The International Swaps and Derivatives Association (ISDA) has published the first in a series of guidelines for what it colloquially refers to as “smart derivatives contracts” (the Guidelines).* A smart derivatives contract is a derivative that incorporates software code to automate aspects of the derivative transaction and operates on a distributed ledger, such as a blockchain. This series of papers is intended to “provide high-level guidance on the legal documentation and framework that currently governs derivatives trading, and to point out certain issues that may need to be considered by technology developers when introducing technology into that framework.”
Derivatives have long been thought to be a fitting use case for smart contract solutions. It is little surprise that derivatives industry incumbents and startups alike are working on novel smart contract solutions to facilitate the execution and clearing of derivatives. Smart derivatives contracts have the potential to create significant efficiencies in the derivatives market by automating the performance of obligations and operations under a derivatives contract. Derivatives settlement is largely reliant upon conditional logic informed by certain data points that can be made available via oracle.
However, swaps trading under lengthy master agreements and at heavy volumes add significant complications. There can be many barriers to smart contract implementation because of the complexity of the legal frameworks, the significant payment netting that occurs, subjective elements of event of default provisions, as well as other costs, fragmentation risks, and technological issues.
ISDA recognizes these complexities and has discussed this with industry participants to determine where it can lend assistance as companies experiment with smart derivatives contracts. ISDA and derivatives traders have voiced concerns about technology developers being sufficiently aware that the legal terms of the ISDA Master Agreement, the supporting documentation, and each individual transaction that sits underneath it, should be appropriately incorporated and not be disturbed without due legal consideration and advice on the potential impact. As a result, ISDA has initiated a series of Guidelines designed to illuminate the core principles of ISDA documentation – and certain important legal terms – that should be maintained when technology is applied to derivatives trading, in a comprehensive fashion with a practical approach.
The introductory ISDA Guidelines, published on January 30, explains what smart derivative contracts are, the legal complexities inherent in such arrangements, principles and models for smart derivatives contracts, and considerations for technology developers. The introductory Guidelines is designed not to make any specific recommendations, but to explain the terms of the ISDA Master Agreement and derivatives contracts in a plain manner and raise awareness of significant legal requirements so that engineers can better understand what is needed in coding smart derivatives contracts.
The Guidelines specifically reiterate ISDA principles for smart derivatives contracts from a prior ISDA whitepaper published last year. Such principles include:
- Smart derivatives contracts should be compatible with existing standards;
- Automation should only be considered in respect of those parts of a derivatives contract that 1) are capable of being automated and 2) will benefit from automation; and
- Effective automation should be based on legal validation.
The Guidelines also describe ISDA documentation architecture and related considerations for technology developers. For example, ISDA documentation is voluminous and complex, with multiple potential addendums, protocols, and annexes intended to form a single agreement for the trading relationship. Accordingly, the Guidelines broach whether technology solutions will affect the boundaries of the ISDA “single agreement.” This type of quandary, and converting legal terms to programming language, will require legal practitioners to work very closely with technology professionals. These Guidelines are now another tool to assist these important discussions between attorneys and technologists.
ISDA’s intellectual contribution is noteworthy because it demonstrates that major industry groups are considering and, perhaps, anticipating that derivatives agreements will transition from tradition paper agreements (and electronic represents of the paper agreements) to “smart contracts” (i.e., a truly digitized – not just electronic – form of agreement) that are executed and settled on a distributed ledger. The Guidelines follow two whitepapers on smart contracts and smart derivatives contracts released by ISDA in the past few years, evidencing a continued interest through the price fluctuations in the cryptoasset markets. As companies offering novel platforms for the construction, execution, settlement, and reporting of derivatives enter the market in the coming years, regulators are likely to pay close attention to ISDA’s sentiments.
Should you have any questions regarding the development of smart derivatives contracts or related software, please contact the authors.
The Guidelines are available here.
The Whitepaper on Smart Contracts is available here.
The Whitepaper on Smart Derivatives Contracts is available here.
*Kari Larsen was a contributor to the Guidelines.