecting contract management technology. In addition to managing the inherent complexity of derivatives contracts, your solution should integrate with existing technology platforms, and be flexible enough to transform data from one system into formats that are accessible to other systems across the organization.

By focusing on technologies that have been designed to manage the nuances of financial contracts and legal documents, you can improve your organization’s contract management capabilities and dramatically reduce the risks lurking in the contractual fine print.

By Jamie Wodetzki, founder of Exari Systems, a global leader in automated document assembly and Contract Life-Cycle Management for large enterprises. Jamie was CEO from 2000 to 2008 and now joins an expanded executive team to grow Exari’s US business. He has 15 years of experience automating and analyzing contracts, and has worked with many of the world’s largest OTC derivatives players on both the sell and buy side. Prior to co-founding Exari, Jamie was a Senior Associate with Minter Ellison, a large Australian law firm, where he focused on copyright, technology and the information industries. He has been an adviser to the Supporters of Interoperable Systems in Australia (’97-’07), a Board member of the Australian Digital Alliance (’98-’08), and represented an international NGO at the WIPO Copyright Treaty negotiations (’96).