Of Standards and Technology: ISDA and Technological Change in the OTC Derivatives Market
There is no lack of interest in new technologies such as distributed ledger technology (DLT) or smart contract technology (SCT). For enthusiasts, DLT and SCT are full of promise. Thanks to technology, the future is meant to be frictionless and more decentralised. However, interest in the ‘plumbing’ underneath, which is required to implement the vision of industry-wide frictionless interactions among market participants, remains more limited. In a recent paper, to be published in the Law and Financial Markets Review, I examine and evaluate how the International Swaps and Derivatives Association (ISDA)—the preeminent trade association for market participants in the Over-the-Counter (OTC) derivatives market—hopes to address implementation challenges through a series of new standardisation initiatives.
‘Standardise to digitise’: the ISDA CDM and the ISDA Clause Taxonomy and Library
ISDA’s standardisation work has been immensely influential. The success of the ISDA Master Agreement, the centre piece of the ISDA documentation architecture for OTC transactions, is unrivalled. However, to remain relevant as a trade association and market standard setter, ISDA must not stand still. It must continue adapting to stay on top of potential market developments. Given the interest in new technologies in the financial sector, it therefore did not come as a surprise that ISDA emerged in the 2010s as a fervent supporter of technological change. Building on its credentials, it launched several standard setting initiatives under the motto ‘standardise [in order] to digitise.’ Among these initiatives is the Common Domain Model (CDM), whose origins can be traced back to the hype that surrounded DLT in the mid-2010s. The CDM has been described as a ‘standardised, machine-readable and machine-executable blueprint for how financial products are traded and managed across the transaction lifecycle.’ In short, the CDM is ISDA’s attempt to take on issues that have long plagued the industry, especially the fact that parties involved in a trade typically have their own ways of representing trades, events, and processes in their internal systems. This can generate inconsistencies and scope for failure. Importantly (and although the CDM is technology independent), it also undermines the value proposition of technologies such as DLT which promise a future of frictionless interactions. Thus, the CDM is ISDA’s answer to the absence of industry conventions on how to digitally represent derivative products as well as the processes and events that affect these products over their lifetime. It was developed by a London-based RegTech firm, REGnosys, and has become ISDA’s flagship initiative on digitisation and automation.
Besides its work at the operational level, ISDA is also undertaking further work on the standardisation and digitisation of its OTC trade documentation. As pointed out, the ISDA Master Agreement is at the heart of this documentation. Together with its associated documentation, it offers a legal agreement standards layer. However, it was not drafted with future automation in mind. It lacks the required structure and precision, and the scope that it leaves for customisation and variation is also problematic for a possible industry-wide automation of contractual provisions. To realise the latter vision, a common legal agreement data model and common digital representations of suitable contractual provisions are required. The ISDA Clause Taxonomy and Library, which consists of a documentation clause taxonomy and a clause library per se, aims to take a first step into this direction. It was developed by D2 Legal Technology (D2LT), a London-based legal technology firm.
It is fair to say that these initiatives, unlike the ISDA Master Agreement, have so far received little academic scrutiny. This is a gap in our understanding of ISDA’s contribution to market standardisation. In my paper, I set out to address this gap. I argue that recent initiatives such as the CDM or the Clause Taxonomy and Library can usefully be examined as an attempt by ISDA to help the industry coordinate on a common foundational standards layer for the digital age. Specifically, these initiatives can effectively be viewed as an attempt by ISDA to offer the industry a focal point for coordination. Ultimately, the ambition is to support technological change and bring the industry closer to a much-vaunted future of frictionless (or frictionless-ish) interactions.
Moreover, ISDA is not only engaging with the market. It is also actively encouraging the regulatory community to embrace its new standardisation efforts. This is noteworthy since it contrasts markedly with the characterisation of ISDA’s work on OTC documentation where Riles (p 32) previously argued that ISDA’s ambition was to stay clear of regulatory authority. This is plainly not ISDA’s approach in relation to its efforts to standardise in order to digitise. Instead, ISDA is seeking an ‘active dialogue’ (p 23) with regulators on how the CDM might be used for regulatory reporting purposes.
Success is uncertain
ISDA’s hopes are high. It clearly aims to emulate its previous successes. However, success will not come easy. Barriers will be hard to overcome. In particular, the paper shows that buried in ISDA’s approach is a basic paradox that ISDA will find difficult to resolve: although the CDM is supposed to ease some key implementation challenges that new technologies face, the future of the CDM as a successful industry standard will, in many ways, be contingent on overcoming the very same implementation challenges. These include significant switching costs and realising network effects. Also, industry-wide success may ultimately depend on whether, and under what conditions, powerful centralised institutions, such as post-trade financial market infrastructures, are willing to leverage their positional advantages to help drive the CDM’s adoption. This latter observation has added relevance in the context of discussions on the future of new technologies such as DLT, which are often associated with a vision of decentralisation and disintermediation. Thus, the fate of ISDA’s CDM may only come to reaffirm that, in the financial sector, market solutions are more likely to prevail if their design choices are not at odds with the preferences/interests of powerful incumbents, including with respect to disintermediation or decentralisation.
Should the regulatory community help drive the adoption of the CDM?
To be sure, ISDA also bets on the regulatory community to help drive the CDM’s adoption. As pointed out, it has encouraged this community to reuse the CDM for regulatory and reporting purposes. If successful, ISDA’s efforts could strengthen the focal point effect of its standardisation initiatives and take the industry a step closer to the vision of seamless interactions across a full range of operational and reporting processes. However, there are good reasons for regulators to be cautious when considering leveraging an industry initiative such as the CDM. ISDA’s efforts are not that of a selfless actor. Whilst ISDA has described the CDM as an open standard and hailed it as available to the ‘entire market free of charge,’ upon a closer look, the picture that emerges is more complex. For one, even though ISDA claims that the CDM is open, other tools such as ISDA Create are not. The latter is a commercial venture with Linklaters. It is a platform for negotiating, creating, and managing legal data from ISDA documentation, which ISDA is also actively cheerleading. Crucially, the CDM and ISDA Create are meant to complement each other. Accordingly, a standard such as the CDM, which is supposed to be ‘open,’ might still effectively serve to support a ‘closed’ platform such as ISDA Create. Moreover, it is plain that ISDA yields significant influence over the CDM’s governance. Clearly, ISDA’s influence would be a matter of concern if regulators were indeed considering reusing the CDM. In short, the CDM’s governance would no longer be fit for purpose. It would need to change. In particular, it would need to foresee a strong role for regulators and, crucially, be open to a broad, diverse, and competing range of interests. With regulators in the driving seat, ISDA would take its place among other participants. Admittedly, such changes might have important downsides. Different interests might come into conflict, which might slow down or otherwise negatively affect output. Regulatory leverage could, accordingly, have a profound impact on a market initiative such as the CDM.
The CDM and the ISDA Clause Taxonomy & Library are two important initiatives that testify to ISDA’s ambitions for the future. Time will tell whether these initiatives will ever come close to the success of the ISDA Master Agreement. My assessment is that it is not going to be an easy ride for ISDA—notwithstanding its past successes.
Dr Pierre Schammo is Professor of Law at Durham University, School of Law (United Kingdom). He is an Associated Academic of the Institute for Data Science at Durham University.
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