How the Derivatives Industry Is Leading the Billion-Dollar Smart Contract Revolution
There are several challenges to overcome before we see widespread adoption of smart contracts, and the derivatives industry is taking the lead in investing the time and money to solve them
Smart Contracts will transform the economy, but there are still practical challenges to overcome before we see widespread adoption, and these challenges will require significant upfront investment
The biggest banks in the world, acting through their trade association, ISDA, are making this investment and taking on these practical challenges so that they can harness smart contracts to cut costs, cut down on mistakes, and speed up transactions for the 18 trillion dollar derivatives market
ISDA is doing crucial work to sort out the technical, business, and legal practicalities of implementing smart contracts, and the benefits will extend to many industries, far beyond derivatives and finance.
The 18 Trillion-Dollar Derivatives Industry Is Working Hard to Harness Smart Contracts
The derivatives industry is the biggest market in the world, where the biggest banks and financial institutions in the world buy and sell contracts with each other to hedge and manage risk. At last count, the total market was valued at over $18,000,000,000,000, and, when multiplied by that kind of money, even small savings can add up fast.
The large financial institutions that participate in the market are always looking for any kind of innovation that can help them cut costs, save time and increase efficiency, and so, through their trade association ISDA, they have spent the last several years sorting out how to implement smart derivatives contracts.
In fact, ISDA (short for the International Swaps and Derivatives Association) has been working through the specific legal, business standards, and technical issues to make smart derivatives contracts a reality. They’ve reported on their work in a library of white papers on their website (and see our overview here).
Background: A Derivative is a Contract for Hedging Risk
A “derivative” is a contract whose value is determined by or “derived from” (hence the name) another asset or group of assets. Derivatives can be used for a number of purposes, including speculation and arbitrage, but the most common use of a derivative is to hedge risk.
Say you are a company based in the United States who just landed a new customer in France who will be paying you in Euros. Great news, but you are worried about something called “foreign exchange risk.” All of your expenses, from rent, to labor costs, to taxes, are paid in U.S. dollars. So one of the things that you're very concerned about is that if the value of the Euro drops against the U.S. Dollar, you are going to wind up getting paid a lot less.
So one of the things that you can do is you can enter into a derivatives contract, known as an FX Swap, where you agree in advance with another party, who is going to agree to buy those Euros at a set dollar value. So you are then “hedged” against the risk that the Euros may drop in value relative to US dollars.
Derivatives Are Highly Standardized And Contain Lots of “If-Then” Logic
There are several reasons why derivatives contracts, such as the FX Swap just mentioned, are good candidates for smart contracts.
First, the typical derivatives contract contains provisions based on conditional logic, i.e. “if then” statements that can be coded into software, e.g. “if value of the Euro is less than X$ on Date Y, transfer Z$ from A to B.”
Second, and related, derivative contracts involve a vast number of transactions that follow the same format for each contract. Take the FX Swap just mentioned: these follow a standard format where only a few parameters, e.g. price, time of execution, quantity, vary from contract to contract. And indeed many derivatives already use standardized contracts. In fact, ISDA uses a standard agreement, called the ISDA Master Agreement, aka “the most important standard market agreement used in the financial world.”
Third, since the financial crisis of 2008, regulators are far more determined to monitor derivatives markets. This has increased the complexity and reporting requirements at every stage of the life cycle.
But Derivatives Also Require Human Judgment
However, there is a separate, very important piece to a derivative contract that requires human judgment and cannot be expressed in simple, “if-then” logic.”
Built into a typical derivatives contract is a set of provisions for handling what happens when things go wrong. Specifically, what happens when one party to the contract is insolvent or is close to insolvent, and won’t be able to pay under the contract as agreed.
It’s beyond our scope right now to explain all the complexities here, but the point is that built into every derivatives contract are a series of provisions that allow the parties to use human judgment, indeed, require the parties to use human judgment when things are going south. For example, requiring a party to give “commercially reasonable notice, if it reasonably believes that it will not be able to make its payment under the contract.
As we’ve discussed previously, any time we see the word “reasonable” in a contract, that is a tell that we need to make sure we leave room for a “human in the loop”
And, as discussed previously, it is difficult to write a contract that uses software to manage certain provisions while leaving room for human judgment to manage others. ISDA is doing important work on exactly how to implement this, and in a later post we’ll do a deep dive on their work on this to date.
Why Smart Derivatives Contracts are Good For Everyone Inside and Outside the Finance Industry
Good news for the millionaires and billionaires who run the banks and invest in derivatives, who are going to save more millions from Smart Contracts, but what about the rest of us? While the big financial players will clearly benefit from adoption of Smart Derivatives Contracts, the benefits will extend far beyond the finance world.
If we are going to get adoption of Smart Contracts, there are, as we’ve seen, some hard problems to solve, including figuring out how inflexible, deterministic software deal with situations where flexibility and good judgment are required.
As I’ve argued elsewhere, I believe that Smart Contracts and Distributed Ledger Technology are going to transform the legal system, the economy, and society. What matters now is real-world adoption.
And, just as with earlier innovations in software, adoption is likely to come first with big enterprises. Large banks started using software many decades before widespread consumer adoption. (See From Airline Reservations to Sonic the Hedgehog: A History of the Software Industry, by Martin Campbell-Kelly). That same pattern is likely to play out here.
In other words, helping big financial institutions improve efficiency and cut costs is an essential milestone on the way to world-transforming adoption of DLT and smart contracts.
What Happens Next: the Derivatives Industry Will Continue to Push Forward on Practical Implementation of Smart Contracts
Derivatives are likely to be one of the first industries where we will see widespread adoption of smart contracts. There’s no question that the biggest financial players in the world have the money and technical chops to invest. Just as importantly, they have a strong incentive to invest in implementing smart contracts because they stand to save so much money from more efficient processing.
In addition, ISDA, their trade association, is one of the most active, powerful standards-setting bodies in the world, and over the past several years ISDA has also shown its commitment to implementing smart contracts. By all indications, they are going to continue to push ahead.
Practical Pointers
In your business and your industry, look at the most critical provisions in the contracts that you use all the time. Which of these are standard contracts that you use all the time? Which of the provisions in these contracts can be expressed in “if-then” logic?
For the provisions that can’t easily be expressed in “if-then” logic – for example, the provisions that use words like “reasonable” – what can you do to standardize those provisions?
What can your trade association do to help? How can your trade association take an active role, as ISDA does for the derivatives industry, in working to standardize contracts and figuring out how to represent them digitally?
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