A lot has been said and written about the potential for smart contracts in the context of derivatives. On our part, we think smart contracts have the potential to unlock value in the derivatives market by offering significant cost and efficiency benefits.
But what exactly do we mean by a smart contract? Is it a fully digital version of the legal agreements we use in the derivatives markets today? Or is it a piece of software that can automate the execution of certain operational actions within those existing paper contracts, but without actually replacing them?
ISDA last week published a paper in conjunction with Linklaters that attempts to answer these questions. The paper delves into the definitions of smart contracts, outlines how they might be used in a derivatives context, and highlights the legal issues they raise.
We have a strong and tested legal framework for derivatives, the ISDA Master Agreement, which has been honed over more than 30 years. But translating that directly into a smart contract context isn’t straightforward. While certain operational clauses – those related to payments or deliveries, for instance – might lend themselves to being automated, others are more subjective or require interpretation or discretion, and will therefore prove more challenging.
ISDA is now taking a critical step in the process by reviewing and updating the ISDA documents and definitions, with the aim of standardizing and formalizing certain clauses to enable them to be more easily represented and executed by smart contract code. This work to future-proof our legal documents will start with the 2006 Definitions for interest rate and currency derivatives.
We’re also looking at how the existing Financial products Markup Language messaging standard could be used in the smart contract space. To lead these developments, a new ISDA legal working group has been set up specifically to focus on smart contracts and distributed ledger. This is in addition to another ISDA initiative to establish the common data and process standards to help drive interoperability of these new technologies.
As in the past, ISDA is working to educate the market, but also to establish industry consensus on the application of operational and non-operational (or discretionary) contract elements. There will be instances where specific elements of the contract can be fully automated, but other elements where natural human language must be applied. Our working groups will unpack these issues, and ISDA is committed to developing industry consensus so there is continuity across platforms.
That would unlock significant efficiencies for derivatives market participants. ISDA’s work to future-proof its documentation is a crucial step to making that happen.