Derivatives Contract Risk

Better risk management preparations in light of COVID-19 Shock

The economic fall out from the global pandemic is already being felt in a number of places in the financial sector, but the true extent is still largely hidden with governments doing their best to prop up economies.   

A glimpse of the contractual risks in derivatives contracts was seen in March this year with the so called ‘COVID-19 shock’ – rapid and large price movements causing a huge increase in margin calls and margin requirements. See link for what went on.

The catalyst this time is different to the 2008 financial crisis – arguably that one could be seen coming whereas COVID took everyone by surprise.  The impacts though are likely to be the same – bad loans, negative rates, ratings downgrades, large changes in funds net asset value (NAV).

In these uncertain times it becomes clear that having a timely view on contract risk is key: 

  •  Collateral optimisation starts with eligibility data, many still rely on collateral management platforms for this view, but those will often take a snapshot at a point in time, based on current ratings and prevailing market conditions.
  • Contracts such as ISDA Master agreements contain specific termination provisions, some through boilerplate, some through elections.  Other standard terms may be modified.
  • Very few organisations have a quick way to get a view into this data.  Their only option is going back to their contract repositories and searching through the scans to answer these questions. Even with technology getting an accurate picture is not easy.

The best approach is to use a contract data management platform – codify this information when you negotiate the contracts.

Ideally going forward you’d be using tools like ISDA Create to do this efficiently and enforce standardisation. Codify your legacy contract data with tools such as Lyncs.  View it all in a single repository that deals with the historic contractual nastiness, new formats such as ISDAs common domain model (CDM) and output from tools like ISDA create and other document generation utilities.

Once you have achieved this you can unlock powerful pre-built analytics to enable you to answer urgent questions in times of crisis within minutes:

  • ‘Which contracts contain a Cross Default provision on one of my entities?’
  • ‘Are there any termination provisions triggered by a rating downgrade of me / my counterparty?’
  • ‘What collateral can I post / receive as margin?’ 
  • ‘What happens if my NAV drops 20% – are there any termination provisions with NAV triggers?’

By using a single platform to homogenise contract data sourced from the new negotiation tools, with non-standard and legacy contracts, you can truly unlock meaningful insights.

Our new Lyncs analytics module helps financial institutions using our leading contract data management software to gain immediate insights on key risks and operational data.

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