Elements of a classical OTC contract

The main elements of a classical OTC derivative product are defined in a so-called “term sheet”. Examples for such terms are variable or fixed interest rate payments, the fixing dates and payment dates and the maturity. In addition, there exists a separate collateral process that is defined in an annex. The exact valuation of the derivative (and hence the precise determination of the collateral) remains undefined.

Five additional contractual elements reduce risk

We extend the contract by five additional elements. We explicitly define

1. how the derivative has to be valued
2. that this valuation determines a frequent (daily) settlement of the market value,
3. that payments are processed automatically on specific accounts,
4. that the derivative terminates automatically upon specific pre-conditions,
5. that the premature termination results in a fully determined termination process with a deposited termination fee

With these five additional elements we eliminate existing procedural weaknesses. Associated risks are not present by construction.

• The valuation is consistent, since it is an agreed clause in the contract.
• Settlement risks are eliminated since there is only one single net transaction. Moreover, the counterparty risk is eliminated since the contract’s termination event is an integral part of the contract itself and fully deterministic. In summary this can create a market where many counterparties contract bilaterallyin a lightweight and procedural efficient way. As an attractive side effect,the systemic riskcan also get reduced

Where are the difficulties

Where are the difficulties? The above changes primarily require fundamental adjustments to the current process landscape.
The collateral process is no longer needed since it is replaced by a daily settlement.
The daily settlement operates on a small net amount stemming frommarket value changes only, since product cash-flows are already netted. Consistent and unified valuation has to be performed independently and in a transparent manner. Finally, the termination criteria have to be monitored and termination has to be enforced independently of the counterparties.

Smart Contracts and Distributed Ledger Technology

There is an ongoing discussion around whether ideas from distributed ledger technology (DLT) are able to find application
in some areas of economic life with the aim of standardizing and automating existing processes.
The basic idea seems attractive: A separate private accounting system of transactions generates redundancies and requires a high reconciliation effort for every participating party. In contrast, within a DLT a unique and public “ledger” would exist which would result in a unique definition and understanding of transactions. Some DLT systems also support so-called “Smart Contracts”: Algorithm based computer protocols on which arbitrary transactions can be processed automatically and in a standardized fashion.

Smart Contract + Derivative = Smart Derivative Contract

Each of our introduced contractual terms -e.g. unique valuation -in the derivative contract present a deterministic algorithm by construction. Uncertainty at any process state of a derivative life-cycle is removed. Therefore,those terms can be represented by a computer program. If we implement a term sheetwith the amendments above in an algorithmically based smart contract, all contract modalities of a derivative will be digitalised. The gain will be twofold: Full clarity of all contract terms as well as the possibility of full automatization of all relevant life-cycle processes.

Conclusion: Rethinking is needed

Not more regulation, but proactive improvements of risk and process culture is needed to further reduce risks and costs in derivative markets. The application of computer-basedalgorithms–Smart Contracts–seems attractive to increase standardization and to remove existing uncertainty. The good thing: With new process definitions we are able to improve risk management or even better to eliminate risk entirely.New process definitions will not only require new technology, but especially a holistic approach across several business departments. This might be one of the challenges in financial industry for the next years to come.

Further Reading

For further detailed reading we refer to the original publication Smart Derivative Contract - Detaching Transactions from counterparty credit risk