This post has been authored by Arnav Maru, currently in his 4th year at Maharashtra National Law University (MNLU), Mumbai.
In a previous post, the concept of smart contracts as used in the legal field was explained comprehensively. Smart contracts are pieces of software that are formed when certain operational terms of a contract are written in the form of electronically executable codes. They were originally envisaged by Nick Szabo and theorized in a paper titled ‘Smart Contracts: Building Blocks for Digital Markets’. He used a rudimentary example of a vending machine to explain the concept. A consumer inserts cash into the machine and enters his preference. The machine then automates the execution of the contract and the goods are delivered to the consumer. The introduction of Blockchain technology has added another dimension to this concept and has exponentially increased its application. Self-executing contracts, based on the Blockchain are a reality now, and have found applications in a myriad of fields. An increasing popularity of the Blockhain and its uses has necessitated an overview of the progress made on this front, both, in terms of legal developments as well as feasibility of actual use.
The Interface of Blockchain and the Derivatives Market
One such innovative, immensely useful, and lucrative application is in the field of derivatives. Explained simply, a derivative contract is one whose value is based on an agreed underlying financial asset or a set of assets. Smart derivative contracts inculcate the advantages of smart legal contracts such as inalterability, self-enforcement and removal of intermediaries, while also providing the flexibility that comes with the written word, necessary for making derivative contracts viable. In September 2018, Bloomberg reported that Morgan Stanley, one of the world’s leading investment banks, would be offering Bitcoin swap trading for clients. CNBC, in a follow up piece, added that Goldman Sachs is working on a derivative for the Bitcoin. These derivatives have been developed on increasing client demand, and have gained traction despite Bitcoin losing a huge chunk of its value in months preceding September 2018.
Smart contracts derive utility from the automated and guaranteed enforcement of promises made ex ante more than anything else. The reduction in enforcement costs has been pegged as their greatest advantage. Researchers have tried to exploit these core advantages and come up with futures, options, and swap models of smart derivative contracts.
Desired Legal Framework
The most important work on taking the model comes from the International Swaps and Derivatives Association (“ISDA”). In a whitepaper published in October 2018, ISDA has developed the concept of a derivative smart contract and laid down a roadmap to their proper construction. In its introduction, the paper lays down that a smart derivative contract lies at the intersection between a smart legal contract, which in itself is a subset of a smart contract, and a derivative contract. The explanation appended to the Venn diagram reads as follows:
“Smart derivatives contracts are smart because they are derivatives contracts with some terms that can be automatically performed. Those terms are expressed in a form that enables their efficient automation. Other terms that are not automatically performed are expressed in natural language.”
Following this analysis, the paper talks about the actual applications of smart contracts to the derivatives market. Automation, as mentioned above, is the key advantage that smart contracts have to offer. A distinction is made between the parts of a derivative contract that can be automated, and the parts of a derivative contract that should be automated. In addition to highlighting that automating the entire contract is neither possible nor desirable, when viewed from a commercial perspective, it also elaborates on how certain ambiguous legal standards, such as ‘a reasonable person’ ought to be so for the proper functioning of private law. A previous paper from ISDA, elaborates on what operational clauses are. Explained simply, they are if-then functions in a derivatives contract. For example, ‘Pay X $100 per share brought on date B if condition Y is met’. These basic Boolean functions are encoded into a smart legal contract and the operational part of a derivative contract is automated.
The natural language of the contract, however, needs to be retained for certain non-operational parts of a derivative contract. Provisions such as the governing law of the contract, arbitration clause, a clause imposing a duty of best efforts on parties, et cetera are non-operational clauses that need the flexibility of the written word. The smart contract can be added as one of the terms to this written contract and integrated in a way that the performance of terms still stands guaranteed. The ISDA has concluded the paper with an effective model for the implementation of such a scenario.
A few other models have come up independently of ISDA. Future or forward options where a smart contract can be programmed to buy or sell security tokens at designated timelines; an options contract where the owner of a security token is given the right but is not burdened with an obligation to sell; a swap model with two different security tokens to hedge against market uncertainties. Their adoption on a commercial scale remains uncertain as of now. While banks and financial institutions have taken steps towards this direction, the solidification of legal frameworks stands in their way.
After an overwhelming response and a positive market reaction, ISDA followed the white paper up with another one titled ‘Legal Guidelines for Smart Derivatives Contracts: Introduction’. In this paper, ISDA has evolved four principles for the development of smart derivatives contracts. The first principle lays down that the smart contract framework needs to meet the existing legal and regulatory framework. While it says that the smart derivative contracts must comply with both, the standards governing smart contracts, and the standard governing derivative contracts, Indian jurisprudence has not developed on the functioning of smart contracts. Any smart legal contract, thus, need only satisfy the provisions of the Indian Contract Act, 1872. The second principle develops on the notion that only the part of the derivatives contract that is capable of being automated should be considered. This commonsensical principle does not need much further elaboration.
The third principle points out that effective automation should be based on legal validation. That is to say, lawyers and legal enforcement officers should be able to validate the legal effect of any coded or automated provision. The legal effect of the code must align with the intended legal effect of the contract. The mere fact of automation must not discount the nature and purpose of the contract. Lastly, leaning more on an economic point of view, the benefit of automation must outweigh the cost of such automation. This principle adds a cost benefit analysis to the feasibility of smart contracts and touches the core of their utility.
The derivatives market in India is still relatively new and undergoes change and development on a regular basis. Markets and technological operations have received the introduction of Blockchain and smart contracts positively. It has huge potential to alter how we think of the derivatives market. ISDA has taken the lead in venturing into tapping the potential that these technologies have in store for us. The whitepapers and other literature need further development and research, and this paper has sought to consolidate the existing works for better understanding in Indian context. No legal machinery or regulatory framework exists at this moment to make the fusion of smart legal contracts and derivative contracts a solid possibility. Until initiative is taken and more research is done in this area, India could fall behind the international trends in fully embracing this advancement. It is urged that foresight be exercised in attempting to make India friendly to such developments. The author sees this piece as a small step towards ensuring the same.