Smart Derivative Contracts (Detaching Transactions from Counterparty Credit Risk: Specification, Parametrisation, Valuation)

Abstract

In this note we describe a smart derivative contract with a fully deterministic termination to remove many of the inefficiencies in collateralized OTC transactions. The automatic termination procedure embedded in the smart contracts replaces the counterparty default by an option right of the counterparty. The application of smart contracts to cure issues in xVAs has been described before, see Morini et. al. (2015, 2017). However, a direct implementation of an OTC derivative as a smart contract may come with its own issues: * If the smart contract is implemented on a crypto-currency blockchain it will introduce a currency conversion risk. * If the smart contract has an automatic termination in case of insufficient wallet amounts, the contract essentially contains a bilateral American option. Both counterparts can willingly terminate the contract by emptying the wallet. This would render the contract useless. In this note we will fully describe the terms of a smart contract to replace a collateralized OTC transaction. We introduce a penalty payment to modify the American option right in the contract. The penalty and the excess amount in the wallet can be seen as a combination of default fund contribution and initial margin, inducing a per-contract termination probability. Hence, each contract come with its own termination probability (corresponding to the default probability). Based on this, ratings could be assigned on a per-contract basis. Such smart contracts are also interesting with respect to the mathematical theory of systemic risk, since each contract represents an individual counterparty, increasing the numbers of individual counterparties in the whole system and possibly justifying the application of mean filed theory (compared to a setup with a large central counterpart (CCP)).