Smart contracts have the potential to significantly increase efficiency in the derivatives market, but a number of issues need to be considered, including determining which contractual terms are suitable for automation. The paper – Smart Derivatives Contracts: From Concept to Construction – sets out a framework for approaching these questions, and highlights areas where additional collaborative work is required.
As a first step, the contractual clauses that are appropriate for automation should be identified, based on feasibility and the resulting operational efficiencies. The paper notes that certain clauses that stipulate a specific action at a specific time – for instance, payments – may be suitable for automation. Others, like certain types of events of default, which involve numerous interdependent variables and may require human intervention, may not.
Another important criterion is the ability for lawyers to validate that the legal effect of any coded or automated provision within a contract is certain. It is therefore imperative that contractual terms are translated into a standardized form that can be clearly understood by both lawyers and programmers.
The paper also notes that the ISDA Common Domain Model (CDM) could play an important role in ensuring that a shared, standardized representation of events and actions that occur through the derivatives lifecycle is applied across the industry.
“Smart contracts could help drive substantial efficiencies in derivatives markets, but standardization is an important pre-requisite. ISDA is exploring opportunities for further standardization across its suite of existing documentations, including the schedule to the ISDA Master Agreement and the 2006 Definitions. Alongside our work on the ISDA CDM, these efforts will form the foundation upon which new technologies like smart contracts can be developed and adopted for use in derivatives markets,” said Katherine Tew Darras, ISDA’s General Counsel.
“A combination of technological, commercial, regulatory and legal standards are all important to the real-world effectiveness of smart derivatives contracts. A holistic regulatory and legal approach, which looks through both a technology and commercial lens, will be fundamental. ISDA’s work, including its CDM, helps show the way market participants can take smart contracts forward in a safe, efficient derivatives market,” said Scott Farrell, Partner at KWM.
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