Complying with new financial regulation has led to the layering of new processes and systems onto existing infrastructure. With a number of new links in the chain – electronic trading, clearing, reporting, margining – derivatives operations have become increasingly complex and unwieldy. No wonder, then, that distributed ledger and smart contracts have excited so much interest. These technologies offer the tantalizing prospect of revolutionizing the way derivatives are booked and managed, automating and streamlining a complex, overburdened system and cutting operational costs.
That’s the vision, anyway. Getting there will be difficult. The term ‘smart contract’ is fairly broad, but is generally taken to mean converting the terms of a trading relationship into shared executable code to automate certain actions or obligations. The intention is to increase efficiency and reduce costs through mutualized processes. Establishing the extent to which such coding should be used – whether it should be adopted for all aspects of a trading relationship or just in some specific areas – is going to be a major debate.
Any transition to smart contracts won’t be easy, either. The industry can’t just smash up the old infrastructure and switch to a new one overnight. To allow trading to continue without hindrance, there will have to be a slow, step-by-step process of change and improvement.
ISDA will play an active part in this evolution. Smart contracts will require standards, and this is an area where ISDA has a long track record, dating back to the publication of the ISDA Master Agreement. We’ve been looking into this issue for some time, and we held our first industry roundtable on the topic earlier this month. At that meeting, we considered how Financial products Mark-up Language (FpML) might be used as a basis for derivatives smart contracts.
FpML is an open source messaging standard for derivatives based on the ISDA taxonomy, and is already widely used in the industry. Using existing standards like FpML as a starting point may be a crucial shortcut to the rollout of industry standard, platform-agnostic smart contracts.
The roundtable was attended by technology experts, law firms and industry participants, and close cooperation between each of these groups will be crucial if smart contracts are to get off the ground. During the meeting, ISDA showcased a proof-of-concept smart interest rate swap contract based on FpML, and much of the discussion focused on how to connect all the various moving parts of a typical derivatives trading relationship together. Should a smart contract be placed on a distributed ledger platform? How does this technology operate within existing legal frameworks, nationally and internationally? Should the legal language of the various ISDA product definitions or legal documentation be folded into the design? How will increased automation affect termination rights and the management of counterparty defaults?
We need to develop answers to these knotty questions, and ISDA will be pushing ahead with more industry discussion in the New Year and beyond – so watch this space. We will be drawing on the breadth and depth of our membership, including sell-side, buy-side and law firms, as well as infrastructure and technology service providers to validate different concepts and technology solutions. The key is to gather the right experts with appropriate domain knowledge to contribute to the design. While others will take on the purely technological challenges, such as scalability and security, ISDA will host the discussion around legal standards and application, and contribute to the development of data standards and code. We are perfectly placed to hold this project together.
This project is part of a wholesale review of derivatives market infrastructure. In September, ISDA released a whitepaper that called for greater standardization in documentation, data and processes.
It won’t be quick and it won’t be easy. But the need for change is obvious, and it’s incumbent upon the industry to work together to make improvements in the most efficient and consistent way.