ISDA Considers the Suitability of Swaps Documentation to the Blockchain

On August 3, 2017, the International Swaps and Derivatives Association (“ISDA”) released a whitepaper that considers whether derivative contracts could operate on a blockchain (the “Whitepaper”).[1]  The Whitepaper, titled “Smart Contracts and Distributed Ledger – A Legal Perspective,” concludes that many of the provisions of the ISDA Master Agreement and related documentation can be translated into conditional logic and coded into “smart contracts.”[2]  While we are still in the early days of distributed ledger technology (“DLT”) and smart contracts, the Whitepaper represents a significant first step towards integrating blockchain into the derivatives market from the leading provider of swaps documentation.

Building on its 2016 whitepaper entitled “The Future of Derivatives Processing and Market Infrastructure”[3], ISDA explains in this Whitepaper that “[d]erivatives are fertile territory for the application of smart contracts and DLT because their main payments and deliveries are heavily dependent on conditional logic.” It proposes the use of a blockchain to store electronic ISDA Master Agreements. The agreements would contain conditional logic triggers programmed by smart contract code, which would facilitate the automation of certain provisions within swaps documentation.  For example, the Whitepaper lists certain “operational” ISDA definitions that embed some form of conditional logic (namely, that upon the occurrence of a specified event at a specified time, a determinative action is required), for example the cash settlement of options transactions.[4]

Moreover, the ISDA Definitions booklets could be translated into “a more formal representation that would be tractable by computers” to allow cross-references. Regulators would then be provided with direct access to the data stored on the blockchain.  The Whitepaper qualifies that a “consistent, non-ambiguous language” would need to be developed for the drafting of smart legal contracts that lawyers could understand and utilize on a global basis.

The Whitepaper acknowledges that certain “non-operational” aspects of the ISDA documentation, for example clauses predicated on good faith or reasonability, are not suited for translation into formal logic.  However, the Whitepaper also proposes that certain subjective provisions could be replaced with determinations by third-party oracles.  For example, a third-party oracle could be relied upon to determine if a credit event has occurred with respect to a  credit derivatives transaction[5].  If the third-party oracle makes such a determination, then the relevant smart contract provisions would be initiated.

ISDA has also commissioned e-contract opinions from a number of jurisdictions to determine whether ISDA documentation can be executed electronically with e-signatures. In relation to the ISDA netting opinions however, the Whitepaper distinguishes between smart contracts on one hand, and legal contracts on the other. The application of smart contract technology should therefore have little impact on the veracity of the ISDA netting opinions as the opinions apply to the legal contracts that the smart technology sits above, rather than displaces.  This is important and illustrates that conditional logic can be over-applied. e.g., to automatically make credit and relationship choices (for example to close-out all outstanding transactions upon the occurrence of an Event of Default where this is not required for the effectiveness of close-out netting or desired under the circumstances).

Moving ISDA documentation to the blockchain could facilitate automated compliance with both the Commodity Futures Trading Commission’s (“CFTC”) swap data reporting and margin requirements in the USA, and European Market Infrastructure Regulation (“EMIR”) reporting requirements in the EU.  Day-to-day compliance with the regulations could theoretically be embedded into smart contracts.  For example, bank accounts or virtual currency wallets could be linked to the smart contract and automatically exchange variation margin as required.  Similarly, the smart contract could be designed to automatically submit swap continuation data and other reports to a swap data repository upon the occurrence of a life cycle event, providing regulators with direct and unencumbered access.  Moreover, counterparties would have all of their swap documentation and confirmations stored on the permissioned, private distributed ledger, reducing the volume of records required to be maintained.  This would make it much easier for swap counterparties to comply with some of the more onerous requirements imposed by the Dodd-Frank Act, for example.

ISDA’s publication represents another milestone in the ever-growing recognition of the usefulness and ramifications of DLT and smart contracts (see our client alert on Arizona and Nevada’s enactment of bills addressing smart contract enforcement here). With influential bodies such as ISDA standing up and taking note, conditional logic states that this trend is set to continue.

If you have any questions regarding the Whitepaper, please contact Kari S. Larsen, klarsen@reedsmith.com, Brett Hillis, bhillis@reedsmith.com, Michael S. Selig, mselig@reedsmith.com, or Alex Murawa, amurawa@reedsmith.com.

 

[1] The Whitepaper is available here.

[2] In its simplest form, a smart contract is a “set of promises, specified in digital form, including protocols within which the parties perform on these promises”, Nick Szabo, Smart Contracts: Building Blocks for Digital Markets, 1996.

[3]To read the 2016 whitepaper, click here.

[4] See sections 8.1 and 8.2 ISDA 2002 Equity Derivative Definitions.

[5] The Whitepaper notes that under the 2014 ISDA Credit Derivatives Definitions, a determination by the Credit Derivatives Determinations Committee that a credit event has occurred would result in an automatic triggering in many cases, subject to certain conditions.

Robert Jaworski to Speak on TRID Compliance at MBA Conference

Bob Jaworski will be speaking at the Mortgage Bankers Association of America’s annual Regulatory Compliance Conference in Washington, D.C.. The conference will be held on September 17-19, 2017 at the Grand Hyatt, Washington. Bob will be part of a Monday afternoon panel on “TRID Compliance Issues,” which will look at the major issues faced by compliance officers under the TILA RESPA Integrated Disclosures (TRID) rule, including the recent changes and some of the real problems with which they’ve had to deal.  Additional information concerning the Conference and the session in which Bob will be speaking can be found on the MBA website.

Nevada Passes FinTech Law

A number of states have jumped into the FinTech fray by enacting legislation or issuing guidance regarding new technologies and digital currencies. The latest of these technology-forward states is Nevada. Following the example set by Arizona, Nevada recently passed a bill clarifying blockchain’s legal status under state law. The law, Senate Bill 398, was signed by the governor June 5 and prohibits local governments from imposing taxes or fees on the use of a blockchain; requiring a certificate, license, or permit to use a blockchain; or imposing any other requirement relating to the use of blockchain. Additionally, the Nevada law states that “if a law requires a record to be in writing, submission of a blockchain which electronically contains the record satisfies the law.” Arizona passed a similar law, House Bill 2417, in March 2017, also requiring that smart contracts and blockchain signatures be given legal binding status.

 

Please read the full client alert on reedsmith.com.

New Jersey Giveth And Taketh Away: Recent Steps to Reduce And To Increase Regulatory Burden On Home Mortgage Lenders

Recently, the State of New Jersey has taken a small step in the direction of less regulation over home mortgage lenders and, virtually at the same time, a potentially more significant step in the opposite direction. Details are set forth below.

NJDOBI Proposes to Eliminate a Regulation

Yes, you read that right! On June 5, 2017, the New Jersey Department of Banking and Insurance (“Department”) published a proposal to repeal a regulation first adopted in 2002 and readopted every 5 years thereafter.  See 49 N.J. Reg. 1273-1274.  That regulation, N.J.A.C. 3:1-16.2(a)3, required the Department to conduct and publish in the New Jersey Register an annual survey of third party appraisal fees (the “Annual Survey”).  The purpose of the Annual Survey was to enable the Department to determine the current “usual, customary and reasonable” fee (“Customary Fee”) that lenders would be permitted to charge their borrowers for the cost of an appraisal, whether “performed and delivered in-house” or obtained from an appraisal management company (“AMC”).  The regulation states that for in-house appraisals, “the fee shall approximate the [Customary Fee] for comparable appraisals by third-party appraisers based on the [Annual Survey]”; and for appraisals obtained from AMCs, “the fee shall not exceed the amount charged by the [AMC] and shall approximate the [Customary Fee] for comparable appraisals by third party appraisers based on the [Annual Survey].”

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New Policies Released Under the Illinois Transmitters of Money Act

On June 13, 2017, the Illinois Department of Financial and Professional Regulation (“IDFPR”) released guidance outlining its policies with respect to the treatment of digital currencies under the Illinois Transmitters of Money Act (“TOMA”).  The guidance document offers a clear distinction between traditional currencies, which it considers “money,” and digital currencies, which it states are not.  The guidance will be welcomed by Illinois residents who use and accept digital currencies in commercial transactions.

Read our full report on the release on our sister site, The FinTech Update.

Agencies Offer Solutions to Shortage of Residential Real Estate Appraisers

On May 31, 2017, acting through interagency guidance, the federal bank regulatory agencies (the “Agencies”) highlighted two approaches for addressing a perceived scarcity of licensed residential real estate appraisers. Federal law requires use of a state certified or licensed appraiser for most federally related transactions (“FRTs”).  For example, federal regulations require appraisals to be conducted for, inter alia, all residential transactions with a value of $250,000 or more, see, e.g., 12 C.F.R. § 34.43(a), and state-certified appraisers are required in certain high dollar value and complex transactions.  See, e.g., 12 C.F.R. § 34.43(d). Furthermore, the OCC may require an appraisal whenever the agency believes that it is necessary to address safety and soundness concerns. See, e.g., 12 CFR § 34.43(c).  A shortage in appraisers may lead to significant delays in the mortgage loan origination or loss mitigation review process.  Therefore, the Agencies’ interagency advisory notes that the use of temporary practice permits and temporary waivers will work to mitigate the shortage of appraisers and allow transactions requiring appraisals to be completed in a timely manner.

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Travis Nelson Elected Chair of New Jersey State Bar Banking Law Section

On May 19, 2017, at the Annual Meeting of the New Jersey State Bar Association, Travis Nelson was elected Chair of the Banking Law Section. Travis, who is resident in the firm’s Princeton and New York offices, previously served as Vice Chair and Secretary of the Banking Law Section.  Upon his election, Travis noted: “I am honored by my peers in the New Jersey banking bar to serve in this unique role.  I hope to use this position to build greater partnerships with other sections of the Bar Association, with the New Jersey Bankers Association, and with academic and community groups throughout the state.  With the dynamic nature of financial regulatory proposals coming from Congress and from the regulators, both in Washington and Trenton, it is more important than ever that banking attorneys remain vigilant so that they may effectively advise their clients.  The Banking Law Section can help.”

Len Bernstein, Chair of Reed Smith’s Financial Services Regulatory Group, and a former Chair of the Banking Law Section, said: “Travis has been a vital member of our banking team, and we look forward to supporting him in his efforts to increase the discussion of emerging issues throughout the New Jersey banking community. From commercial lending, to consumer finance, to bank M&A, to financial technology, the Banking Law Section will benefit from the broad experience and expertise that Travis brings to this leadership role.”  Diane Bettino, the Managing Partner of Reed Smith’s Princeton office and a member of the firm’s Executive Committee, remarked: “Travis’ election as Banking Law Section Chair continues the well-established tradition of the Princeton office for providing thought leaders in New Jersey and nationally.”

Travis serves financial institutions, and their directors and officers, in M&A transactions, regulatory compliance, examinations and enforcement, and litigation. Prior to joining Reed Smith, Travis served in the Enforcement Division at the Office of the Comptroller of the Currency, in Washington, D.C.  Travis is also adjunct faculty at the Villanova University School of Law, where he teaches a course on regulation of financial institutions, is editor of the ABA’s Banking Law Committee Journal, and is a frequent speaker on bank regulatory and enforcement issues.  In addition to his bank regulatory practice, Travis is the Co-Chair of Reed Smith’s Anti-Money Laundering and Trade Sanctions Group.

“LabCFTC” Launched by the CFTC

On May 17, 2017, Commodity Futures Trading Commission (“CFTC”) Acting Chairman J. Christopher Giancarlo announced an “important step forward” in bringing the CFTC’s regulations into the “digital world of the 21st century.”  The CFTC’s new FinTech initiative, LabCFTC, will facilitate cooperation between the CFTC and FinTech innovators.

Read Reed Smith’s full report on our sister site, The FinTech Update.

Blockchain Technology Draws Request for Information from UN

Following the trend of regulators across the globe, the United Nations Office for Project Services’ (“UNOPS”) issued a request for information regarding the application of blockchain technologies on April 24, 2017.  The UNOPS has formed a blockchain group within the United Nations to analyze the possible applicability of blockchain technologies to the international assistance area.  The Request for Information explains that the UNOPS seeks “information widely from the industry of blockchain space and to identify potential partners / suppliers for the future work in the area of international, humanitarian, development or peacekeeping assistance.”

Read the full report on our sister site, the FinTech Update.

Read some of our other reports regarding distributed ledger technology below.

Consultation Document Published on FinTech by European Commission

ESMA Publishes Report on Distributed Ledger Technology

FINRA Issues Report on Distributed Ledger Technology

Regulators Prepare for Innovation in Distributed Ledger Technology

Consultation Document Published on FinTech by European Commission

On March 23, 2017, the European Commission (“EC”) published a Consultation Document entitled “FinTech: A More Competitive and Innovative European Financial Sector.”  The Consultation Document seeks comments regarding the development and regulation of novel financial technologies, including distributed ledger technology (“DLT” or “blockchain”), cloud computing, and artificial intelligence (“AI”).  The EC hopes to obtain feedback from both financial services providers and consumers that will assist it in developing an appropriate regulatory framework for FinTech. It explains, in the Consultation Document, that “appropriate policies on important issues, such as access to technology, data standardisation and security, personal data protection and data management, need to be put in place,” to account for new innovative financial technologies.

 

Read the full report on our sister site, FinTech Update.

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