Smart Contracts Applied

to OTC Derivatives
Contents
1. Overview
2. Smart Contract Implementation
3. Advantages and Challenges
| 1 | 2 | 3 | Overview

Smart Contracts and OTC Derivatives – A Fintech Innovation

Smart Contracts Fintech Innovation

Self executing contract in code

OTC Derivatives
1 Financial Component

Mostly used on the Ethereum

Blockchain

Smart Contracts
Multiple value-add components 2 Technological Innovation
| 1 | 2 | 3 | Overview

What are OTC Derivatives?

A private contract between the two institutions The trade is executed and any initial
is drawn, covering every possible detail of the cash flows are exchanged between
instrument (ex: pricing, settlement dates, rates, the two counterparties (ex: initial
currencies, expiration, etc.) margins, asset collateral, etc.)

The institution finds another Settlement of cash flows at pre-

institution willing to take the other specified dates and margin /
side of their agreement; known as collateral adjustments throughout
a counterparty lifetime of instrument

An institution needs a custom

instrument to hedge its risk, Expiry or termination of
speculate on a market agreement. Any terminal cash
opportunity or achieve a flows are exchanged at this time
specific financial objective

Over-the-counter derivatives are agreements between two counterparties without going through an exchange. This allows more
customizability for both parties, therefore making them preferential over listed derivatives when fulfilling a very specific need.
However, since no central clearing corporation is required, they pose a higher credit risk. The notional value of OTC derivatives
is approximately $550 trillion in the world and such instruments include forward contracts, swap agreements, etc.
| 1 | 2 | 3 | Overview

OTC Derivative Types

OTC Derivative Types Underlying Asset Classes/Products

Interest Rate Derivatives

Options

Commodity Derivatives

Swaps
Foreign Exchange Derivatives

Forwards Equity Derivatives

Fixed Income Derivatives

Futures
Credit Derivatives
| 1 | 2 | 3 | Overview

Risks of OTC Derivatives

• Increased risk of counterparty involved in transaction being

unable to fulfill agreement
Counterparty (Credit) • This results from the lack of an exchange or clearing house
Risk involved in OTC transactions
• Funding risk and settlement risk also arrives from mismatch or
timing of cash flows

• The unsystematic risk faced for adverse changes to the asset

Market Risk • Liquidity risk in the market can also affect the transactions (more
customized OTC contracts increase this risk)

• The general risk associated with failures to evaluate and monitor

Operational Risk the risks, record and monitor transactions, system error or other
human error
| 1 | 2 | 3 | Smart Contract Implementation

Basic OTC Derivatives Process Flow

Drafting up Cash Flow

Recognize the need for Identifying the
contract terms for Trade Executed Settlement or
Derivatives counterparty
the instrument Expiry of contract

A contract between
The trade is executed
An institution needs a the two institutions is
The institution finds and any initial cash Settlement of cash
custom instrument to drawn, covering every
another institution flows are exchanged flows at pre-specified
hedge its risk, possible detail of the
willing to take the dates and margin /
speculate on a market instrument (ex: between the two
other side of their collateral adjustments
opportunity or achieve pricing, settlement counterparties (ex:
agreement; known as throughout lifetime of
a specific financial dates, rates, initial margins, asset
a counterparty instrument
objective currencies, expiration,
collateral, etc.)
etc.)
| 1 | 2 | 3 | Smart Contract Implementation

OTC Derivatives Process Flow through Smart Contracts

Smart Contract Process Optimization

Drafting up
Recognize the need for Identifying the Cash Settlement or
contract terms for Trade Executed
Derivatives counterparty Expiry of contract
the instrument

Smart Contract Pulls automatically

Contract connects
conditions are written from margin account
An institution needs a with Bank’s internal
The institution finds and coded in absolute to settle cash flows.
custom instrument to systems and is
another institution detail to record the Afterwards, all
hedge its risk, granted authority to
willing to take the terms of the contract on computers update with
speculate on a market a distributed shared self execute once
other side of their the new state and the
opportunity or achieve ledger shared between predefined terms and
agreement; known as record is appended to
a specific financial all participants. conditions are met
a counterparty Ethereum
objective
Consistent sharing of data for transparency with validators/regulators

Smart contracts leverage their benefits of immutability and shared distribution to automate the execution of financial derivatives. This
adds transparency by eliminating the middlemen. This results in cost reduction through time savings, as the speed of the smart contract
is limited by the speed of software, not as much by the speed of middlemen processors. Key areas of these time savings: (1) reviewing
and validating contracts (2) Customs, practice and other checks (3) generating reports and informing customers (4) executing contracts
| 1 | 2 | 3 | Smart Contract Implementation

What This Looks Like in Reality

Ethereum Smart contract
Example Ethereum Smart Contract Structure for Financial Derivatives1 networks use nodes to connect
different parties in the derivatives
Ethereum Network transaction process, automate the
Bank Bank validation process, facilitate
custom and practice checks and
execute derivatives trades

Valuation Results for Financial Institutions

Bank Service who adopt distributed ledger
technology effectively2:

50-80% 3-4 Fold

Reduction in Improvements in
operating turnaround times
costs in for transactions
Regulatory trade finance
Authority
Sources: (1) Fries, Christian & Kohl-Landgraf 2019, (2) Bain and Company 2018
| 1 | 2 | 3 | Advantages and Hurdles|

Pros and Cons of Smart Contracts in OTC Derivatives Trading

Advantages Challenges

Increased precision in contractual obligations Enforceability of a contract drafted in code

Decentralization of both operational and Potential increases in settlement times for

systematic risks cross-chain agreements

Balancing settlement times with the incentives

Increased transactional efficiency
for “mining”

Procedural standardization The need for the utmost forecasting accuracy

Transparency across the industry

| 1 | 2 | 3 | Advantages and Hurdles|

Hurdles of Smart Contracts for OTC Derivatives

Inflexibility: For amendments

Legal: Is code law? Identity of all to be made, contract must be
parties must be clearly stated terminated and recreated

Privacy: Extent of secrecy is a Lack of Expertise in

concern for financial institutions Financial Institutions to
implement Smart Contract
infrastructure

Result: Smart Contract technology used for OTC derivates will take 5+ years to be implemented due to mainly
legal and implementation hurdles