By Akber Datoo, Founder and Partner, D2 Legal Technology LLP
Every financial institution knows the essential importance of legal contract information – it underpins everything from regulatory compliance and the management/optimisation of capital, liquidity and collateral. So why are just 16% of organisations completely satisfied with the current level of contract data accuracy? The implications post Lehman of failing to get a handle on legal contract data are serious; yet too many financial institutions are, frankly, still tinkering at the edges of this critical business issue.
Today, those reliant on legal contract data day to day – from compliance and operations to front office – have too little control over its creation or storage, contributing to significant commercial risks. Akber Datoo, founder and managing partner, and Simon Leifer, partner, of D2 Legal Technology, call on the financial industry to take a long, hard look at the governance of legal contract data.
Confused Strategy
When Lehmans failed, many financial institutions around the world had no clear idea of their level of exposure. Worried individuals from diverse departments were floundering around their in-house legal and documentation teams, looking for contracts and struggling to even locate them, let alone understand the essential information they contained. Several years on and while compliance teams have increased in size, even doubled, core legal departments have actually shrunk. Yet it is the quality, accuracy and attainability of that legal contract data that underpins vast swathes of both compliance, operational and key business activity. So where does this leave financial institutions in the face of escalating regulatory demands and ever tougher capital requirements that demand clear understanding and ability to accurately measure their counterparty risk?
One of the key problems is that the ownership of legal contract data is poorly understood and rarely clearly defined within an organisation. Where does the responsibility lie for ensuring legal contract data, especially for complex derivatives, is accurate and usable downstream, both internally and externally? Is the data owned by individual business data consumers; the trading desk that first trades under the legal contract; the IT team that owns the database; or the first system that receives and processes that data? Should it be the remit of the legal team tasked with creating the contracts? In a recent survey, 67% of financial firms reported that the question of who owns and is responsible for the accuracy of legal contract data was not clearly defined.
The traditional concepts of data ownership, stewardship and responsibility for accessing data have simply not been applied in this critical area – and it is only now, still feeling the aftermath of the crisis and in the face of escalating regulatory demands, that organisations are beginning to understand the implications of that lack of data governance.
Understanding Risk
The consequences of this lack of information control are significant. The survey revealed that only 16% of respondents were completely satisfied with the level of contract data accuracy – while 75% had no defined target contract data accuracy levels and did not have a measure of the current level of accuracy. In addition, the majority of collateral agreements reportedly have at least one key legal contract data item incorrectly captured, and as an industry some 5% have missing pages, documents or amendments.
The business implications are even more significant. The UK Financial Conduct Authority (FCA) is clamping down on firms’ failure to meet client money and asset rules – with recent large fines being associated with clear flaws in account naming and incorrect data. The Living Wills (Recovery & Resolution Planning) requirement also highlights the importance of legal contract data. After one regulator rejected every single institution’s initially submitted plans, another has now issued more specific requirements including those that essentially address the current lack of understanding of the data contained in key contracts. But what chance does the Regulatory & Compliance Officer have of locating – let alone trusting – that information given the current lack of contract data accuracy?
In addition to this regulatory stick, improving understanding of the legal contracts can transform business operations. For example, better insight into the nuances of specific contracts can have a huge impact on collateral management and optimisation. While the Basel Committee (part of the Bank for International Settlements) and the International Organisation of Securities Commission have pushed back the deadline regarding margin requirements for non-centrally cleared derivatives, the more insight an institution has into its contractual obligations, the more opportunities there are to influence the balance sheet for capital, liquidity and use that collateral more smartly. As a result of this, institutions will be better able to understand the business they are in, and ultimately achieve a better return on investment.
A credit ratings event is another key issue, with many trading documents including links to drops in credit ratings. A lack of awareness of the implications of such events is a hugely dangerous situation – with an institution at risk of default; facing the need to put up more collateral and capital; or needing to swiftly transfer transactions to a more credit worthy institution.
New Model
Clearly a lack of visibility of legal contract data can have potentially catastrophic consequences; while improving access to this information can transform operational decision making. Historically there has been no universal approach to collecting and storing this information, which has led to the data being treated and interpreted by different parts of the business, leading to inaccuracies and inconsistencies. That has to change and institutions need to introduce new processes to ensure data is captured and stored accurately and usefully.
It is time for organisations to change attitudes to legal contract data and to begin to embrace the good data governance that is inherent within other areas of reference data management (such as product and client). It is no longer acceptable for the in-house legal team to view its responsibility as ending at the point of contract production. Nor are half-hearted attempts to improve document storage, or create summaries to improve speed of access and retrieval adequate.
The truth is that the business could and should be using this data before, during and after contract creation. An institution that is aware of its legal data can be making decisions based on that data that have a significant operational impact internally and externally. And the only way to do this is to move away from silo-based approaches targeted at specific business data stores and embrace a single, consistent ‘golden source’ reference data approach that enables legal contract data to be used effectively within risk data aggregation and reporting.
Conclusion
Right now financial institutions are using vast quantities of manual effort – both internally, off shore and near shore – in an attempt to determine risk by trawling through legal contract data. But this model is outdated and flawed. Post-Lehmans, the market is all about the survival of the fittest: from compliance to effective use of capital – those with a poor return or poor regulatory performance will be closed down or sold off.
So why persist in failing to address one of the key areas that will provide that essential visibility into exposure to enable not only better capital utilisation but also provide a far better handle on liquidity requirements? Why are some Chief Data Officers not putting in place a long term strategy that supports Living Will requirements, addresses FCA demands, minimises exposure to risk and enables institutions to gain significant operational advantage, from reducing capital requirements onwards?
Institutions can no longer afford to treat the quality and accessibility of legal contract data as a side issue – it is time to recognise the essential value of this data.
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