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What are the major risks resulting from financial instruments?
Legal Risk
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Legal risk is the risk of loss because a contract cannot be legally enforced, and includes risks arising from insufficient documentation and insufficient authority of the counterparty. Senior managers should set down procedures that require the relevant department to satisfy itself that the firm’s counterparties have the legal and necessary regulatory (and company) authority to engage in a transaction. This includes ensuring that risk- takers working in the firm’s counterparties have the necessary authorisation from their Board to deal on behalf of the company. The board could insist on a legal audit to be carried out annually by one of its in-house lawyers, or if it does not have the resources, outsource it to an external candidate. Where possible, the firm should use market-standard master agreements (such as the International Swaps and Derivatives Association master agreement). Bilateral agreements must be adequately evaluated for enforceability before any transactions take place. Automatic termination provisions should be established when the relevant legal system does not permit termination freely upon default. Netting agreements should be adequately documented and executed properly.
There should be proper documentation for every deal - deal confirmation, consents, approvals, record of relevant agreement, payment instructions, margin arrangements and any other credit enhancement techniques (if applicable) .
Senior managers should ensure that line managers are familiar with the relevant tax laws and interpretations governing the use of derivatives.
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13 Questions on Risk Management *
What are the major risks resulting from financial instruments?
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