Smart Derivatives Contracting: Automating Interest Rate Swaps in the Over-the-Counter (OTC) Market with the DAML

Abstract

The over-the-counter (OTC) market sees the majority of trading volume in the finance industry, yet it remains vastly unregulated. Inherent to its nature are issues with transparency, efficiency and security, which have been barely addressed by legislators post the 2008 crisis. We propose that the utilization of Smart Contracts in the OTC market and creation of “smart derivatives”, solves the majority of issues that are associated with the market. While other researchers have debated on this matter and proposed the use of Smart Contracts in OTC markets, there are no papers offering an example of practical implementation. We selected interest rate swaps (IRS) as the test-case derivative for implementation in the form of a smart contract. Having unpacked the mathematical and theoretical framework behind structuring and pricing IRS, we produced a Vasicek Simulated Yield Curve from the Ten Year Constant Maturity Treasury Rates and found that the curve was inverted, which, combined with a characteristic LIBOR Simulated Yield Curve pointed to an increasingly negative swap spread for longer maturities that was demonstrated with a plotted Swap Spread. The parameters of the model were derived from live market data through Maximum Likelihood Estimation with Monte Carlo Simulation of Euler Scheme discretized Vasicek instantaneous rates. We concluded that short term interest rate swap contracts were preferable and implemented a one-year Interest Rate Swap by instantiating the DAML Ledger Sandbox. The implementation offers the likely innovation of merging a Swap Execution Facility and a Swap Data Repository into one platform, ensuring end-to-end automation, as well as providing the benefits of visibility, while preserving anonymity, improving efficiency and security in the market.