The evolution of the smart contract enabled by blockchain and other emerging technologies is challenging the legal profession, and lawyers working specifically within the derivatives space may face tough technical and existential questions sooner than most. On the frontier of the public blockchain, derivatives autonomously orchestrated and settled through trust-less code are already an option for hedgers and speculators operating in volatile crypto-currency markets. Frameworks for stable digital assets tied to fiat currencies and de-centralised exchanges have also been modelled, with many further developments in the pipeline. Though these innovations are remarkable, they are only a small proportion of the commercial, social, humanitarian and governmental use cases being proposed and actively explored in the free-for-all races underway to break blockchain technology into the mainstream. In many cases what it will mean for the winners, losers and the non-runners is unclear, but many commentators are sure the process will result in disruption of existing industries and professions, and even the creation of new ones. As would be expected, this atmosphere of opportunity, and threat, has been a particularly reactive catalyst within the old guard of the banking world. In the complex and regulation-burdened world of OTC derivatives, preparations for a distinct, elite and turbo-charged race are well underway. Its circuit is already mapped out, and cars are being hastily but expertly engineered, albeit with a lot of cross-team collaboration. There is little uncertainty on the prizes on offer here, or the risks inherent in being left on the grid.
There are numerous teams stepping up to partake, with agendas that are both distinct and shared, to provide the technological and theoretical foundations that will kick-start the industry forward into this challenge. When it comes to trusting fully autonomous code to own some or all operational aspects of derivative agreements, there is much discussion on the virtues, challenges and benefits of implementing across a “public” vs “consortium/private” blockchain, alongside complimentary technologies and all that is between. For purposes here, we can assume differences in the technical implementation are largely ones of practical and political considerations – with the potential for legal disruption being aligned. Whatever the technological details, the questions posed to the legal profession by this paradigm shift towards what we shall call here ‘on-the-blockchain’ (‘OTB’) derivatives are profound.
The technical obstacles are many and varied, yet by now specific. The open-source, inclusive front-guard are working on clearing the path, and bridges are being built between the virtual and the real. Issues of scalability, privacy and trusted market data and event sources are focusing some of the best technical minds, and it is understood by the growing ranks of converts that blockchain technology offers the potential for all collateral assets – be it fiat, bonds, gold or other – to be indelibly pegged to unique cryptographic codes, protocols and immutable distributed ledgers that securely define and manage asset ownership and transfer. However, to date perhaps legal, regulatory and industry standard organisations have had only ill-defined aspects to address. With recent events that may now be changing. Things are coming into focus. For example, the decentralized, hugely funded yet experimental investment vehicle on public blockchain that is/was “The DAO”, and that appeared to entrench any contractual commitments to its democratically enabled investors in code only, was recently severely compromised by the actions of an anonymous investor taking on the role of a bad actor, utilising only that very code. This real-world example of a smart contract ‘gone wrong’ has crystallised debate on the boundaries, synergies and contradictions between the established and the innovative ideals at play. The potential and need for arbitration and remediation being set between the dichotomies of immutability vs flexibility in the face of legal clauses based on ‘materiality’ or ‘reasonableness’, and absolutes vs degrees of ‘truth’ (or Boolean vs ‘fuzzy logic’ for the technically inclined). Closer to home, cross-industry discussion on the specific approaches to ‘OTB’ contracts is materialising with events such as the “Smart Contract Templates Summit” that took place at the end of June, with ISDA as a key participant [Norton Rose Fulbright notably presented, who coincidently for our metaphor happen to be the global legal adviser to the McLaren Group and a corporate partner of the McLaren Honda Formula 1 team!] An inclusive approach involving academics, practitioners , financiers and entrepreneurs is being laid out, and of course lawyers will need to take on a central role in the efforts to bridge the space between the constituent parts, some which are old, many of which are new.
Questions around smart contract ‘law’ are clearly not unique to the derivatives space, but here they can perhaps be keenly and more readily focused in the context of: the industry’s historic adoption of standard form pre-prints of key documentation, unilateral amendment protocols and asset-class based definitional booklets; and the significant efforts to manage the legal contract terms in legacy ‘paper’ OTC Derivative contracts for better operational, risk and regulatory management, as well as business optimisation. Innovative analysis and related technology application, coupled with some lessons learnt from the efforts of old, brings the invaluable opportunity to elucidate and systemise parameters and their relationships – as the letter of the law, the bytes of the code, and their interactions through innovative non-operational and arbitration frameworks evolve.
Adoption of boilerplate smart-contract templates and rules modifiable through relatively simple variables will very likely be the first step in any movement to ‘OTB’ derivatives. One destination of boiler-plate systemisation maybe that ‘OTB’ derivatives markets evolve into a new generation of standardized “distributed-exchange” traded derivatives – which some will certainly welcome. However, as anyone who has endeavoured to categorise and extract data from broad samples of legacy agreements knows all too well, in the real world there is a vast amount of variation and subtlety built into agreement schedules and annexes. This tendency to mould and complicate has historically had legitimate value, but unsurprisingly is also not immune to cynical intent. If ‘OTB’ derivatives are to also retain scope for innovation and evolution, in this Brave New World lawyers who choose to take the challenge will have to become versed in, and contribute to, the technical and systemic aspects of new grammars and formalisms. Rather than their relationship to the business being relegated in this paradigm shift as some have predicted, in-house lawyers may find themselves having a more direct role in business, being forced to address consequences more explicitly and directly than current negotiation and council implies. In this interpretation it is the lawyers who will have to distinguish between what can, and what cannot, be described in a entirely unambiguous way that is fit for purpose and supply a distributed, trust-less machine with the capacity to complete its duties in current and future contexts. It is worth highlighting that the proposition is equally daunting to the in-house programmer, whose cycles of requirement specifications, engineering, testing, deployment, and notions of business continuity and support are arguably equally disrupted.
The questions of our lawyer and coder (be they two people or one) operate on many parallel levels. As alluded to above, systemic grammatical tools are required that allow for appropriate expression and its translation into the underlying mechanisms in a mathematically provable way, and yet also so its presentation allows all parties to come to an appropriate mutual understanding of the implications of what is being agreed and ‘locked-in’. In addition, for the aspects that sit outside of this scope, innovative prose agreements intimately linked with smart-contracts and implied remediation and arbitration processes will need to be envisioned. In this sense, any effort to construct industry standards and templates has to set the target far wider than the boiler-plate smart-contract code and parameters, with related tools and further new classes of contract extending the traditional agreement family.
Considering the case of ISDA agreements, a point to hand would be the much debated (and litigated!) Section 2(a)(iii) in the ISDA Master Agreement – with the current agreement opening the door for a non-defaulting counterparty to avoid designating an early termination date, terminating the transactions and having to pay a close-out amount to an insolvent estate, whilst exercising the right not to post further collateral or impact re-hypothecation rights via Specified Condition clauses in the Credit Support Annex. It is interesting to consider how such terms would fare in the world of the smart ‘OTB’ agreement. However, it is also worth noting that although discussion to date seems to be framed from the perspective of the current state of OTC derivatives and industry standards, perhaps a pertinent question is to ask what is the likelihood that the real innovation here will not be a mirroring of current practices onto automated smart contracts, but rather that the technological and economical landscape will drive significant change to the types of trades/terms parties want to engage with. Revolutionary innovations that are not easily envisioned from the perspective of current practices may emerge.
The incumbents know the financial, operational, legal and regulatory complexities they are burdened by, and can frame the issue initially as one to be solved amongst themselves and their regulators. Perhaps they can initially shield themselves from, as they see it, the uncertainty, technical challenges and risks of a public blockchain, whilst undergoing the seismic cultural and technical shifts required for realising the potential of this new paradigm. The extension into the Buy-Side, some may say, can wait to the later stages, but it’s clear the promise of the paradigm will be diminished without unprecedented levels of co-operation across institutions, from all sides and participants in the markets. Though at this stage it seems unlikely that those that make it to the podium will operate in mutually exclusive domains, and the prize is a promise for many to share in – to the observer in the stands and the gathering teams there is undoubtedly the sense of an exhilarating and hard race to be run. A ‘Grand Prix’ indeed.