On August 3, 2017, the International Swaps and Derivatives Association (“ISDA”) released a whitepaper that considers whether derivative contracts could operate on a blockchain (the “Whitepaper”). The Whitepaper, titled “Smart Contracts and Distributed Ledger – A Legal Perspective,” concludes that many of the provisions of the ISDA Master Agreement and related documentation can be translated into conditional logic and coded into “smart contracts.” While we are still in the early days of distributed ledger technology (“DLT”) and smart contracts, the Whitepaper represents a significant first step towards integrating blockchain into the derivatives market from the leading provider of swaps documentation.
Building on its 2016 whitepaper entitled “The Future of Derivatives Processing and Market Infrastructure”, ISDA explains in this Whitepaper that “[d]erivatives are fertile territory for the application of smart contracts and DLT because their main payments and deliveries are heavily dependent on conditional logic.” It proposes the use of a blockchain to store electronic ISDA Master Agreements. The agreements would contain conditional logic triggers programmed by smart contract code, which would facilitate the automation of certain provisions within swaps documentation. For example, the Whitepaper lists certain “operational” ISDA definitions that embed some form of conditional logic (namely, that upon the occurrence of a specified event at a specified time, a determinative action is required), for example the cash settlement of options transactions.
Moreover, the ISDA Definitions booklets could be translated into “a more formal representation that would be tractable by computers” to allow cross-references. Regulators would then be provided with direct access to the data stored on the blockchain. The Whitepaper qualifies that a “consistent, non-ambiguous language” would need to be developed for the drafting of smart legal contracts that lawyers could understand and utilize on a global basis.
The Whitepaper acknowledges that certain “non-operational” aspects of the ISDA documentation, for example clauses predicated on good faith or reasonability, are not suited for translation into formal logic. However, the Whitepaper also proposes that certain subjective provisions could be replaced with determinations by third-party oracles. For example, a third-party oracle could be relied upon to determine if a credit event has occurred with respect to a credit derivatives transaction. If the third-party oracle makes such a determination, then the relevant smart contract provisions would be initiated.
ISDA has also commissioned e-contract opinions from a number of jurisdictions to determine whether ISDA documentation can be executed electronically with e-signatures. In relation to the ISDA netting opinions however, the Whitepaper distinguishes between smart contracts on one hand, and legal contracts on the other. The application of smart contract technology should therefore have little impact on the veracity of the ISDA netting opinions as the opinions apply to the legal contracts that the smart technology sits above, rather than displaces. This is important and illustrates that conditional logic can be over-applied. e.g., to automatically make credit and relationship choices (for example to close-out all outstanding transactions upon the occurrence of an Event of Default where this is not required for the effectiveness of close-out netting or desired under the circumstances).
Moving ISDA documentation to the blockchain could facilitate automated compliance with both the Commodity Futures Trading Commission’s (“CFTC”) swap data reporting and margin requirements in the USA, and European Market Infrastructure Regulation (“EMIR”) reporting requirements in the EU. Day-to-day compliance with the regulations could theoretically be embedded into smart contracts. For example, bank accounts or virtual currency wallets could be linked to the smart contract and automatically exchange variation margin as required. Similarly, the smart contract could be designed to automatically submit swap continuation data and other reports to a swap data repository upon the occurrence of a life cycle event, providing regulators with direct and unencumbered access. Moreover, counterparties would have all of their swap documentation and confirmations stored on the permissioned, private distributed ledger, reducing the volume of records required to be maintained. This would make it much easier for swap counterparties to comply with some of the more onerous requirements imposed by the Dodd-Frank Act, for example.
ISDA’s publication represents another milestone in the ever-growing recognition of the usefulness and ramifications of DLT and smart contracts (see our client alert on Arizona and Nevada’s enactment of bills addressing smart contract enforcement here). With influential bodies such as ISDA standing up and taking note, conditional logic states that this trend is set to continue.