ERC-6123: Smart Derivative Contract

Abstract

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The Smart Derivative Contract (SDC) allows fully automizing and securing a financial product's - e.g. a financial derivative or bond - complete trade life cycle.¹ The SDC leverages the advantages of smart contracts to remove many of the frictions associated with the classical derivative life cycle. Most notably, the protocol allows the removal of counterpart risk essentially. The SDC can be implemented using a pre-agreed valuation oracle and valuation model, removing ambiguity in the settlement amounts. The SDC provides methods and callbacks to enable fully automated and fully transactional settlements (delivery-versus-payment, payment-vs-payment). Token-based settlement can be realized by any contract implementation implementing an ERC-20 token. Proof of concepts in terms of two legally binding digital Interest Rate Swaps were conducted in 2021 and 2022.

Motivation

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Rethinking Financial Derivatives

By their very nature, so-called "over-the-counter (OTC)" financial contracts are bilateral contractual agreements on exchanging long-dated cash flow schedules. Since these contracts change their intrinsic market value due to changing market environments, they are subject to counterparty credit risk when one counterparty is subject to default. The initial white paper describes the concept of a Smart Derivative Contract (SDC) with the central aim to detach bilateral financial transactions from counterparty credit risk and to remove complexities in bilateral post-trade processing by a complete redesign.

Concept of a Smart Derivative Contract

A Smart Derivative Contract is a deterministic settlement protocol with the same economic behaviour as a Financial Contract - e.g. an OTC-Derivative or a Bond. Every process state is specified; therefore, the trade and post-trade process is known in advance and is deterministic over the trade's life cycle. An ERC-20 token can be used for frictionless decentralized settlement, see reference implementation. We do provide a separate interface and implementation for a specific "Settlement Token" derived from ERC-20. These features enable two or multiple trade parties to process their financial contracts fully decentralized without relying on a third central intermediary agent. The process logic of SDC can be implemented as a finite state machine on solidity.

Applications

The interface's life cycle functionality applies to several use cases.

Settle-to-Market OTC Derivative

In the case of a settle-to-market OTC derivative, an SDC settles the outstanding net present value of the underlying financial contract on a frequent (e.g. daily) basis. With each settlement cycle, the net present value of the underlying contract is exchanged, and the value of the contract is reset to zero. Pre-agreed margin buffers are locked at the beginning of each settlement cycle so that settlement will be guaranteed up to a certain amount. If a counterparty fails to obey contract rules, e.g. not providing sufficient pre-funding, SDC will terminate automatically with the guaranteed transfer of a termination fee by the causing party. We provide a reference implementation for this case.

Callateralized OTC Derivative

An implementation variante of the protocol can be used to realize a collateralized OTC derivative.² Here the contract manages separate collateral and cash tokens. The constructions allows to eliminate the risk of under-collateralization. Thus, a separate initial margin is not required.

Defaultable OTC Derivative

A defaultable OTC Derivative has no Collateral Process in place. In that case, a smart derivative will settle the according cash flows as determined in the derivative contract specification. A defaultable OTC derivative might end in a state 'Failure to Pay' if a settlement cannot be conducted.

Smart Bond Contract

The life cycle of a bond can also make use of the function catalogue below. The interface enables the issuer to allocate and redeem the bond as well as settle coupon payments. On the other hand, it allows bondholders to interact with each other, conducting secondary market trades. It all boils down to a settlement phase, which needs to be pre-agreed by both parties or triggered by the issuer which can be processed in a completely frictionless way.

Specification

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The methods and event are separated into different interfaces:

• ISDCTrade - events and functions related to trade inception, confirmation and termination.
• ISDCSettlement - events and functions related to the settlement life-cycle of a trade.
• IAsyncTransferCallback - events and the callback function afterTransfer for settlements that utilize and external payment system.
• IAsyncTransfer - events and functions related to async transfer (e.g., for external payment systems).

The ISDC interface is the aggregation of ISDCTrade, ISDCSettlement and IAsyncTransferCallback.

Methods of ISDCTrade

The following methods specify a Smart Derivative Contract's trade initiation, trade termination and settlement life cycle. For further information, please also look at the interface documentation ISDC.sol.

Trade Initiation Phase: inceptTrade

A party can initiate a trade by providing the party address to trade with, trade data, trade position, payment amount for the trade and initial settlement data. Only registered counterparties are allowed to use that function.

The position and the paymentAmount are viewed from the incepter. The function will return a generated unique tradeId. The trade id will also be emitted by an event.

Trade Initiation Phase: confirmTrade

A counterparty can confirm a trade by providing its trade specification data, which then gets matched against the data stored from inceptTrade call.

Here, the position and the paymentAmount is viewed from the confimer (opposite sign compared to the call to inceptTrade).

Trade Initiation Phase: cancelTrade

The counterparty that called inceptTrade has the option to cancel the trade, e.g., in the case where the trade is not confirmed in a timely manner.

Trade Termination: requestTermination

Allows an eligible party to request a mutual termination of the trade with the corresponding tradeId with a termination amount she is willing to pay and provide further termination terms (e.g. an XML)

Trade Termination: confirmTradeTermination

Allows an eligible party to confirm a previously requested (mutual) trade termination, including termination payment value and termination terms

Trade Termination: cancelTradeTermination

The party that initiated requestTradeTermination has the option to withdraw the request, e.g., in the case where the termination is not confirmed in a timely manner.

Methods of ISDCSettlement

Settlement Phase: initiateSettlement

Allows eligible participants (such as counterparties or a delegated agent) to trigger a settlement phase.

Settlement Phase: performSettlement

Valuation may be provided on-chain or off-chain via an external oracle service that calculates the settlement or coupon amounts and uses external market data. This method serves as a callback called from an external oracle providing settlement amount and used settlement data, which also get stored. The settlement amount will be checked according to contract terms, resulting in either a regular settlement or a termination of the trade.

The method may perform a synchonous transfer of the settlement or make use of an IAsyncTransfer, which will finalize the transfer though the callback afterTransfer.

The transactionData is emitted as part of the corresponding event: SettlementTransferred or SettlementFailed This might result in a termination or start of the next settlement phase, depending on the provided success flag.

The parameter settlementData will be ussed as lastSettlementData as part of the SettlementRequested event (see there) and may contain updates to the determination of the next settlement, e.g., data to determine the reference value for margining or the specification of updated margin buffer values.

Settlement Phase: afterSettlement

The method is called to verify and prepare the next settlement and move to that phase. The method may trigger optional checks (e.g. pre-funding check).

Depending on the implementation, this method may be called automatically at the end of performSettlement or called externally (e.g. from a time-oracle to allow for a time-period to prepare the next settlement).

• An implementation that uses adjusting of pre-funding can check the pre-funding within this method.
• An implementation that checked a static pre-funding upon confirmation of the trade might not require this step.

In any case, the method may trigger termination if the settlement failed.

Emits a SettlementTransferred or a SettlementFailed event. May emit a TradeTerminated event.

Methods of IAsyncTransferCallback

Settlement Phase: afterTransfer

This method is called back from a settlement token or from an eligible address if the transfer of the settlement amount was successful. - completes the settlement transfer. The transactionData is emitted as part of the corresponding event: SettlementTransferred or SettlementFailed This might result in a termination or start of the next settlement phase, depending on the provided success flag.

Trade Events

The following events are emitted during an SDC Trade life-cycle.

TradeIncepted

Emitted on trade inception - method 'inceptTrade'

TradeConfirmed

Emitted on trade confirmation - method 'confirmTrade'

TradeCanceled

Emitted on trade cancellation - method 'cancelTrade'

TradeActivated

Emitted when a Trade is activated

TradeTerminationRequest

Emitted when termination request is initiated by a counterparty

TradeTerminationConfirmed

Emitted when termination request is confirmed by a counterparty

TradeTerminationCanceled

Emitted when termination request is canceled by the requesting counterparty

TradeTerminated

Emitted when trade is terminated

Settlement Events

The following events are emitted during the settlement phases.

SettlementRequested

Emitted when a settlement is requested (via initiateSettlement). May trigger the settlement phase.

The argument lastSettlementData is the one that was passed upon a previous settlement in performSettlement (under the name settlementData). It may be used to pass updated settlement specific information calculated during the previous settlement, e.g., when margin buffer amounts are a function of market parameters. In case of an external oracle it can pass the settlementData via performSettlement and pick it up in the SettlementRequested event (allows for stateless external oracles).

SettlementDetermined

Emitted when the settlement phase is started (via performSettlement).

SettlementTransferred

Emitted when the settlement succeeded.

SettlementFailed

Emitted when the settlement failed.

Rationale

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The interface design and reference implementation are based on the following considerations:

• An SDC protocol enables interacting parties to initiate and process a financial transaction in a bilateral and deterministic manner. Settlement and Counterparty Risk is managed by the contract.
• The provided interface specification is supposed to completely reflect the entire trade life cycle.
• The interface specification is generic enough to handle the case that parties process one or even multiple financial transactions (on a netted base)
• Usually, the valuation of financial trades (e.g. OTC Derivatives) will require advanced valuation methodology to determine the market value. This is why the concept might rely on an external market data source and hosted valuation algorithms
• A pull-based valuation-based oracle pattern can be implemented by using the provided callback pattern (methods: initiateSettlement, performSettlement)
• The reference implementation SDCSingleTrade.sol considers a single trade and is based on a state-machine pattern where the states also serve as guards (via modifiers) to check which method is allowed to be called at a particular given process and trade state
• The interface allows the extension to multiple trades with common (netted) settlement.

State diagram of trade and process states

The diagram shows the trade states of a single trade SDC as in SDCSingleTrade.sol.

Sequence diagram of reference implementation 'SDCPledgedBalance.sol'

The following sequence diagram shows the function calls that create the trade and stellement state transitions and the emitted events. Shown is the implementation variante that

• utilizes an asynchronous settlement through a settlement token (see the interface IAsyncTransfer, IAsyncTransferCallback)
• receives the trigger afterSettlement to perfrom checks of settlement pre-conditions (see the corresponding method description afterSettlement)

Sequence diagram of an implementation variant with a separate collateral account

The following sequence diagram shows the implementation variant with a separate collateral account. This diagram show the settlement phase.

Test Cases

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Life-cycle unit tests based on the sample implementation and usage of ERC-20 token is provided. See file test/SDCTests.js ).

Reference Implementation

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An abstract contract class SDCSingleTrade.sol for single trade SDCs as well as a full reference implementation SDCPledgedBalance.sol for an OTC-Derivative is provided and is based on the ERC-20 token standard. See folder /assets/contracts, more explanation on the implementation is provided inline.

Trade Data Specification (suggestion)

Please take a look at the provided xml file as a suggestion on how trade parameters could be stored.

Security Considerations

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No known security issues up to now.

Copyright

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Copyright and related rights waived via CC0.

Footnotes

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