Smart Contracts Frame Blockchain Discussion

As blockchain, a distributed ledger technology, makes regular headlines it is becoming clear that many discussions on its use in financial services center around so-called smart contracts.

Barclays recently tested a way to trade derivatives using smart contracts with the Corda blockchain-style technology from bank consortium R3.  Barclays created an electronic document whose fields could be pre-populated with certain values agreed by the International Swaps and Derivatives Association (ISDA) – a smart contract. 

Smart contracts are the key to using blockchain technology in complex financial transactions, because they can drastically speed up the affirmation and confirmation process. Because smart contracts reduce complexity there are fewer reconciliation issues, which increases efficiency and reduces costs.

Streamlining the counterparty agreement process is key to smart contracts. In T+2, the initiative to reduce securities settlements times from three days post-transaction to two days, the initiative focused on same-day affirmation as one of the keys to success.

Take an interest rate swap, for example. Both counterparty sides of the trade, in their own trading systems, will enter the terms of the deal and the system will generate a coupon structure from the term, interest rates, day count conventions, date roll conventions, holidays, etc. Not only does each side have to enter the same values, but the trading system will have to generate the coupon structure and coupon amounts. Incorrect entry of some of the parameters will generate in mismatches in the coupon structure which will be detected when matching confirmations. But differences in calculating the coupon structure, date roll conventions etc., or missing holidays in the system, could all lead to inconsistencies.  

A smart contract would know how to generate the coupon structure and would have access to distributed ledger static data, such as holiday calendars. So the entire couponed structure and payments schedule would be generated on the blockchain and not independently by each counterparty’s trading system, resulting in terms that should be agreed much quicker.

Post trade you could, for example, automatically calculate floating payments, on reset/payment dates, net the two sides of the trade and settle. There would be no disagreement over payment dates and amounts, and no need to send pre-payment advices.

While blockchain has been enthusiastically discussed with regards to settlements, there are efficiencies and cost reductions throughout the trade lifecycle that would be possible using it. Smart contracts are the key.