A ‘Smart Derivative Contract’: Constructing a Digital Financial Derivative

Inspired by present technological advances we redefine a financial derivative contract which is able to be processed in a fully digital and algorithmic way.

OTC Derivatives and their historic processes

Ten years after the Lehman financial crisis, derivative products are still important instruments in risk management. Among them, non-exchange traded ‘over the counter’ (OTC) derivatives play a significant role. Being a bilateral relationship, OTC derivatives carry contractual risks. Those become especially imminent in case of a looming bankruptcy of a counterparty—commonly called ‘counterparty credit risk’. While some counterparty risks may be managed by derivative contracts itself (by buying default protection), they are mainly reduced by continuous posting of collateral cash-flows (also known as ‘margining’).

Despite such mitigation approaches, the risks have not been eliminated especially because of historic infrastructures and lack of standardization and automation of a trade life cycle processes. However, increasing digital transformation of business processes may help overcome existing inefficiencies. Inspired by present technological advances we radically redefine a derivative contract which is able to be processed in a full digital and algorithmic way. That ‘smart (ie digital) derivative contract’ does not carry counterparty risks by its very construction: complexity which does not exist, need not to be resolved.

Current processes and infrastructure

A closer look on current trade life cycle processes reveals three main unresolved issues. First, the determined collateralization amount based on the daily net present value may differ between counterparties due to usage of different market data and valuation models. Second, redundant booking transactions occur because derivative and collateral cash flows are settled separately and are processed asynchronously which introduces settlement risk. Third, in case of a looming bankruptcy of a counterparty it is uncertain how to act efficiently in terms of early termination of the contract to shorten the period until the open position can be closed with another counterparty (‘Margin Period of Risk’). To remove resulting risks, all those unclear trade life-cycle events need to be defined in exact terms, as it is done for a derivative’s cash flow structure in the first place. This can be legally designed by adding additional contract terms to OTC trade confirmations as well as associated Master Agreement or Credit Support Annex documents.

Key features of a smart derivative contract

Smart contracts are twofold: They are a digital representation of a legally binding contract and an algorithm to perform the procedural fulfillment. To reformulate a classical OTC derivative as a smart contract requires a full deterministic definition of every trade life-cycle event. We consider five procedural elements, which need to be added as contractual components and can be executed automatically:

1. The definition of the method for the determination of the net present value, including market date source, valuation models and parametrization.         
2. A daily—or even more frequent—settlement of outstanding net present values determined by the valuation model. This leaves the contracts exposure to counterparty risk to a one-day gap risk.
3. Both parties have the right to refund the margin amounts upon trade inception and after each settlement (after which none of the counterparties has a claim). Booking on the margin accounts is allowed within a limited time window.
4. The contract will terminate automatically either if a counterparty did not provide a predefined minimum margin by the end of the funding period, or if a settlement could not be processed due to insufficient account balances.
5. Upon termination, the causing party will be obliged to pay a pre-defined and pre-funded termination fee. That fee serves to cover replacement costs and makes it economically inefficient to terminate the contract willfully before its regular maturity. It has to be put on a separate account and is a prerequisite for the inception of the trade.

These terms will convert the contract into a pre-funded cash flow with daily renewal. Termination is penalized and can be made rare. During its lifetime, the cash-flows correspond to those of an OTC derivative. This removes counterparty risks since claims exists only until the next settlement and are pre-funded.

Requirements

For a successful digital representation of the said features, we identify the following requirements:

1. There is an infrastructure on which the contract terms are executed autonomously and in a trusted way. This may include the requirement that none of the counterparties is able to interfere with the infrastructure to alter the terms of contract.
2. A trusted source provides market data for determination of the underlying derivative’s net present value and valuation is performed in a trusted, unique and predefined way. The valuation may be performed within the infrastructure executing the trade or provided to the infrastructure in a trusted way from an external source.
3. The infrastructure has sole access to accounts (‘wallets’) owned by the contract (and not the counterparties) to execute the settlement based on the valuation. The counterparties can access the accounts to adjust the margin amounts only within a limited timeframe. They do not have access to their possible termination fees, which were deposited at trade inception.
4. The infrastructure is enabled to terminate the contract according to the contract rules, transferring a possible termination fee from the party which causes the termination to the opposite counterparty’s wallet and finally opening the account for counterparty access.
5. The infrastructure provides privacy in the form that only the counterparties and a possible trusted third party are able to see transaction amounts and account balances.

These requirements are bold. In contrast with a recent publication by ISDA, we do not give counterparties a suspension right beyond the right to deny providing the margin, which will result in an automated termination with a corresponding loss of the deposited termination fee.

However, we believe that the absence of any additional unclear suspension right will ultimately ensure full clarity, remove uncertainty of the contract’s process states and hence eliminate the counterparty credit risk.

Solutions

The aforementioned requirements may be implemented and fulfilled in a classical way by means of a trusted party which provides market data, acts as a valuation agent, acts as an escrow for accounts, and executes the contractual terms. On the other hand, given technologies like Distributed Ledger Technology (‘DLT’), cryptographic protocols, concepts for digital representations of fiat currencies (eg EUR, USD, GBP) and smart contracts owning accounts, the same requirements may be fulfilled without a third party. In a distributed ledger solution, a lack of a trusted instance can be provided through cryptographic protocols. Hybrid solutions are also possible. For example, a third party may be responsible for some selected services such as the provision of the required valuation functionality.

Challenges

Especially in a DLT based environment there are three central challenges in the construction of a smart derivative contract. First, the concept of a smart derivative contract requires a transfer of digital monetary units (also known as ‘Tokens’) between wallets. Due to the current lack of Central Bank Digital Currencies a third party is needed to provide a stable exchange between a fiat currency and a corresponding digital representation—so-called ‘Stablecoins’. Second, validation of correctness of contract states by the entire network might introduce a lack of privacy regarding bilateral transactions. After tracking and validating several transactions a third party might be able to infer the counterparties trading positions. Some DLT based systems provide a so-called ‘Zero-Knowledge Concept’ which ensures privacy of transactions between participating nodes. Finally, the behavior of the contract given the default of a counterparty may raise legal concerns. It may be possible to find a legally binding setup such that the termination fee can be booked even in the case of default. Note that a similar issue exists for the use of an ‘Initial Margin’ after counterparty default.

Conclusions

In our paper ‘Smart Derivative Contracts’ we reformulated a derivative contract as a perpetual right to post funding to a margin account to avoid its termination and the loss of a termination fee. The specific construction of the smart derivative contract removes counterparty credit risk because the contract will be terminated automatically if sufficient funding is not provided in advance. This design is complementary to current collateral procedures where margin adjustments occur reactively to a respective market value change.

The proposed smart derivative contract allows a fully automated processing of legal agreements regarding OTC derivatives. If not terminated (and termination is supposed to be a rare event by construction), the contract generates the same economic cash-flows as a classical derivative.

In a current conceptual project, we are implementing a first prototype and are further investigating technological and legal issues relating to this prototype.

Christian Fries is head of model development at DZ BANK risk control and Professor for Applied Mathematical Finance at Department of Mathematics, LMU Munich.

Peter Kohl-Landgraf is XVA Analyst at Capital Markets Trading Department at DZ BANK.

Disclaimer: The views expressed in this post are the personal views of the authors and do not necessarily reflect the views or policies of current or previous employers.