Blockchain technology may seem futuristic to some, but there is a use for it in today’s OTC derivatives market. Smart contracts are one example. In a Q&A, Robin Moody, Global Head of SmartDX, explores the concept of smart contracts and how they can be used to help manage OTC derivatives documentation, and support regulatory compliance now. Learn more in an upcoming derivatives documentation webinar.
Q: Let’s start out by identifying what a smart contract is exactly and how they are typically used?
A: A smart contract effectively makes the documentation process both human-readable and machine-readable. A user opens and reads the document just as they would a Word file. But under the covers, a machine-readable version is also created, populated and audited, so that all the various downstream systems are able to consume, read and understand that data instantaneously. A smart contract enables everybody within a firm to have access to the data in that document, rather than having it get lost in a set of text.
Q: How many firms do you think currently use smart contracts?
A: It’s in its early stages. There are only a handful of vendors offering this type of solution at this point. At SmartDX, we have six dealers signed up to use our technology so far and a growing list of 30 buy-side firms that are either evaluating or on-boarding. We have a regular working group that’s expected to broaden that significantly over the coming months.
Q: How are Smart contracts used in practice today for OTC derivatives?
A: Using SmartDX as an example, we are document agnostic, so we can focus on any document type, but our clients are focusing on three broad document categories: relationship documents, such as ISDA Masters, or CSAs; trade documents like master confirmation agreements (MCAs) and term sheets; and post-trade documents like confirmations. In the relationship document space, there are a lot of requirements around repapering and, in particular, collateral documentation at the moment.
Smart contracts can add value when it comes to managing mass repapering and renegotiations. Most firms currently have documentation processes based on Word and e-mail. If you have to repaper several thousand agreements with several thousand counterparties, potentially using both internal and external resources on both sides of the negotiation, sending out thousands of e-mails with thousands of Word documents attached does not play into operational efficiencies. Furthermore, banks no longer have the resources to throw people at the problem. What’s really needed is a collaborative, centralized workflow using a Smart Contract format that builds efficiency into that repapering and renegotiation process.
Smart contracts also give firms the ability to do some clever things with the actual document. It is possible to see at any given time where in the process documents are—how many documents are with the counterparty, how many are with credit or legal departments. Firms can also set permissions and lock down what each user is allowed to do with the documents.
Firms can put controls over who is permitted to do what with a document, whether they are allowed to make free-form changes, or they can pick from a list of pre-approved clauses. This enables firms to retain more control over the management and processing of documents as well as the language that can go into them, and it also enables firms to reduce the skill set required to manage the negotiation on a particular document, because users can only make changes within restricted parameters, with Word, any user can make any change.
A final important point is data extraction. Many organizations have a person, or teams of people, responsible for scouring scanned PDF documents for relevant data points and key messages that they then copy and feed into downstream systems. Updating systems manually like this is not only costly and time consuming, there is also a huge potential for human error. Smart contracts enable users to dynamically build tags into the document, so that at the end of the process they have a machine-readable XML version, which accurately updates all the downstream systems automatically. This eliminates the risk of “fat finger mistakes” and frees internal resources to focus on other tasks.
Q: What types of documents do firms typically use smart contracts for?
A: Most requests at the moment are around relationship documents or confirmations—in particular for the large outreach programs to do with collateral documentation, requirements, terms and conditions, and repapering—and in the post-trade confirmation space. Going forward, regulators are going to be looking more at confirmation requirements. Managing the back and forth of confirmations with a fax machine and an army of people, potentially in an offshore location, will not help firms meet the T+1 or T+2 regulatory timeframe requirements, especially when the industry average is currently north of T+6, depending on the asset type.
“Smart contracts can help firms ensure everyone is working on the most current version of a document—this is especially important when external lawyers are involved, to make sure they are not wasting billable time on old versions.”
Q: What benefits do firms gain from using smart contracts? What processes/technology do they replace?
A: There are several benefits around the management of information and efficiencies that play into ROI. Smart contracts can help firms ensure everyone is working on the most current version of a document, and this is especially important when external lawyers are involved to make sure they are not wasting billable time on old versions.
Smart contracts can reduce the time needed for the document creation, negotiation, and data extraction processes by a third. If you can shave a third off the time it takes to negotiate an ISDA master agreement—which can take up to a year or more—that provides significantly increased control over the processing of the document.
It also reduces risk in terms of making sure you have a fully accurate, machine-readable XML representation of the document. If, in five years, something happens in the industry and you need to understand what data is in a document, you no longer have to send an army of paralegals into the basement to hunt for it. Instead you build a query and run a search to look for certain pieces within your document library.
Most importantly though, it means you can start trading months faster.
Q: What benefits are there from a compliance perspective?
A: The most obvious benefit is in the post-trade space. Smart contracts are not silver bullets when it comes to meeting the T+1 or T+2 timeframes as there are still cultural hurdles to overcome to transition people away from using fax machines. But if we can bring the processing time down by a third, that is a significant advantage when dealing with the requirements for confirmation timeliness.
On the relationship document side, regulators are keen to see that dealers have control around their KYC documents and legal documentation. A smart contract tool gives them control over which paragraphs users can make changes to, what sorts of edits they can make, and provides an audit trail for approvals that may be needed further down the line. If the regulator does come knocking, users will be able to say who approved what, when, and from which PC or IP address. This offers far more insight than a Word and e-mail-based process.
Q: Are there any pitfalls in using smart contracts for OTC derivatives?
A: The biggest hurdle for the smart contracts industry is cultural. Firms are generally very excited about the technology and the span of benefits. But, people internally can be very resistant to changing their day-to-day processes. The industry is addicted to Word—it can be challenging persuading people to use a different document format.
Ten years ago, we probably wouldn’t have had a chance. But with the amount of regulation we see today, and new requirements to demonstrate control and show more structured processes around documentation, things have changed. Dealers’ pockets are also not as deep as they once were—they can’t throw 50 bodies at a project to fix a particular problem. They have to be more operationally efficient with their money. Increased regulatory restrictions and operational constraints mean the industry is ready for a shift towards more smart contracts.
Q: How can firms start using smart contracts today? What steps do they need to follow to get up to speed?
A: The technology is delivered as a Software-as-a-Service, so there is nothing to be installed or maintained within the organization. This means firms can be up and running fast, and the fact they are using a shared infrastructure that is externally managed enables easier collaboration with third parties.
We have built up a base template library to make adoption of smart contracts easier. These templates are 75% fit for purpose. Dealers can pick up a particular template and customize the remaining 25%, which may take a handful of days. Then there is a training effort to enable the cultural shift towards using the new document format.
Q: How do you see the use of smart contracts evolving for the OTC derivatives world?
A: The more documents that are processed in this way, the more understanding we will have of the details that go into them. We could potentially help the industry standardize certain documents and the language that goes into them. There is widespread use of non-standard terms in the industry—dealer A might call a product ABC, while dealer B calls it XYZ. When you actually understand what is in the document, it could be that these products are 90% the same.
If we can provide feedback to the industry, saying these documents are 90% the same, they can become standardized and reduce the need for negotiations. It may seem counterintuitive for a smart contracts company to talk about taking away documentation. But new regulations are requiring more documentation types for things like client outreach and repapering asset agreements. In the medium to long term, firms will need to provide significantly more documentation. Our strategy is to help increase efficiency and build standards into the documentation process, which will help firms meet their obligations to the regulators and make the industry safer for everybody.
* Join us for an upcoming webinar “Derivatives Documentation Digitalization” Sept 29th.
