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Legal-Services Firm's $73 Million Deal Strips The Mystery From Derivatives Trading

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The global financial crisis was partly a massive back-office failure. As the mortgage market imploded, investors, regulators and even bank executives struggled to understand what their exposures were in a multitrillion-dollar international web of swaps, derivatives and other securities that were memorialized in contracts that were understood, if at all, only by the people who negotiated them.

That’s by and large still the system we have today, with tens of thousands of contracts, running to millions of pages of dense legal text, sitting on hard drives in PDF form, their authors possibly long gone in the waves of firings that followed the crisis.

“To find out what your exposure is, you have to crack the seal on the PDF, get a lawyer, read it and determine the counterparty risk,” said Mark Harris, a founder of Axiom Law, a fast-growing legal services firm. To determine the firmwide risk of collateral increases triggered by a debt downgrade, say, “the only way to quantify it is to comb through 30,000 contracts.”

Axiom is trying to change that by bringing a combination of software and outsourced legal talent to the business of complex financial transactions. The firm recently signed a $73 million contract with a big global bank it won’t name (“one of the world’s largest,” it says) to process the bank’s “master trading agreements,” such as the standardized contracts governing swaps.

The multiyear deal could be seen as outsourcing a fundamental process required to keep the bank in compliance with regulations, but Harris says it's precisely the opposite: By moving routine but still highly complicated transactions onto an electronic platform run by Axiom's team of lawyers and paralegals, the bank's lawyers and executives can focus on negotiating bigger, more customized deals as well as maintaining the bank's compliance with capital and other regulations.

"The incumbent model is largely artisanal," said Harris. "It's perfect for novel challenges that are irreducibly complex, but it's not necessary for the bulk of commerce."

The $73 million bank deal represents a major expansion and shift in strategy for Axiom, which I last wrote about in 2011, when the firm was approaching $100 million in sales. Now closer to $200 million, Axiom still gets much of its revenue from providing lower-cost legal services to corporations, based on a stripped-down model utilizing experienced attorneys it hires away mostly from traditional firms.

The deal also drew the interest of Mary Schapiro, who was chairman of the Securities and Exchange Commission from 2009 to 2012 and before that chief executive of the Financial Industry Regulatory Authority. She’s joined Axiom’s board of directors, partly because she thinks the firm has the right solution to problems she and other drafters of the Dodd-Frank law tried to fix through regulation.

“I frankly saw it as an interesting opportunity to be involved in the modernization of the law,” said Schapiro, who post-SEC also sits on GE’s board and as an advisor to Promontory Financial Group, a risk management consulting firm. “While I absolutely see the business potential here, I also see it answering a concern regulators have, of really having firms get a handle on their risk exposures.”

The problem for regulators and bank executives stems from the mass-customization aspect of many modern financial instruments. Unlike a routine stock trade, say, swaps and derivatives frequently are governed by detailed contracts that are negotiated by in-house and outside lawyers over weeks or even months with special terms for each customer. The counterparties may negotiate a master agreement to govern repeated transactions, but those still tend to be hundreds of pages long with specific financial implications hiding within each clause.

Going into the financial crisis some banks attempted to compile contracts in electronic form and code the legal terms within them, using low-priced lawyers and paralegals in places like India. But most banks still lack a comprehensive system for negotiating and tracking these deals, Axiom executives said.

“If you ask a bank, `How many of your agreements in the last six months were outside of standard on your netting provision,’ most have no idea,” said Paul Carr, Axiom’s New York-based president. “They are simply not geared up to deal with level of scrutiny that is demanded by regulatory environment.”

That environment is getting tougher all the time, as demonstrated by news the Justice Dept. is seeking criminal pleas from four big banks over their alleged foreign-currency manipulation. Operating through email, online chat rooms and other channels, traders at JPMorgan, Citigroup and other banks allegedly yanked around forex rates and ripped off their customers, with or without the knowledge of their superiors.

The system Axiom developed with its unnamed client sets up an audit trail at every stage, identifying each clause that deviates from standard contract terms and requiring approvals first from Axiom lawyers and then up the chain to bank executives.

“If you can’t fit it within the accepted swim lanes, it will be flagged,” Harris said.

There will still be super-complex deals the bank will negotiate itself, using in-house lawyers and outside specialist firms, Harris said. But the routine stuff is supposed to flow through Axiom’s process. The bank is still fully responsible for monitoring compliance and of course bears the risk of the contracts it negotiates. What Axiom provides is lower-cost legal work and an electronic platform that preserves and compiles all the records for easy access.

Harris is hoping to sign more deals like this as banks realize they can save money at least two ways by outsourcing their routine legal work. One is Axiom’s main sales pitch: They can provide legal services much cheaper than traditional firms because they have lower overhead. Instead of expensive offices and a pyramid structure built upon legions of less experienced associates, firms like Axiom hire experienced lawyers who have mostly bailed out of corporate firms and can work on their own. But banks also can save money on capital, Harris said, if they have a better understanding of the financial impact of their complicated derivatives book. A large part of that is driven by terms that lawyers can understand best.

(The cost of capital was highlighted in a recent Wall Street Journal editorial under the headline "Regulation is Good For Goldman," in which Goldman Sachs Chairman Lloyd Blankfein was quoted as saying the bank was “prepared to have this relationship with our regulators” for "a long time.")

Axiom has been working on the process for several years and scaled it up for the bank. Teams of lawyers work in secure facilities around the world, walled off from each other so potentially lucrative inside information can't leak out. Incident reports are electronically logged each time a contract deviates from standard, or the process itself deviates from normal steps. Paralegals and other people with lawyerly skills scan the completed contracts and code them into a computer system so the bank's financial executives can assess, in real time, the financial implications of each clause.

Swaps and other arrangements with hedge funds, for example, often have highly complicated rules for when and how much collateral each side must put up when the market turns against them. Bank prime-broker operations traditionally have kept a close eye on the capital levels of individual hedge funds, but regulators now want to know the aggregate impact of these deals, both on the bank and the market at large.

"The combination of complexity, connectedness and sheer opacity contributed to the financial crisis," Schapiro said. Aggregating data was a main goal of Dodd-Frank as well as the SEC's push to register hedge funds. "We have to be able to harness technology to manage those risks," she told me.

Running the trading operation through a transparent box might also cut down on "London Whale" type episodes, where traders push an unconventional strategy that works well until it doesn't.

"When you don’t have an auditable, transparent process where everything is documented, where you don’t have the rigidity that keeps weird and special stuff from happening, weird and complex stuff happens,” Harris said.