Agreements undergird much of the civilized world and the derivatives industry is no different. While necessary, contracts can take significant effort to manage. They are lengthy, time-consuming and can cause disagreements in interpretation between parties. However, technology, particularly when paired with collaboration between parties, can help alleviate many of the challenges that contracts bring. This approach saves time and money, both for contracts under negotiation and executed contracts that need remediation as a result of changes such as the LIBOR transition to SOFR.
Many firms have no digitisation process to extract the underlying contract information and operational rules required to monitor and enforce agreements. Physically or electronically stored documents require users to interpret and enter agreement details into each party’s internal system. Unilateral interpretations and disparate systems lead to disputes and operational risk.
Even if a digitisation process is already in place, firms must follow industry standards that define what data to obtain from contracts, otherwise different levels of recorded information will result. Each difference in interpretation and captured data levels affects all downstream processes that require these details. The downstream impact exacerbates the initial mismatch, turning contract interpretation into an unnecessary high-stakes process of manual resolution.
A standardised contract and data model, on the other hand, has one agreed upon format for stakeholders to follow. The centralised data extraction process draws from consolidated contract examples to build an industry memory. As each document is processed, the industry memory increases the likelihood that the extracted legal clauses match previously codified patterns. When both parties work from a uniform representation of data, it ensures that consistent data is fed to downstream processes, resulting in a more efficient workflow with fewer disagreements among counterparties. Without operational disputes that require time to reconcile and resolve, firm resources can be redeployed on more value-added functions.
Machine learning can create standards that interpret legal clauses the same way every time. This ensures consistency across contracts, saves time and reduces costs. Provided these standards address the complexity inherent in these agreements, the entire industry will benefit from the enhanced consistency. The standards can also be used to remediate differing interpretations of past contracts, allowing parties to have a golden record to work for future agreements.
By using a centralised digitisation service, it also outsources the process of monitoring data exception, which further reduces cost. Outsourcing digitisation services enables providers to set up stable teams of trained analysts in place of project-based teams that required a ramping up and down period. This engagement model is a much more cost-efficient approach than reviewing the exceptions manually.
As the transition from LIBOR to SOFR looms and contracts need remediation, contract analysis will play a significant role. Contract analysis is similar to digitisation in that contracts are converted to machine-readable text. Rather than extract all data points defined by industry standards, contract analysis addresses specific questions about the data in a set of contracts. Compared to digitisation, contract analysis is more ad hoc and more akin to a series of reports that address questions about the data, such as whether a contract has language regarding LIBOR that would need to be remediated to account for SOFR.
In the case of LIBOR, for firms faced with thousands of potential contracts needing remediation, manual analysis of these contracts is not feasible from a cost, labor or efficiency standpoint. If firms use service providers to conduct the contract analysis, it results in standardised remediation processes. It also reduces project timelines by avoiding the project startup mistakes commonly seen in individual initiatives.
While technology has already had a tremendous impact on the derivatives industry, standardisation can unlock even more benefits for the industry. Even before the COVID-19 pandemic disrupted the industry, there was a healthy appetite for standardisation across the industry. Now more than ever, there is an imminent need to reduce and eliminate reliance on paper documents and manual processes. The industry must come together swiftly to create a digitised golden source representation of their legal contracts.
By Richard Barton, Head of Product Management at AcadiaSoft