January 30, 2019

ISDA published the first in a series of "legal" guidelines for smart derivatives contracts. The guidelines outline some potential smart derivatives contract models, set out principles for the development of smart derivatives contracts, and identify contractual and documentation issues that may be relevant in the development and implementation of new technology platforms, products, and solutions for use within the derivatives industry.

The guidelines are not intended to specify or recommend any particular approach, or address any particular technological application or project. Rather, they are intended to provide high-level guidance on the legal documentation and framework that governs derivatives trading and to point out certain issues that may need to be considered by technology developers when introducing technology into that framework. The guidelines establish that smart derivatives contracts do not necessarily need distributed ledger technology (DLT) to function and the adoption of smart derivatives contracts could be facilitated through other technology solutions. However, DLT is well-suited to the implementation of smart contract technology. These guidelines, therefore, assume that many smart derivatives contract models and applications may make use of DLT in some form.The paper establishes the following four principles in the development of smart derivatives contracts:

  • Smart derivatives contracts should be compatible with existing standards.
  • Only those parts of a derivatives contract that are capable of being automated should be considered.
  • Effective automation should be based on legal validation.
  • Only those parts of a derivatives contract where there exists sufficient benefit in automating should be considered for automation.

The guidelines also outline the considerations for technology developers. The application of technology solutions to ISDA documentation raises some interesting questions about the precise boundaries of the single agreement architecture. One of the most fundamental questions is whether computer code might ultimately form part of the single agreement. The single agreement approach ensures that each party has a single legal relationship and financial exposure to its counterparty. Where the technology application is designed to record transaction data, it will be important to consider whether this data or any data outputs (for example, settlement records) should be considered part of the single agreement. A potential consequence of data sitting outside the single agreement construct is that it may not be admissible for construction of the overall legal and contractual relationship in the event of a dispute or close out. ISDA guidelines specify that, in designing technology enabled solutions for the trading or processing of derivatives, technology developers should work with their legal advisers to understand the various points of connection between each of the documents, take account of legal relationships created with any third parties, and consider how the solution may impact upon the entirety of the contractual relationship.

 

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Keywords: International, Banking, Securities, Regtech, Derivatives Contracts, Smart Contracts, Distributed Ledger Technology, Guideline, ISDA

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