A Study of Legal Risk Associated with Financial Derivatives

Author:S.K.S. Yadava*, Manpreet Kaurb

Abstract:
The study examines the concept and the elements of legal risk associated with financial derivatives. A model of legal risk has been developed based on the literature review. A survey conducted on institutional investors and financial institutions there is awareness of the legal risk associated with derivatives. The limitation is that they could correlate it with documentation only whereas legal risk is multi-dimensional in nature. It is this very nature of legal risk makes it difficult to identify its origin. The involvement of legal firm while entering into derivatives contract becomes important because of the multiple laws and multiple regulatory agencies governing the derivatives. But organisations shy away from involving legal firms for their services mainly because of incomplete understanding of the whole concept of legal risk in derivatives and the other reasons being the long procedure of documentation and the cost of legal services. The other significant reasons of not involving legal services are lack of legal expertise and the organisation may itself not be very particular about the laws. Regulation of derivatives does hold a major concern for the participants and even self-regulation by the trading organisation was suggested as a significant means of regulating the derivatives market. Organisations have failed to identify legal risk as one of major risks associated with derivatives. The major focus is on managing liquidity risk followed by operating risk. Hence, the organisations have failed to make a separate policy for legal risk management. The main legal risk faced by the organisations with reference to all derivatives is that the other party to the transaction will fail to pay. The study finally suggests a model for managing legal risk.

Keywords:Keywords: Legal risk, derivatives, documentation, regulation.

DOI:

International Journal of Trade & Commerce (Vol: 3 Issue:1)