Smart contracts and distributed ledger technology could bring cost and efficiency benefits to the derivatives market, says a new whitepaper from ISDA and Linklaters. Along with the whitepaper, ISDA has launched an industry legal working group to focus on smart contracts.

In order to unlock value in the derivatives market and realise the benefits smart contracts and distributed ledger technology could bring, work is underway to standardise and formalise clauses within ISDA's legal documents and ISDA Definitions. The whitepaper outlines a possible near-term application of a smart contract for derivatives and underlines the importance enabling legal clauses and actions within the ISDA Definitions to be represented and executed via smart contract code.

ISDA says that preparations are underway to update and future-proof documentation, starting with the 2006 Definitions for interest rate and currency derivatives. The new working group has been launched in conjunction with other work to develop common data and process standards to facilitate the interoperability of new technologies such as smart contracts.

ISDA notes that the common data and process hierarchy work it is leading is critical to developing the operational building blocks for smart contracts. Such work complements its development of smart contracts and broader governance structures, with its whitepaper exploring where a smart contract can be applied to automate the execution of certain specified actions and also where a broader governance framework for non-operational legal agreements can be applied to future-proof existing product definitions and legal documents.

"The ISDA Master Agreement is possibly the most successful legal contract of all time, but the advent of smart contracts offers the possibility for it to become even more powerful. This paper is the first step in considering how that can come about," says Paul Lewis, derivatives and structured products partner at Linklaters.

The whitepaper establishes several key points, not least the difference between smart contract code and a smart legal contract. Whereas the former refers to code designed to execute certain tasks, the latter refers to elements of a legal contract being represented and executed by software.

It is also noted that certain operational clauses within legal contracts lend themselves to automation, but others, such as the governing law of a contract, are less easily rendered into machine-readable code. Some legal clauses are subjective or require interpretation, which also creates challenges.

The whitepaper says that a possible near-term application of a smart contract is for the legal contract to remain in natural legal language, but for certain actions to be automated via a smart contract. This would require actions such as payments and deliveries to be represented in a more formal, standard way within the ISDA Definitions, so that they can be read by machines.

Furthermore, transaction data could be held on a permissioned, private distributed ledger made available to regulators. This step would mean that there was a single, shared representation of each trade.

JL