Smart derivative contracts – closer than you think?
Smart contracts, which are computer protocols intended to digitally facilitate, verify or enforce the negotiation or performance of a contract have the potential to radically change the way in which parties interact by allowing the safe performance of transactions without the need for a third party intermediary using blockchain technology.
One area which would be revolutionised by the introduction of smart contracts is the highly regulated and complex derivatives trading industry. However, given its complexity, there are many challenges which need to be overcome in order to make this a reality.
From Concept to Construction
The International Swaps and Derivatives Association, Inc. (ISDA) has over recent years actively explored the use of smart contracts to improve the efficiency of the derivatives market. In October 2018, ISDA and King & Wood Mallesons jointly published a white paper entitled Smart Derivatives Contracts: From Concept to Construction. This paper discussed what is required to practically apply and use smart contracts – including the legal, technological and operational requirements and standards.
In doing so, the paper established four fundamental principles for the development of smart derivative contracts:
- smart derivative contracts should be compatible with existing standards
- only those parts of a derivative contract that are capable of being automated should be considered
- effective automation should be based on legal validation
- only those parts of a derivative contract where there exits sufficient benefit in automating should be considered for automation.
ISDA uses the ISDA Common Domain Model (ISDA CDMTM) and creates a framework that it suggests could be used to construct smart derivatives contracts. The framework is as below:
| Select the parts of a derivatives contract for which automation would be both effective and efficient ↓ |
| Change the expression of the legal terms of a derivatives contract into a more formalized form ↓ |
| Break the formalized expression into component parts for representation as functions ↓ |
| Combine the functions into templates to use with particular derivatives products ↓ |
| Validate the templates as having the same leal effect as legal terms of derivatives contracts ↓ |
The paper addresses each step in detail, highlighting potential issues, but also potential solutions.
Legal guidelines
In 2019, ISDA has continued its rapid consideration of smart derivatives contracts by publishing the first two papers in a series entitled Legal Guidelines for Smart Derivatives Contracts.
The first paper, titled ‘Introduction’ and published in January 2019, is intended to explain the core principles of ISDA documentation and to raise awareness of important legal terms that should be maintained when a technology solution is applied to derivatives trading. The most recent paper, published in February 2019, summarises the main elements of the ISDA Master Agreement and sets out possible considerations for technology developers. Further papers are set to follow providing more detailed analysis on other ISDA documents.
What next?
ISDA’s rapid development of a framework to support the use of smart contracts has the potential to transform derivatives trading.
Further papers on the application of legal guidelines to other ISDA documents are set to follow, but there is still a long way to go to transform ISDA’s general guidance and principles into practical applications for the derivatives market.