Could Smart Contracts Save Credit Default Swaps?
In Shakespeare’s play The Merchant of Venice, the Venetian merchant Antonio enters into a loan contract, interest free, that should he be unable to repay the loan, he will need to forgo “a pound of flesh” (essentially his life, because the human anatomy cannot cope with such large losses of flesh) in return.
Unfortunately, Antonio is indeed unable to repay his debt and as the moneylender Shylock comes to claim his “pound of flesh,” Antonio is saved by Portia, who on a reading of the contract discovers that while Shylock is indeed entitled to Antonio’s flesh, there is nothing stated with regards to Antonio’s blood.
Shylock is thus thwarted and Antonio’s life is saved, on the back of a legal, contractual, technicality.
As so often happens, life it seems, imitates art.
Credit default swaps (CDSs), the oft maligned instruments that contributed to the 2008 Financial Crisis, are in many ways similar to Shylock’s contract with Antonio.
CDSs are insurance-like derivatives designed to compensate creditors when a debtor goes bust. But because a company can go under in a variety of ways, the devil, as always, is in the details.
A company can close and have its assets sold off, or restructure its debt and keep operating. A company can enter into a scheme of arrangement, or file for bankruptcy protection. But which one of these events is a “default”?
Many CDSs are standardized and most disputes are handled through strict, interpretation of contacts, sticking to the form as opposed to the substance, as in the case of Antonio’s “pound of flesh” contract.
And while Antonio’s contract was essentially written in blood, a reader of The Merchant of Venice may feel somewhat dissatisfied in the ruling against Shylock.
Because after all, Shylock was offering a substantial loan at zero interest. And while no one is arguing for a minute that Shylock ought to be able to take Antonio’s life in exchange for his default, surely the substance of the contract would have at least dictated that Shylock be entitled to some form of recompense for his loan?
Which is why an arbitration decision at the end of January may prove to be a turning point in the sanctity of contracts for CDSs.
Looking into the Spirit Realm
In what appears to be a break with convention of sticking to the letter of contracts when it comes to CDSs, an arbitration tribunal sought to divine the intentions of the contracting parties instead.
The matter arose out of the sudden plunge in value of US$600 million worth of CDSs, when traders realized that the entity they were written against, VodafoneZiggo, a Dutch telecommunications company had been wound up.
Bonds in VodafoneZiggo had been transferred to a new entity, rendering the CDSs written against the company essentially worthless.
But this would not have mattered if market supervisors had been informed within 90 days of the company’s winding up. Instead, traders in VodafoneZiggo’s CDSs took almost a year to notice something was up.
So buyers of the CDSs against VodafoneZiggo relied on a clause in the CDS stating that the CDS could be transferred to a new entity if it had assumed “all of the obligations of the old one.”
The crucial bit of text here was that the word “obligations” was written in lower case, whereas elsewhere in the CDS, the word “Obligations” is capitalized.
And while most readers of the contract may not note the difference, lawyers (what a pity) most certainly did.
CDS documents typically capitalize the word “Obligation,” indicating that the CDS is referring specifically to the entity’s bonds. But because in one place in the VodafoneZiggo CDS, “obligation” was not capitalized, a committee of layers from ten banks and five fund managers (the arbitration tribunal) ruled that the ongoing “obligations” were immaterial and the CDSs should be transferred to the new entity, which immediately returned value to the VodafoneZiggo CDSs.
And while the decision matched the spirit of the CDS, it materially deviated from the form, which raises broader issues.
Uncertainty Is Not The Mother of Invention
Because the CDS markets are lubricated by the assumed immutability of contracts, the fact that an unaccountable committee should undermine the sanctity of contract could have serious ramifications on CDSs in general.
The value of a CDS is that parties should be able to rely on the automatic execution of the contract.
If a company goes into default or becomes insolvent or wound up, the CDS should pay out. The whole point of using standardized contracts is that there should be no room for ambiguity or interpretation and more importantly, there should be speed of resolution.
Futures contract for instance are extremely specific and determinate in their constitution. Given the trillion-dollar nature of the industry, there is simply no room for ambiguity and uncertainty.
But the decision in VodafoneZiggo’s case, while true to the spirit of the contract and therefore justiciable, has now introduced uncertainty into the CDS industry which has already diminished in size from a high of US$61.2 trillion in 2007, to only US$9.4 trillion in 2017.
And while some of that shrinkage is due to regulatory changes such as the netting off of contracts, it has also reduced liquidity.
Business, as Shakespeare’s Antonio soon discovers, is fraught with risk. The whole idea of a CDS is to provide a market for the trading of that risk, which improves the flow of commerce and lubricates the global business flow.
Yet if counterparties to a CDS can no longer rely on a strict, literal interpretation of a CDS, their inherent value is undermined.
Even Portia took a strict literal reading of Antonio’s debt to Shylock in order to thwart Shylock’s attempt to enforce his claim for a “pound of flesh.”
But the difficulty that CDSs sometimes face extends to the area of self-executing smart contracts written on the Ethereum blockchain as well.
Ideally, such smart contracts can and should only apply to highly specific and determinable parameters which can tap onto an “oracle” or verified source of information or data for execution.
For instance, an Ethereum futures smart contract for Bitcoin must be able to glean the Bitcoin price from a specific source and such parameters must be clearly spelled out in the smart contract.
Because CDSs are generally targeted at institutional investors and traded, over-the-counter or OTC instead of on exchanges, they are in many ways perfectly positioned to take advantage of smart contract operation to prevent situations such as what had occurred in VodafoneZiggo’s case.
To begin with, because the smart contract would constantly be “listening” for the data that would trigger execution, traders of the contract would not have missed the winding up of VodafoneZiggo for almost a year.
Smart Contracts Could be A Smarter Solution?
Smart contracts would also encourage greater clarity in contract construction for CDSs. To begin with, the definition of “default” would gain greater certainty as drafters of the smart contract would necessarily bargain vigorously beforehand the specific circumstances of default, leaving little to no ambiguity when a CDS would likely execute.
But the VodafoneZiggo arbitration also raises interesting problems of logic for companies looking to leverage self-executing blockchain-based smart contracts.
Given that smart contract execution on the blockchain is irreversible, certainty, especially in the case of futures contracts is desirable.
But in other cases such as in CDSs, there may be specific reasons why the parties may desire some leeway to determine the specific circumstances for execution. For instance, parties may not have considered a unique set of circumstances such as force majeur surrounding the event of default.
It is also entirely possible that parties to a CDS may desire a “compromise” resolution to the event of default instead of to the severity and irreversibility of a self-executing smart contract.
Yet smart contracts have the potential to weed out ambiguity which typically adds to dispute resolution costs — a committee of lawyers from ten banks and five fund managers, all billing hourly, is anything but cheap.
By forcing parties to clearly spell out and define their intentions at the time of entry into the contract, plus the threat of a self-executing smart contract hanging like the Sword of Damocles over the heads of the parties, parties may be encouraged to negotiate contracts more thoroughly, with greater thought and with greater precision.
As a friend once remarked, a wedding is a lot cheaper than a divorce.
In the world of contracts, defaults and dispute resolution are the divorce and can often cost far more in terms of time and money wasted than a properly negotiated contract.
There are good reasons therefore to be precise before the contract is created, especially if these smart contracts have the potential to become templates for general use.
Clearly drafted, well thought-out, irreversible, self-executing smart contracts could create scalable solutions, which could revolutionize entire industries or even create new ones.
Lawyers (with strong pecuniary motivations) understandably and oftentimes deliberately, introduce ambiguity within contracts because this allows for wiggle room at a later date — it also allows for lucrative litigation or arbitration down the line.
Given that the markets for CDSs are worth trillions of dollars and are unregulated, the stakes are high. Yet CDSs fundamentally serve an economic purpose — the re-appropriation of risk — and could be better managed to encourage economic activity.
CDSs allow banks to lend to a wider range of firms, including firms that would sometimes never get a loan, because banks can then hedge out their credit exposure.
CDSs allow pension funds, which are often required to protect their capital, to invest in higher yielding bonds.
With trillions of dollars at stake, certainty in such contracts isn’t a luxury, it’s a necessity. Smart contract technology may provide a more elegant solution than the current state of the market.