Academic journal article Journal of Risk and Insurance

Legal Risk in the Financial Markets

Academic journal article Journal of Risk and Insurance

Legal Risk in the Financial Markets

Article excerpt

Legal Risk in the Financial Markets, by Roger McCormick, 2006, Oxford, UK: Oxford University Press, pp. ix + 297.

The use of information and communication technologies, globalization, and the liberalization of financial markets have all gone hand in hand with increasingly complex financial innovations. These new products, the new technologies, and the increased exposure to different, sometimes conflicting, legislation have increased the importance of legal risk. This legal risk in now recognized as a form of operational risk by the Basel II accords. In an innovative, ambitious, path-clearing work, Roger McCormick attempts to clarify what constitutes legal risk in the financial markets and how to manage it. He provides many examples of such risks that, he repeats often, have small probabilities but large impacts, large enough to wipe out a business and create systemic effects for other contracting parties. The examples he provides, as well as the compilation of different definitions and different perspectives to these risks, makes the book an ideal source for generating material for a course on English law in financial markets.

In the introduction, McCormick divides this risk into two categories: the risk of being sued (type 1 risk) and the risk of losing money because of technical defects in the way the transaction is done especially if the other contracting party defaults (type 2 risk). According to McCormick writing in 2005/2006, the type 2 kind of risk can create systemic risks, owing largely due to legal uncertainty, but it is occupying the market much less in recent years, reassured by English court decisions. He felt that the market, at that time, was more concerned with type 1 risk and the rise of the opportunism culture of suing or as he aptly terms it, "having a go." Recent events show that systemic risk really existed and that indeed the financial market and its actors did not really understand the legal ramifications of all the complex financial products that had been bought, and that there were many technical defects in the way transactions were being conducted. Thus, the importance of his work is reinforced.

This financial crisis highlights the importance of the work by McCormick, daring because not even the financial markets understand the legal risks involved, and few lawyers, if any, would really understand the complexity of all the financial products. The book is therefore useful to policymakers, lawyers, and financial actors, besides academics. To heighten the interest of policymakers to the book, McCormick points out that there is competition in the market place on the laws to adopt and if England wants its laws to be adopted, then it would have to create more legal certainty and reduce risk. For this, the government needs to constantly monitor the marketplace for new technologies and new products that have been introduced and ensure that actors involved with these innovations understand the legal ramifications.

The first part of the book provides some historical examples of legal uncertainty in financial markets based largely on English law examples, notwithstanding four isolated mentions of cases in other countries. The examples include a case on swaps, another on charge backs in the context of invoice discounting, and a third on settling differences (set-offs/netting) in the context of bankruptcy. McCormick justifies the usefulness of English law as it is, according to a British financial newspaper, the most important law in international financial transactions. In any case, a start has to be made somewhere, and harmonization through directives and imitation may have rendered legislations similar enough for the legal niceties to be comprehensible to a wide Audience even if treated differently in different laws.

The second part of the book presents the characteristics of legal risk, using the historical examples as a justification for the importance of the subject. …

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