Smart derivatives contracts: From concept to construction

This article was written by Scott Farrell and Claire Warren.

King & Wood Mallesons and the International Swaps and Derivatives Association, Inc. have published a new whitepaper that sets out practical steps for developing smart derivatives contracts. This is part of ISDA's broader work to drive further standardization in the international derivatives markets and facilitate automation. Importantly, the whitepaper highlights the critical link between the technological possibilities and the commercial, legal and regulatory realities in using smart contracts effectively.

The whitepaper can be found here. ISDA's announcement can be found here.

Smart contracts could help revolutionise the international derivatives markets by creating much-needed efficiencies that would benefit the entire industry. But transforming smart contracts from an exciting concept to having practical application presents a number of challenges.

From a legal perspective, a number of issues need to be considered. What contractual terms should be automated? How should these terms be expressed? How can lawyers validate the legal effect of any automated contractual terms that are not expressed in natural language?

The paper analyses some of these issues from both a technological and a legal perspective, and proposes a practical framework for constructing smart derivatives contracts, as shown in the following diagram.

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The paper also notes that ISDA's Common Domain Model (ISDA 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.

In this article, we extract just a few "snapshots" from the paper.

What is a Smart Derivatives Contract?

As a useful starting point, the paper describes what a smart derivatives contract is, and how it relates to derivative contracts, smart contracts and smart legal contracts. Smart derivatives contracts are at the intersection between derivative contracts and legally effective smart contracts.	[click image to view a larger version]
[click image to view a larger version]	Smart derivatives contract are smart because they are derivative contracts with some terms which can be automatically performed. Those terms are expressed in a form that enables their efficient automation. Other terms that are not automatically performed are expressed in natural language.

What standards should they be compatible with?

The paper explains that, in order for smart derivative contracts to achieve their potential to improve efficiency in derivatives markets, they need to be compatible and consistent not only with technological standards, but also with commercial, regulatory and legal standards. ISDA's Common Domain Model (ISDA CDM) can provide an effective foundation for this coordination.

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What parts of a derivative contract could be automated?

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There is significant complexity in the terms of a derivatives contract, and not all parts of the contract could be automated. Further, of those parts which could be automated not all should be automated. The paper sets out a framework for determining how these choices could be made, by reference to the effectiveness of representing particular legal concepts in an automated form, the efficiencies in automating particular provisions and the ability for lawyers to validate the legal effect of any coded or automated provision of the contract.

What happens when something unexpected happens?

There is also significant complexity outside of the terms of a derivatives contract, in the way that it interacts with events and circumstances beyond its control. This includes how the contract can adapt to changes in laws and the impact of unexpected events, such as the default of a party. Automation will not be able to cope with all of these circumstances, many of which are unpredictable, and a method of managing this is described in the paper.

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What might a smart derivatives contract look like?

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Once the parts to be automated are selected, the paper sets out a process for representing those provisions in an automatable form, through formal representation. This representation is not a programming language itself, but it bridges the gap between legal drafting and programming languages in a manner that lawyers and programmers can both use and understand. In derivatives, ISDA's Common Domain Model (ISDA CDM) can provide an effective foundation for the development of the standards which underpin this.

Smart derivatives contract are smart because they are derivative contracts with some terms which can be automatically performed.  Those terms are expressed in a form that enables their efficient automation. Other terms that are not automatically performed are expressed in natural language.

What's next?

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.  This requires collaborative work between members of the technological, commercial, legal and regulatory professions. Expertise in the technology used, the commercial context of its use, the regulation that applies to it and the law that supports its effectiveness, are all critical. The paper sets out some areas where this work is needed next.  Engagement in these efforts will be important for those whose future is connected with either the financial markets or the development of smart contracts in a broader context which are to have real-world legal effectiveness.

Notes

1. The KWM authors received generous assistance from leading experts in the academic, technological and legal communities in the preparation of the whitepaper, and would like to thank Dr Mark Staples of CSIRO's Data61, Dr Christopher Clack of University College, London, Dr Philippa Ryan of the University of Technology Sydney and Professor Ross Buckley of the University of New South Wales.

2. For further thought leadership work in smart contracts by the KWM team, please also see:

   - "Lost and Found in Smart Contract Translation – Considerations in Transitioning to Automation in Legal Architecture", Farrell, Machin and Hinchliffe, available here with the papers presented to the 2017 Congress of the United Nations Commission on International Trade Law and also in the Journal of International Banking Law and Regulation, Volume 33, Issue 1 (2018);

   - "10 points on financial market smart contracts", Farrell, Griffin, Hinchliffe and Warren, (2016) here; and

   	- "How to use humans to make 'smart contracts' truly smart", Farrell, Warren, Hinchliffe and Ottensooser, (2016) here.
   	Further reading materials are referenced in the whitepaper.