Yao Qian from the Technology Bureau of the Securities Regulatory Commission: Blockchain-based OTC Derivatives Financial Infrastructure

This article is sourced from the July 2021 issue of "Contemporary Financier," authored by Yao Qian.

Yao Qian, Director of the Technology Supervision Bureau of the China Securities Regulatory Commission
After the outbreak of the 2008 international financial crisis, regulatory authorities paid close attention to the potential risks in the over-the-counter (OTC) derivatives market and implemented a series of reforms. The main measures included promoting the "on-exchange" trading and clearing of OTC derivatives and establishing financial infrastructure—Transaction Reporting Repository (TR)—to enhance the transparency of the OTC derivatives market. This article analyzes the real pain points of the OTC derivatives market after regulatory reforms and proposes solutions based on blockchain technology. First, a blockchain-based OTC derivatives information exchange platform. Second, a blockchain-based OTC derivatives trading platform. Given that OTC derivatives contracts have conditional payment or settlement characteristics, they can be written as smart contracts, leading to the development of "smart derivatives contracts." This article explores the specific implementation ideas and related legal issues of smart derivatives contracts and proposes the concept of a smart transaction reporting repository.

1. Real Pain Points of the OTC Derivatives Market

High Business Pressure from Strict Regulation
The regulatory reforms in the OTC derivatives market after the 2008 international financial crisis helped improve market transparency and prevent systemic risks. However, on the other hand, regulatory requirements such as electronic trading, centralized clearing mechanisms for OTC derivatives, and transaction reporting repository systems have made the business processes of OTC derivatives increasingly complex. Participants in the OTC derivatives market not only need to interact with counterparties but also frequently exchange information with electronic trading platforms, central counterparty clearinghouses, transaction reporting repositories, and regulatory authorities, conducting activities such as trading, confirmation, clearing, settlement, and reporting. The high operational and compliance costs place significant business pressure on market participants, leading to an increasingly strong demand for further optimization of processes and cost reduction.

Demand for Business Automation Due to Low Efficiency
The customization characteristics of OTC derivatives are quite evident. While they can better meet the personalized needs of participants, they also suffer from low business efficiency. For instance, both parties to a transaction must negotiate and confirm contract terms "one-on-one," which is time-consuming and involves a lot of repetitive work and document preparation costs. Custom contracts are not easily transferable or replaceable, resulting in low liquidity. The workload for managing collateral, events, and contracts with different counterparties is heavy, requiring constant tracking and management of various contracts and careful attention to numerous "bewildering" terms, which is not an easy task.

To some extent, the ongoing standardization of OTC derivatives data, documents, agreements, and processing workflows has effectively improved trading efficiency. For example, the ISDA Master Agreement establishes relatively fixed and standardized contract terms and a clear and unified default handling mechanism for OTC derivatives trading, facilitating quick transactions for market participants and reducing negotiation costs. The CPSS-IOSCO recommends establishing a Legal Entity Identifier (LEI) system as a mechanism for aggregating OTC derivatives data and suggests developing product classification standards led by the industry as a common basis for classifying and describing OTC derivatives products. However, this is far from sufficient. As ISDA CEO Scott O'Malia stated, "The current derivatives market infrastructure is costly and inefficient. There is almost no way to implement large-scale automation solutions across the industry because each firm and platform has its own processes and models, requiring a lot of coordination work to ensure that all parties to the contract receive the same information."

To support efficient transaction matching, confirmation, execution, clearing, event management, and contract management, it is necessary to further build a unified, open, efficient, compliant, and robust OTC derivatives infrastructure platform that can be executed automatically based on existing standardization efforts. This would achieve higher operational efficiency, more consistent regulatory compliance, and improved data quality and market transparency. Undoubtedly, this work requires the joint efforts of market participants, regulatory authorities, self-regulatory organizations, and other stakeholders.

2. Blockchain-Based OTC Derivatives Information Exchange Platform and TR
The blockchain-based OTC derivatives information exchange platform (hereinafter referred to as the "Blockchain Information Exchange Platform," see Figure 1) achieves information sharing and interconnection among different entities such as market participants, electronic trading platforms, central counterparty clearinghouses, transaction reporting repositories, and regulatory authorities through a distributed network, avoiding multiple information exchanges and thereby reducing the business pressure brought by strict regulation.

On-Chain Contract Information
OTC derivatives trading continues with the existing business processes, where market participants first negotiate one-on-one or reach a trading contract through the matching of an electronic trading platform. The order information and transaction confirmation information between market participants and the electronic trading platform can be relayed through the Blockchain Information Exchange Platform. Then, the off-chain contract information is put on-chain, sharing information with the central counterparty clearinghouse and transaction reporting repository. The central counterparty clearinghouse conducts contract replacement and netting based on the contract information received from the Blockchain Information Exchange Platform, forming new contracts, which are then transmitted to the Blockchain Information Exchange Platform for real-time sharing with market participants and transaction reporting repositories. Various transaction reporting repositories collect and organize the complete information on derivatives from the Blockchain Information Exchange Platform and disclose information to regulatory authorities, market participants, and the public as required. To protect transaction privacy, privacy protection solutions such as secure multi-party computation, homomorphic encryption, and zero-knowledge proofs can be considered for the on-chain, transmission, and sharing of contract information. Another benefit of putting off-chain contract information on-chain is that the hash fingerprint of the off-chain contract can be stored on-chain, utilizing the immutability of blockchain to ensure the authenticity of the contract.

Blockchain-Based Transaction Reporting Repository
Clearly, the Blockchain Information Exchange Platform itself has the functions of collecting, storing, and disclosing OTC derivatives trading data, and can therefore directly develop into a transaction reporting repository. Unlike transaction reporting repositories established by centralized institutions such as central securities depositories, central counterparties, and trading platforms, it is a decentralized transaction reporting repository with characteristics such as difficulty in tampering and multi-point sharing. To better meet regulatory requirements, it is recommended that the Blockchain Information Exchange Platform be constructed under the leadership of regulatory authorities, with unified specifications for the format, standards, models, classifications, and disclosure procedures and scope of the on-chain data, as well as relevant data governance and management.

3. Blockchain-Based OTC Derivatives Trading Platform and TR
In addition to building a blockchain-based OTC derivatives information exchange platform, the infrastructure for OTC derivatives can be fundamentally transformed using smart contracts and the blockchain technology features of "transaction as confirmation," "transaction as settlement," and "transaction as reporting," to create a unified, open OTC derivatives trading platform that executes automatically, achieving automation in the OTC derivatives trading process, risk management, and regulatory reporting, thereby improving business efficiency and reducing operational costs.

OTC Derivatives and Smart Contracts
The decentralized or non-centralized characteristics of blockchain naturally align with the "one-on-one" trading of OTC derivatives. The on-demand customization of smart contracts also meets the personalized needs of OTC derivatives contracts. Moreover, OTC derivatives contracts such as forward contracts, options contracts, swap contracts, and swap agreements have conditional payment or settlement characteristics. For example, payments or asset deliveries are based on conditions such as time points, underlying asset prices, or events, which is a typical "if then" Boolean logic. Therefore, they can be written as predefined condition execution codes embedded in the blockchain, transforming them into smart contracts. Currently, various institutions, including the International Swaps and Derivatives Association (ISDA), investment banks, and fintech companies, are actively exploring the design and application of smart derivatives contracts. For instance, ISDA's first version of the Common Domain Model (CDM) for digital derivatives contracts released in June 2018, and Barclays Bank's prototype trading tests for vanilla interest rate swap contracts based on distributed ledger technology published in 2016.

4. Smart Derivatives Contract Trading Platform
Smart Contracts and Automatic Execution
Automatic execution is not an exclusive feature of smart contracts. It can also be applied in daily bank transfers through automatic transfer agreements with commercial banks, enabling automatic execution of fund transfers. However, vending machines and automatic transfer agreements do not have the characteristic of mandatory performance; sellers, banks, or even initiators can intervene and stop the automatic execution of the business. Additionally, automatic transfer agreements are operated by third parties as intermediaries, which carry credit risk and operational risk. In contrast, the deployment and execution of smart contracts only require the signing and acknowledgment of both parties to the transaction, without the need for intermediaries. After consensus verification and storage by the blockchain network, they become difficult to tamper with. Even if one party regrets, the smart contract will strictly execute according to the code, making it unstoppable, thus significantly reducing performance risk. Furthermore, the automatic triggering execution based on computer code and the distributed ledger technology of blockchain eliminates the necessity for continuous information exchange between the two parties, greatly simplifying business processes and reducing operational costs.

Operational Terms and Non-Operational Terms
Although derivatives are an excellent application area for smart contracts, the terms of OTC derivatives contracts are relatively complex, and not all terms can be written as smart contract code. For example, some terms can be expressed as Boolean logic and can be written as "if then" codes, which can be called operational terms. For instance, the operational terms of a swap contract require that the amount payable on the payment date equals the product of the calculated amount, the floating interest rate (plus or minus the spread), and the day count fraction; the operational terms of an options contract require that the amount payable on the exercise date equals the number of options exercised multiplied by the exercise price difference; the operational terms of a forward contract require one party to pay the other an amount equivalent to the difference between the settlement price and the forward price; and so on. Conversely, some terms are not easily expressed as pure Boolean logic and are difficult to write as code, which can be termed non-operational terms. For example, terms that specify which law applies in the event of any dispute; terms that specify the jurisdiction that any dispute may involve; terms that state that written legal documents represent the complete agreement between the parties; and so on. These terms are purely expressed in natural legal language and are still difficult to convert into computer language at least for now.

For certain operational terms, if the triggering conditions are non-objective and rely on subjective judgment, it is also difficult to execute them automatically through smart contracts. For example, the flawed asset system for OTC derivatives involves subjective judgments regarding implied defaults or potential defaults, which can easily lead to disputes. One solution is to introduce notaries on-chain, such as judicial institutions, arbitration institutions, or juries.

Smart Derivatives Contracts
Based on the operability of the terms of OTC derivatives contracts, operational terms can be put on-chain and encoded as smart derivatives contracts, while the remaining non-operational terms continue to be expressed in natural legal language. Thus, the OTC derivatives contract is decomposed into two contracts: one is the off-chain derivatives contract based on natural legal language; the other is the on-chain smart derivatives contract based on computer language. These two contracts in different "languages" are both complementary and substitutive. The complementary relationship is reflected in that the on-chain and off-chain contracts complement each other, jointly carrying all the functions of the existing OTC derivatives contract. The substitutive relationship lies in that when the predetermined conditions are triggered, the on-chain smart derivatives contract executes automatically, enforcing performance, reducing disputes, and thereby decreasing the need to enforce the off-chain legal contract through court proceedings to resolve disputes.

The data source that triggers the execution conditions of the smart derivatives contract, commonly referred to as the "oracle," is crucial. The "oracle" can connect to external data sources such as data service providers, IoT sensors, financial institutions, and government departments through APIs based on data needs, and can also call the outputs of other smart contracts on-chain as data inputs. A trustworthy, reliable, and accurate "oracle" is an important prerequisite for applying smart derivatives contracts. Incorrect data input will inevitably lead to erroneous contract execution and output. To address this, various measures can be considered: first, running oracles in a trusted execution environment; second, building decentralized oracles to avoid hacking attacks, prevent tampering, and ensure reliable and accurate data input; third, obtaining data from trusted external data sources and conducting data security audits, etc.

Legal Effectiveness
Law is the institutional foundation of finance. Each financial transaction can be viewed as the establishment and performance of a sales contract. In each OTC derivatives transaction, both parties must sign a contract. When the parties' intentions align, the contract is established. A contract is valid as long as it does not violate laws, administrative regulations, or public order and good morals, thus imposing obligations and responsibilities on both parties. In on-exchange transactions, although it is not necessary to sign a contract for every transaction, laws and regulations such as the Securities Law, Contract Law, and Futures Management Regulations have already stipulated the rights and obligations of the parties involved in transactions, effectively providing a universal trading contract for all parties. This is a mandatory provision that investors entering the market must comply with. However, universal contracts cannot cover all scenarios and are difficult to meet the personalized needs of different investors. In OTC transactions, counterparties can negotiate fully based on their needs and intentions, and contract terms can be added, reduced, or modified.

Similarly, whether the on-chain smart derivatives contract has sufficient legal effectiveness becomes a key point. If the smart derivatives contract is not formally recognized by law, even if it is executed automatically and mandatorily on-chain, a disputing party can still seek judicial "rollback." One solution is to include the smart contract code in the off-chain legal contract and specify the execution platform and address of the smart contract. Just like a housing mortgage, where the bank and the customer agree in the contract to withdraw mortgage repayments from the agreed customer account at regular intervals, the legal effectiveness of the bank's withdrawal action comes from the agreement. Without the agreement, the bank cannot arbitrarily withdraw funds from the customer's account. Similarly, if the law does not recognize smart derivatives contracts, the legality of their actions must be clarified through off-chain contracts; otherwise, they cannot withstand judicial scrutiny.

From a theoretical perspective, smart derivatives contracts align with the civil law definition of intention and can be recognized as legal acts. First, smart derivatives contracts are transparent; both parties to the transaction can fully understand the contract content when invoked, and both parties can modify the smart derivatives contract according to their own intentions, thus the contract reflects the intentions of both parties. Intention can be expressed verbally or in writing. The representation of the intention of both parties in the form of computer code is a written form of expression, which falls under the category of data messages as defined by the Contract Law. Second, only after both parties digitally sign can the smart derivatives contract execute automatically. The signature represents the traders' acknowledgment and willingness to execute the smart derivatives contract, which is a commitment. Once the commitment is made, the contract is established.

Currently, several states in the United States have recognized the effectiveness of smart contracts. In China, consideration could be given to clarifying the legal effectiveness of smart contracts in the Civil Code or supporting the legality of smart derivatives contract trading in the Securities Law and Futures Law.

Smart Transaction Reporting Repository
As a super node of the smart derivatives contract trading platform, regulatory authorities can automatically and in real-time obtain information about smart derivatives contracts, which is "transaction as report." For the off-chain natural legal derivatives contracts formed by non-operational terms that cannot be put on-chain, although they cannot be encoded into computer language, their information can be put on-chain, forming a complete set of OTC derivatives information together with the on-chain smart derivatives contract information, which can be automatically reported to regulatory authorities. At the same time, the information disclosure rules of the transaction reporting repository can also be encoded as smart contracts, using the global market information collected by the transaction reporting repository as data input to disclose different granularities of transaction information to stakeholders and the public with different access permissions through smart contracts. Thus, an intelligent transaction reporting repository that automatically collects and discloses OTC derivatives trading information is effectively created.