Five Steps for Proactively Managing OTC Derivatives Documentation Risk

Lehman Brothers’ filing of a Chapter 11 petition in September 2008 sent both Lehman and its derivatives counterparties scrambling to find and make sense of the reams of documentation that governed their rights and obligations in the wake of that cataclysm.  The bewildering challenge of terminating and valuing thousands of transactions was compounded by the fact that some counterparties could not promptly locate all of their documentation, and many of those that could were surprised – both negatively and positively – by what it contained when they read it.  The consequences of the Lehman bankruptcy are now in the rear-view mirror for most counterparties, but the market now faces other serious challenges.  In particular, the OTC derivatives market is hurtling toward the brave new world of clearing, which will simplify some aspects of derivatives transactions, but not all of them.  Not only are non-cleared transactions going to persist on a substantial scale, but many users likely will have a mix of both cleared and non-cleared transactions in their portfolios.  This compounds the complexity of documentation of OTC derivatives, making it critical that market participants stay on top of their documentation.  Unfortunately, there are signs – including two recent reports – that many market participants may not be keeping pace in monitoring and managing all of the necessary details of their OTC derivatives portfolios.  As so many counterparties learned from Lehman’s bankruptcy, such disarray is a recipe for disaster.  Only by keeping a close eye on documentation – both on the trading floor and in the legal and compliance functions – can problems be minimized or avoided, and opportunities exploited.  In a guest article, Anne E. Beaumont, a partner at Friedman Kaplan Seiler & Adelman LLP, identifies five best practices that OTC derivatives users of all sizes should adopt to manage the risks and to take best advantage of the opportunities presented by their documentation – and be well-prepared for any crisis, whether it is another major counterparty collapse like Lehman, or something more modest.  See also “How Have Dodd-Frank and European Union Derivatives Trading Reforms Impacted Hedge Fund Managers That Trade Swaps?,” Hedge Fund Law Report, Vol. 6, No. 40 (Oct. 17, 2013).

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