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Capital-Markets Activities Manual
Activities: Legal Risk
Source: Federal Reserve System
(The complete Activities
Manual (pdf format) can be downloaded from the Federal Reserve's web
An institution's trading activities can lead
to significant legal risks. Failure to correctly document oral transactions
can result in legal disputes with counterparties over the terms of the
agreement. Even if adequately documented, agreements may prove to be unenforceable
if the counterparty does not have the authority to enter into the transaction
or the terms of the agreement are not in accordance with applicable law.
While the legal risks associated with trading activities vary depending
on the type of activity, over-the-counter (OTC) derivative transactions,
in particular, give rise to the risk that a contract could be unenforceable
if challenged. Master agreements with netting provisions, whether used
in connection with OTC derivatives or other transactions, also give rise
to a risk that the netting provisions of the agreements may be unenforceable.
The unenforceability of a netting agreement may expose an institution
to significant losses if it relied on the netting agreement to manage
its credit risk or for capital purposes.
As part of sound risk management, institutions should take steps to guard
themselves against legal risk. Active involvement of the institution's
legal counsel is an important element in ensuring that the institution
has adequately considered and addressed legal risk. An institution's policies
and procedures should include appropriate review by in-house or outside
counsel as an integral part of the institution's trading activities, including
new-product development, credit approval, and documentation of transactions.
While some issues, such as the legality of a type of transaction, may
be addressed on a jurisdiction-wide basis, other issues, such as enforceability
of multi-branch netting agreements covering several jurisdictions, may
require review of individual contracts.
This section discusses some of the primary areas of concern with respect
to legal risk. These issues generally are of greatest concern in connection
with OTC derivatives contracts, but are relevant to other trading activities,
If the terms of a transaction are not adequately
documented, there is a risk that the transaction will prove unenforceable.
Many trading activities, such as securities trading, commonly take place
without a signed agreement, as each individual transaction generally settles
within a very short time after the trade. The trade confirmations generally
provide sufficient documentation for these transactions, which settle
in accordance with market conventions. Other trading activities involving
longer-term, more complex transactions may necessitate more comprehensive
and detailed documentation. Such documentation ensures that the institution
and its counterparty agree on the terms applicable to the transaction
and satisfies other legal requirements, such as the ''statutes of frauds''
that may apply in many jurisdictions. Statutes of frauds generally require
signed, written agreements for certain classes of contracts, such as agreements
with a duration of more than one year (including both longer-term transactions
such as swaps and master or netting agreements for transactions of any
duration). Some states, such as New York, have provided limited exceptions
from their statutes of frauds for certain financial contracts when other
supporting evidence, such as confirmations or tape recordings, is available.
In the OTC derivatives markets, the prevailing practice has been for institutions
to enter into master agreements with each counterparty. Master agreements
are also becoming common for other types of transactions, such as repurchase
agreements. Each master agreement identifies the type of products and
specific legal entities or branches of the institution and counterparty
that it will cover. Entering into a master agreement may help to clarify
that each subsequent transaction with the counterparty will be made subject
to uniform terms and conditions. In addition, a master agreement that
includes netting provisions may reduce the institution's overall credit
exposure to the counterparty.
An institution should specify its documentation requirements for transactions
and procedures for ensuring the consistency of documentation with orally
agreed-on terms. Transactions entered into orally with documents to follow
should be confirmed as soon as possible. Documentation policies should
address the terms to be covered by confirmations for specific types of
transactions and transactions that are covered by a master agreement;
policies should specify when additional documentation beyond the confirmation
is necessary. When master agreements are used, policies should cover the
permissible types of master agreements. Appropriate controls should be
in place to ensure that confirmations and agreements used satisfy the
institution's policies. Additional issues related to the enforceability
of the netting provisions of master agreements are discussed below (see
Special attention should be given to the
definition of trigger events that provide for payment from one counterparty
to another or permit a counterparty to close out a transaction or series
of transactions. While in the ordinary course of events, these contractual
disputes can be resolved by parties who wish to continue to enter into
transactions with one another, they can become intractable in the event
of serious market disruptions. Indeed, the 1998 Russian market crisis
raised calls for the establishment of an international dispute resolution
tribunal to handle the large volume of disputed transactions when the
Russian government announced its debt moratorium and restrucEagle Tradersg.
Trigger events need to be clearly and precisely defined. In the Russian
crisis, the trigger events in some master agreements did not include a
rescheduling of or moratorium on the payment of sovereign debt. Even where
sovereign debt is covered by the master agreement, it may be appropriate
to specify that not only debt directly issued by the sovereign, but also
debt issued through governmental departments and agencies or through other
capital-raising vehicles, falls within the scope of the trigger event.
Moreover, when a trigger event has occurred, but the contract expires
before the expiration of a cure period or before the completion of a debt
restrucEagle Tradersg, the non-defaulting party can lose the protection
of the contract absent clear provisions to the contrary.
The occurrence of trigger events also may give rise to disputes regarding
the appropriate settlement rate at which to close out contracts. It may
be difficult to argue in favor of substitute settlement rates that were
not referenced as a pricing source in the original documentation. However,
original pricing sources may not be available or may be artificially maintained
at non-market rates by a government seeking to preserve its currency.
Contracts also should be clear as to whether cross-default provisions
allow or require the close-out of other contracts between the parties.
Finally, close-out provisions should be reviewed to determine what conditions
need to be met before the contract can be finally closed out. Formalities
in some contracts may delay the close-out period significantly, further
injuring a non-defaulting counterparty.
If the counterparty does not have the legal
authority to enter into a transaction, the institution runs the risk that
a legal challenge could result in a court finding the contract to be ultra
vires and therefore unenforceable. Significant losses in OTC derivatives
markets resulted from a finding that swap agreements with municipal authorities
in the United Kingdom were ultra vires. Issues concerning the authority
of municipal and other government units to enter into derivatives contracts
have been raised in some U.S. jurisdictions, as well. Other types of entities,
such as pension plans and insurance companies, may need specific regulatory
approval to engage in derivatives transactions.
A contract may be unenforceable in some circumstances if the person entering
into the contract on behalf of the counterparty is not authorized to do
so. Many entities, including corporations, have placed more extensive
restrictions on the authority of the corporation or its employees to enter
into certain types of derivatives and securities transactions.
To address issues related to counterparty authority, an institution's
procedures should provide for an analysis, under the law of the counterparty's
jurisdiction, of the counterparty's power to enter into and the authority
of a trading representative of the counterparty to bind the counterparty
to particular transactions. It also is common to look at authorizations
of boards of directors or trustees to enter into specific types of transactions.
Depending on the procedures of the particular institution, issues relating
to counterparty capacity may be addressed in the context of the initial
credit-approval process or through a more general review of classes of
Concerns have been raised in a number of
jurisdictions, including in the United States, as to whether OTC derivative
transactions would be considered illegal under various statutes prohibiting
gambling contracts, bucket shops, or off-exchange futures trading. In
the United States, the threatened application of the offexchange-trading
prohibition of the Commodity Exchange Act (CEA) to OTC derivative transactions
presented a significant legal risk. However, the Commodity Futures Trading
Commission (CFTC) has exempted a broad range of OTC derivatives from the
CEA, eliminating the risk that instruments meeting certain conditions
would be found to be illegal off-exchange futures. The exemption nevertheless
limits the use of multilateral netting and similar arrangements for reducing
credit and settlement risk, and reserves the CFTC's enforcement authority
with respect to fraud and market manipulation.1
The CFTC's exemption provides significant comfort with respect to the
legality of most OTC derivative instruments within the United States.
The risk that a transaction will be unenforceable because it is illegal
may be higher in other jurisdictions, however. Jurisdictions outside the
United States also may have licensing or other requirements that must
be met before certain OTC derivatives or other trading activities can
be legally conducted.
To address the risks that a transaction may be unenforceable because of
illegality, an institution should establish and follow procedures to ensure
adequate review of new products. Products that are new to the institution
and existing products being offered by the institution in a new jurisdiction
should be covered. Legal review of products or transactions may take place
as part of the new-product review or credit-approval process.
To reduce settlement, credit, and liquidity
risks, institutions increasingly use netting agreements or master agreements
that include netting provisions. ''Netting'' is the process of combining
the payment or contractual obligations of two or more parties into a single
net payment or obligation. Institutions may have bilateral netting agreements
covering the daily settlement of payments such as those related to check-clearing
or foreign-exchange transactions. Bilateral master agreements with netting
provisions may cover OTC derivatives or other types of transactions, such
as repurchase agreements.
1. See 17 CFR 35. Instruments covered
by the CFTC's exemption also are excluded from the coverage of state bucket
shop and gambling laws.
Master agreements generally provide for routine transaction and payment
netting and for closeout netting in the event of a default. Under the
transaction and payment netting provisions of such an agreement, all payments
for the same date in the same currency for all covered transactions are
netted, resulting in one payment in each currency for any date on which
payments are made under the agreement. Close-out netting provisions, on
the other hand, generally are triggered by certain default events, such
as a failure to make payments or insolvency. Such events may give the
non-defaulting party the right to require early termination and close-out
of the agreement. Under close-out netting, the positive and negative current
replacement values for each transaction under the agreement are netted
with respect to the non-defaulting counterparty to obtain a single sum,
either positive or negative. If the sum of the netting is positive, (that
is, the transactions under the agreement, taken as a whole, have a positive
value to the non-defaulting counterparty), then the defaulting counterparty
owes that sum to the non-defaulting counterparty.
The results may differ if the net is negative, that is, the contracts
have a positive value to the defaulting counterparty. Some master agreements
include so-called ''walk-away'' clauses, under which a non-defaulting
counterparty is not required to pay the defaulting counterparty for the
positive value of the netting to the defaulting counterparty. The current
trend, however, has been to require payments of any positive net value
to either party, regardless of whether the party defaulted. Revisions
to the Basle Capital Accord have reinforced this trend by not recognizing
netting agreements that include a walkaway clause, as discussed more fully
The effectiveness of netting in reducing risk depends on both the adequacy
and enforceability of the legal arrangements in place. A major source
of concern for market participants has been the enforceability in bankruptcy
of the close-out netting provisions of master agreements covering multiple
derivative transactions. When a bank has undertaken a number of contracts
with a particular counterparty subject to a master agreement, the bank
runs the risk that, in the event of the counterparty's failure, the receiver
for the counterparty will refuse to recognize the validity of the netting
provisions. In such an event, the receiver could ''cherry pick,'' or repudiate
individual contracts under which the counterparty was obligated to pay
the bank, while demanding payment on those contracts on which the bank
was obligated to pay the counterparty.
The Financial Institutions Reform, Recovery, and Enforcement Act of 1990
(FIRREA) and amendments to the Bankruptcy Code, as well as the payment
system risk-reduction provisions of the Federal Deposit Insurance Corporation
Improvement Act (FDICIA), have significantly reduced this risk for financial
institutions in the United States.2
The enforceability of close-out netting remains a significant risk in
dealing with non-U.S. counterparties that are chartered or located in
jurisdictions where the legal status of netting agreements may be less
well settled. Significant issues concerning enforcement and collection
under netting agreements also arise when the counterparty is an uninsured
branch of a foreign bank chartered in a state, such as New York, that
has adopted a ''ring fencing'' statute providing for separate liquidation
of such branches.
In evaluating the enforceability of a netting contract, an institution
needs to consider a number of factors. First, the institution needs to
determine the legal entity that is its counterparty. For example, if the
bank is engaging in transactions with a U.S. branch of a foreign bank,
the relevant legal entity generally would be the foreign bank itself.
Additionally, some master agreements are designed to permit netting of
transactions with multiple legal entities. A further consideration is
the geographic coverage of the agreement. In some instances, bank counterparties
have structured their netting agreements to cover transactions entered
into between multiple branches of the counterparties in a variety of countries,
thereby potentially subjecting the agreements to a variety of legal regimes.
Finally, the range of transactions to be covered in a single agreement
is an important consideration. While there is an incentive to cover a
broad range of contracts to achieve a greater reduction of credit risk,
over-inclusion may be counterproductive if contracts are included that
jeopardize the enforceability of the entire agreement. Some institutions
deal with this risk by having separate agreements for particular products,
such as currency contracts, or separate master agreements covered by an
overall ''master master'' agreement.
Regardless of the scope of a master agreement, clarity is an important
factor in ensuring the enforceability of netting provisions. The agreement
should clearly specify the types of deals to be netted, mechanisms for
valuation and netting, locations covered, and the office through which
netting will be done.
2. Risks related to netting enforceability
have not been completely eliminated in the United States. Validation of
netting under FDICIA is limited to netting among entities that may be
considered to be ''financial institutions.''
Reliance on Netting Agreements
While netting agreements have the potential to substantially reduce credit
risk to a counterparty, an institution should not rely on a netting agreement
for credit-risk-management purposes unless it has adequate assurances
that the agreement would be legally enforceable in the event of a legal
challenge. Further, netting will be recognized for capital purposes only
if the bank has satisfied the requirements set forth in the Basle Capital
Accord (the accord). To meet these requirements, the netting contract
or agreement with a counterparty must create a single legal obligation,
covering all transactions to be netted, such that the bank would have
either a claim to receive or an obligation to pay only the net amount
of the individual transactions in the event a counterparty fails to perform
because of default, bankruptcy, liquidation, or other similar circumstances.3
Netting contracts that include a walk-away
clause are not recognized for capital purposes under the accord.
To demonstrate that a netting contract meets the requirements of the accord,
the bank must have written and reasoned legal opinions that, in the event
of a legal challenge, the relevant courts and administrative authorities
would find the bank's exposure to be the net amount under-
• the law of the jurisdiction in which the counterparty is chartered
and, if a foreign branch of a counterparty is involved, then also under
the law of the jurisdiction in which the branch is located;
• the law that governs the individual transactions; and
• the law that governs any contract or agreement necessary to effect
Under the accord, the bank also must have procedures in place to ensure
that the legal characteristics of netting arrangements are regularly reviewed
in light of possible changes in relevant law. To help determine whether
to rely on a netting arrangement, many institutions have procedures for
internally assessing or ''scoring'' legal opinions from relevant jurisdictions.
These legal opinions may be prepared by outside or in-house counsel. A
generic industry or standardized legal opinion may be used to support
reliance on a netting agreement for a particular jurisdiction. The institution
should have procedures for review of the terms of individual netting agreements,
however, to ensure that the agreement does not raise issues, such as enforceability
of the underlying transactions, choice of law, and severability, that
are not covered by the general opinion.
Institutions also rely on netting arrangements in managing credit risk
to counterparties. Institutions may rely on a netting agreement for internal
risk-management purposes only if they have obtained adequate assurances
on the legal enforceability of the agreement in the event of a legal challenge.
Such assurances generally would be obtained by acquiring legal opinions
that meet the requirements of the Basle Accord.
3. The agreement may cover
transactions excluded from the risk-based capital calculations, such as
exchange-rate contracts with an original maturity of 14 calendar days
or less or instruments traded on exchanges requiring daily margin. The
institution may consistently choose either to include or exclude the mark-to-market
values of such transactions when determining net exposure.
4. A netting contract generally must be found to be enforceable in all
of the relevant jurisdictions for an institution to rely on netting under
the contract for capital purposes. In some jurisdictions in which the
enforceability of netting may be in doubt, however, an institution may
be able, in appropriate circumstances, to rely on opinions that the choice
of governing law made by the counterparties to the agreement will be respected.
A multi-branch master netting agreement covers transactions entered into
between multiple branches of an institution or its counterparty that are
located in a variety of countries. These agreements may cover branches
of the institution or counterparty located in jurisdictions where multi-branch
netting is not enforceable, creating the risk that including these branches
may render the entire netting agreement unenforceable for all transactions.
To rely on the netting agreement for transactions in any jurisdiction,
an institution must obtain legal opinions that conclude (1) that transactions
with branches in user-unfriendly jurisdictions are severable and (2) that
the multi-branch master agreement would be enforceable, despite the inclusion
of these branches.
Currently, the risk-based capital rules do not specify how the net exposure
should be calculated when a branch in a netting-unfriendly jurisdiction
is included in a multi-branch master netting agreement. In the meantime,
institutions are using different practices, which are under review with
the goal of providing additional guidance. Some institutions include the
amount owed by branches of the counterparty in netting-unfriendly jurisdictions
when calculating the global net exposure. Others completely sever these
amounts from calculations, as if transactions with these branches were
not subject to the netting agreement. With respect to transactions with
branches in netting-unfriendly jurisdictions, some institutions add on
the amounts they owe in such jurisdictions (which are liabilities) to
account for the risk of double payment,5
while other institutions add on the amounts owed to them in such jurisdictions
(which are assets). The approach an institution uses should reflect the
specifics of the legal opinions it receives concerning the severability
of transactions in netting-unfriendly jurisdictions.
Financial institutions are increasingly using collateral agreements in
connection with OTC derivatives transactions to limit their exposure to
the credit risk of a counterparty. Depending on the counterparties' relative
credit strength, requirements for posting collateral may be mutual or
imposed on only one of the counterparties. Under most agreements, posting
of collateral is not required until the level of exposure has reached
a certain threshold.
While collateral may be a useful tool for reducing credit exposure, a
financial institution should not rely on collateral to manage its credit
risk to a counterparty and for risk-based capital purposes unless it has
adequate assurances that its claim on the collateral will be legally enforceable
in the event the counterparty defaults, particularly with respect to collateral
provided by a foreign counterparty or held by an intermediary outside
of the United States. To rely on collateral arrangements where such cross-border
issues arise, a financial institution generally should have written and
reasoned legal opinions that (1) the collateral arrangement is enforceable
in all relevant jurisdictions, including the jurisdiction in which the
collateral is located, and (2) the collateral will be available to cover
all transactions covered by the netting agreement in the event of the
The effectiveness of netting in reducing risks also depends on how the
arrangements are implemented. The institution should have procedures to
ensure that the operational implementation of a netting agreement is consistent
with its provisions.
Netting agreements also may require that some of a financial institution's
systems be adapted. For example, the interface between the front-office
systems and back-office payment and receipt functions needs to be coordinated
to allow trading activity to take place on a gross basis while the ultimate
processing of payments and receipts by the back-office is on a net basis.
In particular, an internal netting facility needs to-
• segregate deals to be netted,
• compute the net amounts due to each party,
• generate trade confirmations on the trade date for each trade,
• generate netted confirmations shortly after the agreed-on netting
• generate net payment and receipt messages,
• generate appropriate nostro and accounting entries, and
• provide for the cancellation of any gross payment or receipt
messages in connection with the netted trades.
5. The risk of double payment is
the risk that the institution must make one payment to a counterparty's
main receiver under a multi-branch master agreement and a second payment
to the receiver of the counterparty's branch in the netting-unfriendly
jurisdiction with respect to transactions entered into in that jurisdiction.
An area of growing concern for legal practitioners
has been the documentation of non-deliverable forward (NDF) foreign-exchange
transactions. The NDF market is a small portion of the foreign-exchange
market, but is a large part of the market for emerging-country currencies.
An NDF contract uses an indexed value to represent the value of a currency
that cannot be delivered due to exchange restrictions or the lack of systems
to properly account for the receipt of the currency. NDF contracts are
settled net in the settlement currency, which is a hard currency such
as U.S. dollars or British pounds sterling.
An NDF contract must be explicitly identified as such-foreign-exchange
contracts are presumed to be deliverable. The index should be clearly
defined, especially in countries in which dual exchange rates exist, that
is, the official government rate versus the unofficial ''street'' rate.
NDF contracts often provide for cancellation in the event of certain disruption
events specified in the master agreement. Disruption events can include
sovereign events (the nationalization of key industries or defaults on
government obligations), new exchange controls, the inability to obtain
valid price quotes with which to determine the indexed value of the contract,
or a benchmark obligation default. Under a benchmark obligation default,
a particular issue is selected and, if that issue defaults during the
term of the contract, the contract is cancelled. Care should be taken
to ensure that cancellation events are specifically described to minimize
disputes as to whether an event has occurred. In addition, overly broad
disruption events could cause the cancellation of a contract that both
counterparties wish to execute.
The International Swaps and Derivatives Association (ISDA) has established
an NDF project to develop standard documentation for these transactions.
The ISDA documentation establishes definitions that are unique to NDF
transactions and provides sample confirmations that can be adapted to
reflect disruption events.
REVIEW OF LEGAL ISSUES
Review by legal counsel, either in-house
or outside the institution, should be an integral part of an institution's
activities in the OTC derivatives markets. This review may take place
at a variety of different levels. Some issues, such as documentation of
transactions and the legality of OTC contracts, may be addressed appropriately
on a jurisdiction-wide basis. Other issues, such as the enforceability
of multi-branch netting agreements covering several jurisdictions or cross-border
collateral arrangements, may require review of the individual contracts.
The institution should have established procedures to ensure adequate
legal review. For example, review by legal counsel may be required as
part of the product-development or credit-approval process. Legal review
also is necessary for an institution to establish the types of agreements
to be used in documenting OTC derivatives, including any modifications
to standardized agreements that the institution considers appropriate.
The institution also should ensure that prior legal opinions are reviewed
periodically to determine if they are still valid.
Legal Risk Examination Objectives
1. To determine if the institution's internal policies and procedures
adequately identify potential legal risks and ensure appropriate legal
review of documentation, counterparties, and products.
2. To determine whether appropriate documentation requirements have been
established and that procedures are in place to ensure that transactions
are documented promptly.
3. To determine whether adequate assurances of legal enforceability have
been obtained for netting agreements or collateral arrangements relied
on for risk-based capital purposes or credit-risk management.
4. To determine whether the operational areas of the bank are effectively
implementing the provisions of netting agreements.
5. To determine whether the unique risks of NDF contracts have been considered
and reflected in the institution's policies and procedures, if appropriate.
Legal Risk Examination Procedures
The following should be used by examiners as guidelines to assist their
review of the institution's trading activities with respect to legal risk.
This should not be considered to be a complete checklist of subjects to
1. Obtain copies of policies and procedures that outline appropriate legal
review with respect to new products.
a. Does the institution require legal review of new products as part of
the product-review process?
b. Do the procedures provide for review of existing products offered in
2. Obtain copies of policies and procedures that outline review requirements
for new counterparties.
a. Does the institution require review of new counterparties to
ensure that the counterparty has adequate authority to enter into proposed
b. Do the institution's procedures ensure further review of counterparty
authority if new types of transactions are entered into?
3. Obtain copies of policies and procedures that establish documentation
a. Has the institution established documentation requirements for all
types of transactions in the trading area?
b. When are master agreements required for OTC derivative or other transactions
with a counterparty?
c. Does the institution require legal review for new agreement forms,
including netting agreements and master agreements with netting provisions?
d. Who has authority to approve the use of new agreement forms, including
new master agreement forms or agreement terms?
e. How does the institution ensure that documents are executed in a timely
manner for new counterparties and new products?
f. Does the institution have an adequate document-management system to
track completed and pending documentation? How does the institution follow
up on outstanding documentation?
g. What controls does the institution have in place pending execution
of required documentation, such as legal-approval requirements, before
the execution of master agreements or credit controls when documentation
of collateral arrangements is not complete? Please note that documentation
has not been executed until it has been signed by appropriate personnel
of both parties to the transaction.
h. In practice, is required documentation executed in a timely manner?
i. Who has the authority to approve exceptions to existing documentation
j. Do the procedures ensure that documentation is reviewed for consistency
with the institution's policies?
k. Who reviews documentation?
l. Does the institution specify the terms to be covered by confirmations
for different types of transactions, including transactions that are subject
to master agreements?
m. If the institution engages in NDF transactions, does the documentation
address the index to be used and clearly specify that the contract is
for a non-deliverable currency? Are disruption events, if any, described
4. Obtain copies of policies and procedures concerning review of enforceability
of netting agreements and master agreements with netting provisions.
a. Does the institution have procedures to ensure that legal opinions
have been obtained addressing the enforceability of a netting agreement
under the laws of all relevant jurisdictions before relying on the netting
agreement for capital purposes or in managing credit exposure to the counterparty?
b. Do the procedures include guidelines for determining the relevant jurisdictions
for which opinions should be obtained? Opinions should cover the enforceability
of netting under (1) the law of the jurisdiction in which the counterparty
is chartered, (2) the law of any jurisdiction in which a branch of the
counterparty that is a party to the agreement is located, (3) the law
that governs any individual transaction under the netting agreement, and
(4) the law that governs the netting agreement itself.
c. When generic or industry opinions are relied on, do the procedures
of the institution ensure that individual agreements are reviewed for
additional issues that might be raised?
d. Does the institution have procedures for evaluating or ''scoring''
the legal opinions it receives concerning the enforceability of netting
e. Who reviews the opinions? How do they communicate their views as to
the enforceability of netting under an agreement?
f. Who determines when master netting agreements will be relied on for
risk-based capital and credit-risk-management purposes?
g. Who determines whether certain transactions should be excluded from
the netting, such as those in connection with a branch in a netting-unfriendly
h. When the institution nets transactions for capital purposes, are any
transactions that are not directly covered by a close-out netting provision
of a master agreement included? If so, does the institution obtain legal
opinions supporting the inclusion of such transactions? For example, if
the institution includes in netting calculations foreign-exchange transactions
between branches of the institution or counterparty not covered by a master
agreement, ask counsel if the institution has an agreement and legal opinion
that support this practice.
i. Does the institution have procedures to ensure that the legal opinions
on which it relies are periodically reviewed?
j. Does the institution have procedures in place to ensure that existing
master agreements are regularly monitored to determine whether they meet
the requirements for recognition under the institution's netting policies?
5. Obtain copies of policies and procedures concerning review of the enforceability
of collateral arrangements.
a. Does the institution have guidelines that establish when and from what
jurisdictions legal opinions must be obtained concerning the enforceability
of collateral arrangements before the institution relies on such arrangements
for risk-based capital or credit-risk-management purposes?
b. Who reviews the opinions?
c. Who determines when a collateral arrangement may be relied on by the
institution for credit-risk-management or risk-based capital purposes?
d. Do the procedures ensure that legal opinions relied on by the institution
are reviewed periodically?
6. Obtain samples of master agreements, confirmations for transactions
under such agreements, and related legal opinions.
a. Does the institution maintain in its files the master agreements, legal
opinions, and related documentation and translations relied on for netting
b. Have the master agreements and confirmations been executed by authorized
c. Have master agreements been executed by personnel of the counterparty
that the institution has determined are authorized to execute such agreements?
d. Does the institution maintain records evidencing that master agreements
and related legal opinions have been reviewed in accordance with the institution's
policies and procedures?
7. Obtain copies of the institution's policies and procedures concerning
the implementation of netting arrangements.
a. Do the procedures ensure that the terms of netting agreements are accurately
and effectively acted on by the trading, credit, and operations or payments-processing
areas of the institution?
b. Does the institution have adequate controls over the operational implementation
of its master netting agreements?
c. Who determines whether specific transactions are to be netted for risk-based
capital and credit-risk-management purposes?
d. When is legal approval for the netting of particular transactions under
a netting agreement required?
e. How are the relevant details of netting agreements communicated to
the trading, credit, and payments areas?
f. How does each area incorporate relevant netting information into its
systems? g. What mechanism does the institution have to link netting information
with credit exposure information and to monitor netting information in
relation to credit exposure information?
h. Do periodic settlement amounts reflect payments or deliveries netted
in accordance with details of netting agreements?
i. How does the institution calculate its credit exposure to each counterparty
under the relevant master netting agreements?
j. If the master agreement includes transactions excluded from risk-based
capital calculations, what method does the institution use to calculate
net exposure under the agreement for capital purposes, and is that method
k. If a master agreement includes transactions that do not qualify for
netting, such as transactions in a netting-unfriendly jurisdiction, how
does the institution determine what method to use to calculate net exposure
under the agreement for capital purposes?
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