The derivatives market is a 10 trillion dollar market (or, depending on who you ask, maybe 500 trillion or, maybe, quadrillion dollar) market and the market’s global trade association, the International Swaps and Derivatives Association (better knowns as “ISDA”) has recently released a report on the legal framework for using smart contracts for “creating efficiencies and cost savings.” The report, “Legal Guidelines for Smart Derivatives Contracts: Introduction” is available here: https://www.isda.org/2019/01/30/legal-guidelines-for-smart-derivatives-contracts-introduction/. Contributors to the report include attorneys from some of the largest global law firms in the U.S. and the U.K.

As I’ve said before , the financial industry is likely to be one of the first adopters of smart contracts as a way to cut costs, speed up transactions, and reduce errors (which are themselves a big source of costs).

Anyone interested in the potential of smart contracts should be watching the finance industry closely, because it looks like widespread adoption of smart contracts will start there.

How Businesses Use Derivatives to Hedge Risk

A “derivative” is a contract whose value is determined by or “derived from” (hence the name) another asset or group of assets. Derivatives can be used for a number of purposes, including speculation and arbitrage, but the most common use of a derivative is to hedge risk. Say you are running an airline. One of your biggest, and most volatile, expenses is jet fuel and so one of your biggest risks is that the price of jet fuel will spike. One way to protect yourself from swings in fuel price is to hedge your risk by buying derivatives. To take a simple example, you buy a call option, a contract that gives you the option to purchase jet fuel at a certain price during a certain date range. (But note, for any current or future Airline CEOs reading this, that not everyone agrees that hedging fuel is worth the cost, so DYOR).

The Process for Managing Derivatives Is Cumbersome, Time-Consuming and Costly

According to a very helpful report by Linklaters, one of the “Magic Circle” of London-based global law firms, the derivatives industry is interested in exploring Smart Contracts as a way to “streamline increasingly cumbersome and time-consuming processes, and cut costs.”

There are several reasons why Smart Contracts seem like a good fit for handling derivatives

First, the typical derivatives contains provisions based on conditional logic, i.e. “if then” statements that can be coded into software, e.g. “if price of copper is greater than X$ on Date Y, transfer Z$ from A to B.” Contrast more “nuanced” provisions, e.g. “A agrees to use commercially reasonable efforts to help B secure financing.” (But note that derivatives contracts include some of these nuanced provisions as well.)

Second, and related, derivatives involve a vast number of transactions that differ along a small set of parameters. Take the fuel hedging derivatives mentioned above: these follow a standard format where only a few parameters, e.g. price, time of execution, quantity, vary from contract to contract. And indeed many derivatives already use standardized contracts. In fact, ISDA uses a standard agreement, called, appropriately enough the ISDA Master Agreement, aka “the most important standard market agreement used in the financial world.”

Third, there is, to put it mildly, since the financial crisis of 2008, regulators have shown a great deal more interest in monitoring derivatives markets. This has increased the complexity and reporting requirements at every state of the life cycle.

In a Trillion Dollar Market, Even “Small” Savings Add Up Fast

As noted above, the market for derivatives is astronomically huge and so even a small savings becomes significant when multiplied by 500 trillion.

Everyone agrees that the derivatives market is astonishingly huge, but nobody seems to know how huge: estimates range from 500 trillion to 1.2 quadrillion (yes that is a link aol.com and yes it is from 2010. It is a good article. Don’t hate. Investopedia concurs with AOL.). The ISDA has made a cool “white board” video that explains how they measure the market and the Money Project has created a cool infographic that compares the derivatives market to other financial markets.

Why Smart Derivatives Contracts are Good For Everyone, Inside and Outside the Finance Industry

So, you ask, hurray for the millionaires and billionaires who run the banks and invest in derivatives, who are going to save more millions from Smart Contracts, but how does this help the rest of us?

As I’ve argued elsewhere, I believe that Smart Contracts and Distributed Ledger Technology are going to transform the legal system, the economy, and society. What matters now is real-world adoption. See , Smart Contracts — The Path to mainstream adoption, by Harry Papacharissiou (@pappas9999 ) of Genesis Blockchain Services (@GenesisBlockchn )

And, just as with earlier innovations in software, adoption is likely to come first with big enterprises. Large banks started using software many decades before widespread consumer adoption. (See From Airline Reservations to Sonic the Hedgehog: A History of the Software Industry, by Martin Campbell-Kelly)

In other words, helping big financial institutions improve efficiency and cut costs is an important MILESTONE on the way to world-transforming adoption of DLT and smart contracts.

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This post "Smart Contracts are Set to Transform the Trillion Dollar Derivatives Industry" originally appeared on LawSnap.com.