Outsmarting counterparty risk with smart contracts

What if over-the-counter derivatives could be traded without any counterparty risk?

Post-crisis rules aimed at mitigating counterparty risk require them to be centrally cleared or bilaterally margined using regulator-approved models. 

But there may be a simpler solution – using smart contracts and distributed ledger technology. 

“We thought, can we redesign a derivative from the beginning, such that all those fixes are not needed?” says Christian Fries, head of model development at DZ Bank. “We did not try to replicate a classical derivative, but something that has the same cashflows, the same economics, but without all the complexity,” he explains.

Fries and Peter Kohl-Landgraf, a senior business analyst and digital officer in the capital markets trading department at DZ, propose a novel template for a smart derivatives contract that removes counterparty risk – along with the need for its mitigants – from a transaction.

“This paper shows how the digitisation of contracts may not only make the system more efficient, reconciliations less frequent and settlements quicker, but that it can also improve the risk profile of financial products,” says Massimo Morini, who leads the scientific co-ordination effort for Banca IMI in Milan.

Morini argues that a decentralised system could eliminate many of the complexities – such as  valuation adjustments – associated with OTC derivatives. He laid some of the theoretical foundation for smart contracts used by Fries and Kohl-Landgraf.

The key innovation of their contract is the introduction of a pre-funding mechanism and deterministic termination procedure.

When entering the smart contract, counterparties agree to fund a margin amount based on the size of the potential transaction. The margin goes into each counterparty’s own wallet and cannot be paid before the previous settlement occurs, or after the time in which the margin is checked. Once the margin is checked to ensure it complies with the rules of the contract, the contract is valued and it can proceed to settlement, before a new cycle begins.

If the margin is not paid during the admissible window, or it is insufficient to make the payment, the contract is automatically terminated. To discourage counterparties from forcing a premature termination, which may pose issues in the case of American options and swaptions, a prefunded termination premium may also be introduced.

This paper shows how the digitisation of contracts may not only make the system more efficient, reconciliations less frequent and settlements quicker, but that it can also improve the risk profile of financial products

Massimo Morini, Banca IMI

The prefunding mechanism and termination clauses – together with the optional termination premium – de facto remove the counterparty risk associated with the transaction.

Once a trade is live, it would resemble a product with daily settlements, with significantly lower margining costs than conventional contracts. “The prefunding is similar to an initial margin. But since we can increase the frequency of this process, the margin is much smaller,” Fries explains.

Kohl-Landgraf describes it as both a product innovation and a process innovation.

“You have a product innovation because it’s a new structured product. It has a slightly modified payoff and it also changes from the regulatory side. It doesn’t have counterparty risk but it has market risk and liquidity risk in a certain sense,” he says. “And you have a process innovation: it’s a clear settlement process where the smart contract takes over the entire settlement procedure. And the only thing the banks need to do is to provide sufficient funding.”

The contract design also addresses some of the challenges of introducing disruptive technologies to banks. “Building a new infrastructure requires inputs and approvals from many departments, so we put quite some effort into finding a common language that could be equally understood by people from quant analysis, trading, IT, legal and risk control,” says Kohl-Landgraf.