In the last issue of the Corporate & Commercial Newsletter published in August 2020, an introduction to the International Swaps and Derivatives Association ("ISDA") architecture was given. This issue intends to give an overview on how the 2002 ISDA Master Agreement (the "ISDA Master Agreement") can be applied to smart derivatives contracts. It also highlights the relevant legal considerations that market participants should be aware of in the application.
What is a smart derivative contract?
Pursuant to the Legal Guidelines for Smart Derivatives Contracts: Introduction published by ISDA in 2019, the term "smart contract" can be interpreted in multiple ways and one of its best definitions is as follows: "A smart contract is an automatable and enforceable agreement. Automatable by computer, although some parts may require human input and control. Enforceable either by legal enforcement of rights and obligations or via tamper-proof execution of computer code."
A derivative is generally known as a contract between two or more parties whose value is dependent on the underlying financial asset(s).
In this article, a smart derivative contract is in essence a derivative that incorporates computer code to automate certain aspects of the derivative transaction via the use of technology such as distributed ledgers. As such, terms written in computer codes can be executed automatically by computer under pre-defined conditions. For instance, provisions that require a party to make payments or deliveries to another party on the occurrence of a pre-defined event are well-suited to automated processing.
The Application of ISDA Master Agreement
on smart derivative contracts
The ISDA Master Agreement is a standard contract that governs all over-the-counter ("OTC") derivatives transactions by setting out provisions which govern the overall relationship between parties thereto. Subsequent to the 2008 financial crisis, market participants have become more vigilant in managing and reducing risks. The use of ISDA Master Agreement in smart derivative contracts allows market participants to apply a set of standardized derivative transaction documentation to govern their rights and obligations. It therefore provides certainty, consistency and transparency which are conducive to risk containment and reduction in trading OTC derivatives.
Generally speaking, parties to smart derivative contracts should pay particular attention to the following non-exhaustive categories of terms in the ISDA Master Agreement:
Contract formation and amendments
Section 3 of the ISDA Master Agreement sets out representations that parties give to one another when entering into the ISDA Master Agreement, such as no agency, powers to enter into and perform the contract, no violation or conflict with any law or constitutional documents, and the accuracy of information. Such representations are repeated at each time when a transaction is entered into under the ISDA Master Agreement.
Section 4 of the ISDA Master Agreement sets out provisions in relation to the agreements between parties, such as the provision of specified information, the obtainment of necessary governmental or other approvals and the payment of stamp duty.
Section 9 of the ISDA Master Agreement governs the amendment mechanism for the terms of the ISDA Master Agreement. Any amendment will only be effective if in writing and executed by each of the parties involved. Given the need to amend/update the underlying computer code of a smart derivative contract which may affect the underlying contract, it is important for parties to be familiar with the amendment provisions of the ISDA Master Agreement. Parties may also consider agreeing on an alternate mechanism to deal with technology driven changes if the existing amendment mechanism under the ISDA Master Agreement is deemed unsuitable.
Events of default and termination events
Provisions on events of default and termination events are set out in section 5 of the ISDA Master Agreement.
The ISDA Master Agreement sets out 8 standard events of defaults, such as the failure to pay or deliver, the breach or repudiation of agreement, misrepresentation, cross-default and bankruptcy. Upon the occurrence of an event of default, the non-defaulting party may opt to continue or terminate all transactions of the smart derivative contracts under the ISDA Master Agreement.
The ISDA Master Agreement also defines 5 standard termination events where it is possible that neither party to the smart derivative contracts is at fault, such as illegality, force majeure event, tax event, tax event upon merger or credit event upon merger. Upon the occurrence of a termination event, the affected party can elect to terminate the transactions affected by it.
Parties to smart derivative contracts can also contemplate new types of events arising as a result of the adoption of new technology, such as cyber-attacks or coding errors.
Notably, the ISDA Master Agreement is not automatically terminated upon the occurrence of an event of default or a termination event as parties are still entitled to decide whether to terminate the transactions involved. Thus, it is crucial for technology developers to develop a system that allows parties to suspend automated performance upon the occurrence of the event of default or termination event and to exercise discretion on the matter.
Early termination and close-out set-off
Section 6 of the ISDA Master Agreement sets out provisions in relation to early termination and close-out netting.
Upon the occurrence of an event of default or a termination event which is not remedied in time, a party may be entitled to close out or terminate transactions under the ISDA Master Agreement. The close-out process involves 5 main steps, namely:
(1) occurrence of an event of default/a termination event
(2) election by a party to close out or terminate transaction by sending a notice to the other party which may stipulate an early termination date
(3) cessation of payment and delivery obligations on the early termination date
(4) valuation of the early termination amount, i.e. the amount of losses incurred in replacing the terminated transactions or the economic equivalent of the material terms of the terminated transactions
(5) payment of the early termination amount
In relation to step 4 above, the non-defaulting party or the non-affected party will have the option to replace all outstanding payment and delivery obligations of the other party arising from the terminated transactions with a single early termination amount. This process is called the close-out set-off.
In the context of smart derivative contracts, parties can consider applying technology solutions to monitor the occurrence of any event of default or termination event, such as by referring to oracles or other external data sources, in order to determine whether they are entitled to terminate any transaction which may subsequently trigger the close-out process. In terms of calculation of the early termination amount, parties are recommended to contemplate from the outset as to how they may obtain valuations for smart derivative contracts as its replacement costs may not be readily available at the point of close out and it is uncertain as to whether the technology platform related costs can be included in the calculation.
Section 13 of the ISDA Master Agreement sets out the governing law and jurisdiction which are relevant for dispute resolution.
Under the smart derivative contract, disputes between parties can arise from the transaction level (such as from the disagreement over the calculation of a particular transaction in settlement), the standard events of default or termination events as provided for in the ISDA Master Agreement or other non-anticipated events such as fraud. In addition, derivative market participants will also need to take into consideration the additional sources of disputes specific to the smart derivative contract, such as incorrect data inputs or any delay in payment due to system failure.
When a dispute arises, parties may elect not to fulfil their obligations until the dispute is resolved. Under a smart derivative contract, since the performance of certain obligations such as payments may be automated, it is crucial for parties to consider designing the smart derivative contract in such a way that would allow either party to pause the automated performance of obligations under the contract while there is any outstanding dispute between the parties and to resume the same when the dispute is resolved.
The law governing smart derivative contracts and their legal documentation is complex and still evolving with the everyday advancement of technology. Parties are therefore advised to seek professional opinion from their legal or other advisers before using the ISDA Master Agreement or other standard ISDA documentation for their smart derivatives contracts.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.