Smart Derivatives Contracts: From Concept to Construction

Smart contracts could help revolutionize the derivatives market by creating much-needed efficiencies that would benefit the entire industry. But transforming smart contracts from an exciting concept to practical use will present 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?

This paper considers some of these issues, and proposes a practical framework for constructing smart derivatives contracts. This includes:

  • Selecting parts of a derivatives contract for which automation would be effective and efficient;
  • Changing the expression of the legal terms of those parts of the derivatives contract into a more formalized form;
  • Breaking the formalized expression into component parts for representation as functions;
  • Combining the functions into templates for use with particular derivatives products; and
  • Validating the templates as having the same legal effect as the legal terms of a derivatives contract.

In developing this framework, the ISDA 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.

For smart derivatives contracts to fulfill their potential, it is important they are developed in a way that is compatible and consistent with the technological, commercial, regulatory and legal standards applicable to both derivatives contracts and smart contracts. This will require knowledge and experience from different disciplines and domains. 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.

These suggestions, and the issues discussed in this paper, are intended to stimulate further collaborative work between ISDA and its members in developing a set of principles that can be used to construct smart contracts for derivatives that are not only technologically efficient, but are legally effective and consistent with ISDA’s mission to promote safe and efficient markets.

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