Applying technology to legal data
15 March 2022
Akber Datoo, CEO of D2 Legal Technology, talks to SFT about the complexity of managing legal data and outlines solutions that can help clients to manage counterparty-type and netting determinations
Image: stock.adobe.com/monsitj
Over the past 18 months, several financial institutions have failed to meet regulatory expectations due to deficiencies in regulatory capital calculation, specifically when determining if counterparty exposure can be treated on a net versus gross basis. These issues are particularly prevalent in agency lending, owing to the additional complexity introduced by the principal-agent relationship.
The Basel Accord framework outlines steps that financial institutions can undertake to reduce credit exposure through their trading agreements and contracts and through a review of market and legal risk in the case of a counterparty default. When these steps are taken and a favourable determination is reached, a counterparty’s trading exposure can be measured on a net versus a gross basis. This “close-out netting” treatment has a direct bearing on the amount of regulatory capital that must be assigned to a firm’s trading positions with a particular counterparty — and, for the largest financial institutions, the regulatory capital impact can run into billions of dollars.
In the US, broker-dealers are required to perform regulatory capital calculations, as prescribed by the Securities and Exchange Commission (SEC) rule 15c3-1, Net Capital Requirements for Brokers and Dealers, at the principal level rather than the agent lender level.
The legal analysis involved in reviewing the enforceability and validity of close-out netting provisions under the Global Master Securities Lending Agreement (GMSLA), MSLA and other securities lending master agreements is admittedly not straightforward, with a level of technical insolvency law analysis that results in legal opinions than can run into hundreds of pages for some jurisdictions. However, issues tend to arise far earlier in the process – for example, just who is your counterparty?
For financial institutions to benefit and accurately calculate their exposures on a net rather than gross basis, regulations require that a reasoned and up-to-date independent legal opinion be obtained which confirms that close-out netting of transactions concluded under the relevant master agreement type, and with the relevant counterparty type, is valid in the jurisdiction of their counterparty.
Operational challenges
This is where the challenge comes…
The required legal opinions in this area are generally complex and dense, often running into many hundreds of pages. Correct interpretation and application of the legal opinion requires careful reading, cross-referencing and may require multiple checks related to the counterparty.
The level of granularity a legal opinion can often go into regarding which counterparties are covered in scope — and which are not — is not easy to establish. The nuances — regarding how this counterparty typing is defined in a legal opinion — are unique to this area and client onboarding teams are simply not equipped for this. For example, a definition of a term may cross reference one or more other definitions. Given how the details are often buried within an abundance of definitions and footnotes within these dense legal opinions, it is dependent on specialist lawyers, with years of familiarity with close-out netting opinions, to provide the necessary expertise regarding how to identify and classify counterparties for this purpose.
Many organisations have tried to operationalise this analysis by over-simplifying the analysis, often shifting the work to the client-onboarding task rather than a legal team. This is the crux of the issue. Client onboarding does not have the appropriate skills and expertise to conduct the required analysis. Conversely, researching counterparties, checking registration databases for factual details of a counterparty, is a suboptimal task for a skilled and experienced capital markets lawyer.
Agency lending specific challenges
Instinctively, one might think there would at least be some alignment across legal opinions provided for other agreement types, such as repo lending under the Global Master Repurchase Agreement (GMRA) or derivatives trading under an ISDA considering close-out netting and collateral enforceability. However, sadly this is not the case, with the counterparty scope and definition sometimes varying, often due to different counsel selection for the same jurisdiction, or even where the same counsel is selected for other more esoteric reasons such as the historic scope of a particular opinion. One such example is the most recent joint ICMA GMRA and ISLA GMSLA legal opinion for Japan, under which labour credit associations are only covered in respect of the GMSLA.
All this is exacerbated in agency lending by a range of factors. Lenders are in many cases niche entity types — for example pension funds of fire departments of a particular US state — which are not commonly covered in the industry netting opinions. The agent lender has typically done some due diligence, but it will not generally consider that it is responsible for assessing the netting determination. Rather, it will work on the basis that this is for the borrowing bank to manage. The borrowing bank may therefore have to commission, review and pay for a number of legal opinions.
Also, to protect commercial interests, there will often be detailed confidentiality agreements in place that will typically restrict the ability for the borrowing bank to share the identity of the lend=---=-er inside its organisation. This has been documented by the Securities Industry and Financial Markets Association (SIFMA) Agent Lender Disclosure Taskforce (2006), which outlines a detailed client information sharing model among market participants. In an agency arrangement, this model restricts sharing of principal details between trading desks, but does provide the necessary exceptions for compliance, legal and credit departments to obtain the required details on a need-to-know basis. Accordingly, agreements, when uploaded into legal agreement systems, may not refer to the end lender by name but may instead utilise a short name or code. Consequently, an already difficult process — to establish its type — becomes that much harder.
An agent lender may be acting for a few hundred borrowers or, in some cases, many thousands. Accordingly, umbrella agreements are often employed, where a GMSLA or MSLA is deemed to be in place, based on the terms of the main agreement with the agent lender. This effectively replicates the base agreement, but possibly changes the relevant terms so that these are appropriate for the relevant lenders, while also amending the terms to take account of the borrower’s requirements.
This, again, presents a number of issues. Legal agreement data systems struggle with the template agreement that will be replicated and how to differentiate this against each of the many cloned agreements. Maybe not all of the end principals have been cleared from a “know-your-client” perspective, since trading is not due to begin immediately with all of the end principals and these KYC requirements have been deferred until trading is imminent.
Moreover, catastrophically, it has been too easy to mistakenly conduct the netting determination on the manager rather than the end lender – as a number of regulatory breaches will illustrate.
Also, we cannot overlook the challenge that the volume and scale of agency lending creates, potentially dumping a few thousand borrower entities, to be assessed for netting determination purposes, within a single umbrella agreement.
The answer must be a more scalable solution that is operationalised. This is just a question of counterparty and client data that requires a more efficient and better thought out industry solution.
Accordingly, D2LT launched a counterparty type determination service in 2021, providing this counterparty type information for netting determination purposes — in fact linking the counterparty’s legal entity identifier (LEI) to the relevant legal opinions. This is not something firms need to struggle through individually. It is simply client data that one should be able to look up whenever it is needed.
The Basel Accord framework outlines steps that financial institutions can undertake to reduce credit exposure through their trading agreements and contracts and through a review of market and legal risk in the case of a counterparty default. When these steps are taken and a favourable determination is reached, a counterparty’s trading exposure can be measured on a net versus a gross basis. This “close-out netting” treatment has a direct bearing on the amount of regulatory capital that must be assigned to a firm’s trading positions with a particular counterparty — and, for the largest financial institutions, the regulatory capital impact can run into billions of dollars.
In the US, broker-dealers are required to perform regulatory capital calculations, as prescribed by the Securities and Exchange Commission (SEC) rule 15c3-1, Net Capital Requirements for Brokers and Dealers, at the principal level rather than the agent lender level.
The legal analysis involved in reviewing the enforceability and validity of close-out netting provisions under the Global Master Securities Lending Agreement (GMSLA), MSLA and other securities lending master agreements is admittedly not straightforward, with a level of technical insolvency law analysis that results in legal opinions than can run into hundreds of pages for some jurisdictions. However, issues tend to arise far earlier in the process – for example, just who is your counterparty?
For financial institutions to benefit and accurately calculate their exposures on a net rather than gross basis, regulations require that a reasoned and up-to-date independent legal opinion be obtained which confirms that close-out netting of transactions concluded under the relevant master agreement type, and with the relevant counterparty type, is valid in the jurisdiction of their counterparty.
Operational challenges
This is where the challenge comes…
The required legal opinions in this area are generally complex and dense, often running into many hundreds of pages. Correct interpretation and application of the legal opinion requires careful reading, cross-referencing and may require multiple checks related to the counterparty.
The level of granularity a legal opinion can often go into regarding which counterparties are covered in scope — and which are not — is not easy to establish. The nuances — regarding how this counterparty typing is defined in a legal opinion — are unique to this area and client onboarding teams are simply not equipped for this. For example, a definition of a term may cross reference one or more other definitions. Given how the details are often buried within an abundance of definitions and footnotes within these dense legal opinions, it is dependent on specialist lawyers, with years of familiarity with close-out netting opinions, to provide the necessary expertise regarding how to identify and classify counterparties for this purpose.
Many organisations have tried to operationalise this analysis by over-simplifying the analysis, often shifting the work to the client-onboarding task rather than a legal team. This is the crux of the issue. Client onboarding does not have the appropriate skills and expertise to conduct the required analysis. Conversely, researching counterparties, checking registration databases for factual details of a counterparty, is a suboptimal task for a skilled and experienced capital markets lawyer.
Agency lending specific challenges
Instinctively, one might think there would at least be some alignment across legal opinions provided for other agreement types, such as repo lending under the Global Master Repurchase Agreement (GMRA) or derivatives trading under an ISDA considering close-out netting and collateral enforceability. However, sadly this is not the case, with the counterparty scope and definition sometimes varying, often due to different counsel selection for the same jurisdiction, or even where the same counsel is selected for other more esoteric reasons such as the historic scope of a particular opinion. One such example is the most recent joint ICMA GMRA and ISLA GMSLA legal opinion for Japan, under which labour credit associations are only covered in respect of the GMSLA.
All this is exacerbated in agency lending by a range of factors. Lenders are in many cases niche entity types — for example pension funds of fire departments of a particular US state — which are not commonly covered in the industry netting opinions. The agent lender has typically done some due diligence, but it will not generally consider that it is responsible for assessing the netting determination. Rather, it will work on the basis that this is for the borrowing bank to manage. The borrowing bank may therefore have to commission, review and pay for a number of legal opinions.
Also, to protect commercial interests, there will often be detailed confidentiality agreements in place that will typically restrict the ability for the borrowing bank to share the identity of the lend=---=-er inside its organisation. This has been documented by the Securities Industry and Financial Markets Association (SIFMA) Agent Lender Disclosure Taskforce (2006), which outlines a detailed client information sharing model among market participants. In an agency arrangement, this model restricts sharing of principal details between trading desks, but does provide the necessary exceptions for compliance, legal and credit departments to obtain the required details on a need-to-know basis. Accordingly, agreements, when uploaded into legal agreement systems, may not refer to the end lender by name but may instead utilise a short name or code. Consequently, an already difficult process — to establish its type — becomes that much harder.
An agent lender may be acting for a few hundred borrowers or, in some cases, many thousands. Accordingly, umbrella agreements are often employed, where a GMSLA or MSLA is deemed to be in place, based on the terms of the main agreement with the agent lender. This effectively replicates the base agreement, but possibly changes the relevant terms so that these are appropriate for the relevant lenders, while also amending the terms to take account of the borrower’s requirements.
This, again, presents a number of issues. Legal agreement data systems struggle with the template agreement that will be replicated and how to differentiate this against each of the many cloned agreements. Maybe not all of the end principals have been cleared from a “know-your-client” perspective, since trading is not due to begin immediately with all of the end principals and these KYC requirements have been deferred until trading is imminent.
Moreover, catastrophically, it has been too easy to mistakenly conduct the netting determination on the manager rather than the end lender – as a number of regulatory breaches will illustrate.
Also, we cannot overlook the challenge that the volume and scale of agency lending creates, potentially dumping a few thousand borrower entities, to be assessed for netting determination purposes, within a single umbrella agreement.
The answer must be a more scalable solution that is operationalised. This is just a question of counterparty and client data that requires a more efficient and better thought out industry solution.
Accordingly, D2LT launched a counterparty type determination service in 2021, providing this counterparty type information for netting determination purposes — in fact linking the counterparty’s legal entity identifier (LEI) to the relevant legal opinions. This is not something firms need to struggle through individually. It is simply client data that one should be able to look up whenever it is needed.
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