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Managing Hedge Fund Risk and Financing: Adapting to a New Era by DAVID P. BELMONT, CFA

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Counterparty Risk Mitigation Strategies

Obviously, clearly documenting contracts, selecting high-quality counterparties and diversifying brokers reduces the likelihood and magnitude of a failure by a broker.

Timely, Detailed and Enforceable Documentation

Although written documents per se may not be necessary to establish a contract, they are the best evidence of the terms of a contract and the best means of ensuring that parties agree on the specific terms of a transaction. Failure to document a transaction appropriately or expeditiously, therefore, creates unnecessary counterparty risk.

Delays in documentation are surprisingly common. Lapses between the time a transaction is entered into and the execution of documents evidencing the transaction can give rise to the risk that one of the parties could walk away from the trade or dispute its terms. In much the same way, inaccurate or incomplete documents could lead to litigation when parties misunderstand their obligations and, as a result, fail to perform as expected. Equally significant, hedge funds can confront unexpected market and credit risk as a result of misunderstandings about how documents work, particularly in disrupted markets. Close-outs of transactions in which funds experience unanticipated market and credit losses during contractual grace and notice periods provide a good example of this risk. In addition, in litigation, documents are frequently put under a microscope and any flaw is magnified and used as an excuse ...

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