We are entering an era of automated electronic contract formation with the benefits set to extend to securities lending and its Global Master Securities Lending Agreement (GMSLA). I have been following the International Swaps and Derivatives Association’s (ISDA) master agreement for some time and noted its recent acceleration of automated contract formation.
ISDA and the International Securities Lending Association (ISLA) have agreed to collaborate with the latter committing to “work to model and code specific securities financing transactions components for inclusion in the [Common Domain Model], creating greater alignment between derivatives and securities lending markets.”
I welcome this move. ISDA has been leading the way with the rolling out of a digital clause library that contains 42 standardised amendment clauses, selected following analysis of 50,000 samples from 3000 ISDA master agreements. In tandem, ISDA Create — a new platform that allows firms to negotiate and execute derivatives documentation online — will allow lawyers to digitally create contracts by clicking on clauses in a checkbox exercise.
These twin projects come under the purview of ISDA’s standardise to digitise policy. Standardisation, the creation of a Common Domain Model (CDM) and standard amending clauses are a sine qua non for digitisation. As ISDA’s CEO explains: “The CDM establishes a standard set of digital representations for events and processes that occur throughout the lifecycle of a trade. Aligning our documentation and definitions with these standards is critical to enable scalable automation.”
ISLA is set to port these concepts over to the GMSLA. The benefits are obvious. Days spent reviewing and amending documentation are whittled down to hours, drastically shortening negotiating times with concomitant cost savings.
My concern has been a whiff of complacency. I have no doubt the number of ISDA master agreement negotiator lawyers will diminish proportional to the adoption of digital contract formation. And this is understandable.
But while I partake in the romp of enthusiasm one should guard against throwing caution to the wind. Automated contract formation, much like the derivatives they govern, is a double-edged sword that requires careful handling. Used correctly, legal risk can be reduced and efficiency increased, yet used recklessly without sufficient human oversight, scrutiny and probing, digital contract formation will prove harmful and, in extremis, ruinous.
Why? Because master agreements are not without flaws and clauses are sometimes the result of imperfect compromises between lawyers from different member firms with competing interests. The human mind is not omnipotent and will often fail to envisage scenarios that seem remote at the time of contract execution.
The chances of idiosyncratic scenarios being detected and mitigated are increased if a contract is individually negotiated by a lawyer based at a contracting firm who is better placed to understand the nuances of the firm, its risk profile, risk tolerance and trading objectives.
This discerning mind, nuance and sensitivity risks being sacrificed at the alter of digitisation and efficiency. Sensible firms will retain careful human oversight during master agreement formation and reap the rewards of digitisation. It is equally true that some firms will become complacent, and come to rue the penny pinching if disputes occur later.
I recently spoke to a former head of research of ISDA who explained how every time he landed at London Heathrow he was haunted by the famous Hazel v Hammersmith and Fulham London Borough Council [1992] where the law lords voided ISDA-negotiated interest rate swap agreements ab initio due to lack of capacity to contract.
More recently in the infamous Lomas v Rix, lengthy and complicated litigation ensued arguing over whether payment was ever due if a counterparty was subject to an event of default in one transaction, who was never-the-less owed money by the non-defaulting counterparty on a net-basis but that the latter – not wishing to pay, refused indefinitely to serve a notice of default. This had the effect of something of a legal limbo. ISDA intervened in the case, and in the aftermath rushed out an amending clause to add a time limit.
ISLA’s membership must ensure the lessons of Lomas v Rix are at the fore as they embark on standardisation and digitisation. This project will lead to huge efficiency savings for most – but will cause large losses for the reckless who blindly rely on them.
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