How Software Can Help Us Make Smarter, Faster, Cheaper and Better Contracts
Automating contracts will bring huge benefits, but to get there, businesses will have to embrace standardization and digitization.
We are about to see a transformation of business and society as we learn to use software to automate contracts
To get there, we will need to rethink the way we build and manage contracts: this means standardizing contracts and representing them digitally
The Derivatives industry, through its trade association, ISDA, is developing an approach to managing contracts that will benefit every industry
Recap: The ISDA Approach
Last week we introduced the “ISDA Approach” – an approach developed by ISDA (@ISDA), the trade association for the biggest banks in the world who are eager to use smart contracts to improve the 18 trillion dollar market for derivatives.
To recap: The focus of the ISDA Approach is to
use automation to handle certain aspects of each contract (e.g., calculating and making a payment based on a set formula) while
making sure that we still allow for human judgment to allow flexibility in unforeseen circumstances (e.g., giving notice “within a reasonable time” after a party “reasonably believes” that it will not be able to pay as agreed).
For more see our piece last week: How a New Type of Software is About to Revolutionize Business Contracts
Harnessing Automation
A “smart derivatives contract” will automate certain parts of the contract using what we have termed “deterministic” automation controlled by a decentralized network of computers. “Deterministic” because it will do exactly what it is programmed to do, no more no less. And we can rely on the software to do this because it is controlled by this decentralized network, more commonly known as “blockchain.”
This automation will bring huge benefits in the form of reduced costs, more efficiency, faster processing, and fewer errors. But at the same time, deterministic automation can only go so far. There are limits to what it can do because there are parts of a contract that can’t easily be automated. We can address this limitation by separating out those parts of the contract that can be automated from those that can’t. Generally, the parts of a contract that can be automated are the parts of the contract that can be stated in “if-then” logic and formulas. Example: “if the price of copper is over X on the first of the month, then transfer money to A’s account according to the following formula.”
Engineering All Parts of a Contract to Work Together
But while we can separate out these “automatable” provisions from the “non-automatable” provisions, we still need to make sure that all the pieces of the contract work together.
Making sure that all the parts of a contract – any contract – work together is a hard problem. It happens all the time with "traditional" contracts that two different provisions conflict (or seem to conflict). Section 15.1 says the contractor is supposed to paint the building white, but section 27 says to "follow the work order," and the work order says to paint the building blue. So the court is left trying to read the two provisions together and figure out whether the contractor breached the contract when it painted the building white.
This gets even harder if parts of the contract are going to be implemented in software running on a decentralized network (aka through a "smart contract.") What if there is an inconsistency between what the software does and what the intent of the party seems to be?
Two Steps: Standardizing and Digitizing
In order to help make sure that the automated provisions work with the rest of the contract, ISDA calls for a two-step approach (1) to standardize, as much as possible, ALL terms of the contract and (2) to create a digital model of the entire contract and the entire business process.
Step 1: Standardizing
The first step in the two-step process is to go through and standardize the language used in all of these contracts.
ISDA has done this through a big effort called the ISDA Clause Library.
Standardizing contract language is harder than it looks. For one thing, there are multiple levels of standards.
Legal standards. These standards provide certainty that contractual arrangements are enforceable as a matter of law.
Regulatory standards. These standards ensure that parties are transacting in compliance with the relevant rules and regulations that are applicable to the derivatives markets and its participants.
Commercial standards. These standards set out the market practice for how commercial arrangements are reached and performed.
Technological standards. These standards establish a common framework for development and for achieving consistency between results.
From Ciarán McGonagle (@CPMcGonagle) If we build it, will they come? Developing and distributing digital standards for smart derivatives contracts
ISDA has developed a taxonomy (the ISDA Clause Library) for industry-standard documentation, including the ISDA Master Agreement. ISDA analyzed thousands of agreements and clauses and worked with over one hundred market participants to identify the most common clauses.
By using standardized language for a given provision, it makes it easier to match that to a particular computer code implementation. This in turn makes it easier to review and ensure that the code faithfully implements the intent of the provision.
Step 2: Digitizing
The second of two steps – after standardizing the language – is to create a digital model of each step in the process of managing a derivative. This goes beyond merely representing the terms of the contract. It includes a standard way to digitally represent each event and process involved in handling the entire life-cycle of a derivatives contract.
ISDA has built a standard, known as the “Common Domain Model” (or “CDM”) based on an open-source framework called the Digital Asset Modelling Language (or “DAML”) developed by Digital Asset (@digitalassetcom).
We wind up with an entire contract and an entire business process represented digitally. The parties can then decide how, and whether, and which parts of the contract and which parts of the business process to automate. Even for the parts that aren’t automated in code, the parties have much better data, and much more consistent data. They can then use that to improve business processes and analytics, and to get a better understanding of their business.
To take a basic, oversimplified example, usually contracts contain many dates: the date to renew, the date when payment is due, the date when a license expires, the deadline for giving notice of cancellation. For most companies, even big companies, it remains a fairly labor-intensive process to review all that data, and then store it in a database somewhere. And furthermore, it’s a labor-intensive process to keep the whole database updated, especially as contracts get negotiated, new terms are added, etc. Furthermore, different companies have their own idiosyncratic ways of and their own formats for representing dates. By coming up with a standardized digital representation, we skip all that and wind up with data that we can work with.
In other words, we wind up with a contract that works well with:
Decentralized automation, i.e. blockchain smart contracts;
Standard business process automation;
Human readers, including business people, lawyers, and judges who have to interpret the contracts; and
Databases and information systems.
The Work ISDA Is Doing Now Will Help Every Industry Later
ISDA is laying the groundwork for an entirely new way to build and manage contracts, not just for the derivatives industry, but for everyone.
As Scott O’Malia, CEO of ISDA explained,
The current derivatives infrastructure is hugely inefficient and costly, and there’s virtually no way to implement scalable automated solutions because each firm and platform uses its own unique set of representations for events and processes.
ISDA Common Domain Model (ISDA CDM)…..Why now?
What’s true for the Derivatives Industry is true for every other industry, in fact even more so, because the Derivatives Industry is leagues ahead of nearly every other industry with regard to standardizing and automating contracts.
The ISDA Approach, built in collaboration with Digital Asset, is going to change everything about the way the whole world manages contracts.
First, it provides a way to use software to vastly improve efficiency by using software automation, whether by blockchain or by other means.
Second, by creating a digital model of an entire contract, it will vastly increase the ease of extracting data from contracts.
Third, by standardizing contracts, and pieces of contracts, the ISDA approach will vastly reduce uncertainty and increase clarity. This helps everyone who deals with contracts, from sales to operations to every other department in a business.
Fourth, by bringing regularity to contracts and contract data, it will bring increased transparency to regulators, and also clarity for courts when they need to adjudicate disputes.
Related to all this, ISDA, and the big financial institutions that are its members, are going to go through the hard knocks of actually implementing this new approach to contracts and “working the bugs out” as it bumps up against reality.
The Derivatives Industry Is Going to be the First to See Widespread Enterprise Adoption of Smart Contracts
Derivatives are likely to be one of the first, if not the first, major use case where we see widespread enterprise adoption. The big banks and financial institutions in the derivatives market have the money and the incentives to do everything they can to harness software to reduce costs and speed up transactions.
We have seen several pilot projects using smart contracts in the finance world and no doubt we will see more over the next few years. One reason that adoption may come sooner in the derivatives space is that, in most cases, only two parties are required to roll out a smart contacts solution. As long as the two parties to the contract agree, they can proceed without the approval of, say, a regulator or centralized intermediary. Meanwhile, ISDA, their trade association, continues to do great work developing legal and technical standards.
My guess is that adoption will, to use my favorite Hemingway reference, happen two ways: gradually and then all of a sudden. Once the first few projects succeed and it's clear how much money is being saved, then others will rush in. At first those “others” will be others in the derivatives space. But eventually, many other industries will want to adopt the benefits as well.
As these initial projects demonstrate that they can save money and affect the bottom line, the ball will start rolling down the hill, and then it's going to pick up speed very fast. There will certainly be bumps in the road, just as there were, when, decades ago, banks started using communications networks and software. But the good news is that the big banks will have the money, and the motivation and the smarts to solve those problems.
And the rest of us will benefit as they figure out a brand new way to manage contracts. A new way that is going to change everything.
Practical Pointers
Look at what aspects of your contracts you might be able to automate. Which parts of your contracts can be represented in conditional logic, i.e. “if-then” statements and formulas? These are the best candidates for automation.
How can your trade association, or other standards body, figure out how to standardize typical contract terms used in your industry?
Start looking at ISDA’s Common Domain Model and Digital Asset’s DAML framework to see how it could be adapted to your business and your industry.
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