On April 7, 2016, the Depository Trust Clearing Corporation (DTCC) announced that it, along with six other entities, successfully completed testing of so-called “smart contracts,” using blockchain technology, to trade and manage post-trade life-cycle events for standard single-name credit default swaps (CDS).

Smart contracts are computer protocols that enforce the terms of a contract in a partially or fully self-executing and/or self-enforcing manner. They use the same logic as contractual provisions, and in some circumstances can provide an additional layer of security over traditional contracts. A common existing use of smart contracts is in digital rights management, where they act to prohibit those who have not actually made a purchase from accessing digital media or software.

Blockchains, also known as distributed ledgers, function in a networked database and have previously been endorsed by the DTCC (see Legal Update, DTCC: Blockchain Could Revolutionize Financial Infrastructure). Each time an asset is transferred, the transfer information is recorded on the asset's ledger, which is distributed to each server on the network (a node). Nodes check the asset's transaction history against what is recorded on other nodes in the network to ensure that only the true owner of the asset has engaged in the transfer and to ensure that no asset is transferred multiple times. Using this method, the asset's transactions history and any transfers can be mathematically verified.

Using blockchain technology to distribute smart contracts that govern the post-trade life-cycle (including economic terms, permissions, and event processing), which were created from trade confirmations, the working group was able to execute in a close peer-to-peer network all aspects of a CDS transaction, including:

CDS transactions were chosen because of their complexity and, during 85 structured tests of the technology, the tests achieved a 100% success rate. In additional to providing an alternative to complex, manual processes across global financial intuitions, the test demonstrated that new technology could give regulators unprecedented real-time transparent access to individual trade details, risk metrics and systemic exposure for individual entities, while continuing to provide confidentiality and privacy.

The participating entities included:

The announcement of the successful test came on the heels of a speech made by CFTC Commissioner Giancarlo at the DTCC Blockchain symposium, in which he endorsed unfettered exploration into the new technology, invoking the “do no harm” mantra of minimal government intervention or regulation. Giancarlo advocated facilitating investment and innovation in this areas, by, among other things, repealing existing regulations, such as CFTC Regulation 1.31 (17 C.F.R. § 1.31), which mandates that records must be kept in their original form or native file format and could interfere with the development of new technologies that require more flexibility.

One benefit of smart contract and smart transactions is a layer of transparency that is not available in traditional bilateral agreements. Attorneys need to be aware that smart contracts are a new type of legal document that appear to be here to stay. Transactional lawyers – in particular derivatives lawyers (for the time being at least), are going to need to familiarize themselves with these types of documents and attempt to get comfortable with their mechanics, as well as attendant legal issues.