Auction Type Resolution on Smart Derivatives
Yusuke Ikeno, James Angel, Shin'ichiro Matsuo, Ryosuke Ushida
aa r X i v : . [ q -f i n . T R ] F e b Auction Type Resolution on Smart Derivatives
Yusuke Ikeno , James Angel , Shin’ichiro Matsuo , and Ryosuke Ushida Georgetown University, { yi106,angelj,sm3377,ru64 } @georgetown.edu Abstract.
This paper proposes an auction type resolution for smartderivatives. It has been discussed to migrate derivatives contracts tosmart contracts (smart derivatives). Automation is often discussed in thiscontext. It is also important to prepare to avoid disputes from practicalperspectives. There are controversial issues to terminate the relationshipat defaults.In OTC derivative markets, master agreements define a basicpolicy for the liquidation process but there happened some disputes overthese processes. We propose to define an auction type resolution in smartderivatives, which each participant would find beneficial.
Keywords:
OTC derivatives · Dispute resolutions · Auction.
OTC derivatives are traded in the financial market for the purpose of hedging ortransforming market risk and speculations. According to BIS statistics, notionalamounts outstanding in the first half of 2020 is 606,810 billion US dollars . Thisfigure is significant since the global GDP in 2019 is 87,799 billion (the WorldBank data ).After the financial crisis, the regulation for OTC derivatives had got harderto stabilize financial markets. This made the post trading process more compli-cated. Not only financial institutions but also non financial derivatives users aresuffering from the regulation cost.The financial industry finds that distributed ledger technology and smartcontracts could improve their business. The purpose is not only to make theiroperations more efficient but also pioneer new area. For example, JPMorgan de-veloped ”Quorum” and Barclays held some hackasons called ”DerivHack”. Thereare many research cases globally. Recently many central banks are studying dig-ital currencies, which would have a significant impact on OTC derivatives as oneof the use cases.[5]Though there are many types of products, it is well known that they are com-posites of conditional cash flows or settlements.There are some studies that showthey can be expressed in a functional programming framework.[8] This featurealso inspires it is appropriate to bring these products into smart contracts. https://data.worldbank.org/indicator/ny.gdp.mktp.cd Y. Ikeno et al. Morini discussed re-design of the buisiness model noting that ”Blockchain tech-nology was created to change some trust-based business processes to make themless reliant on trust”. [17] He also investigated the implementation of collateralsettlement on public blockchain. [18]ISDA had published a series of guidelines for smart derivative contracts fromlegal perspectives .[15]Fries and Kohl-Landgraf thought regulatory implementations are inefficientdue to historic infrastructures and lack of standardization and automation ofa trade life cycle processes.[11] They also implemented prototypes under someassumptions of digital currencies. [9, 10]Clack and McGonalge discussed how smart contract code might process andautomate payments-related and deliveries-related events and proposed we shouldunderstand derivatives contracts at different levels, in terms of both the legaldocumentation and the work-flow. [4]
It is important to process close-out effectively because events of defaults affectsignificantly. Though master agreements define basic processes to close out, cal-culation methodology is vague to some extent.Clack and Datoo recently discussed how we can make smart close-out ef-ficiently from legal perspectives. [7] We discussed this issue from operationalviewpoint. As the liquidation process at default contains conflicts between in-volve parties by nature, the stakeholders are likely to take actions to protect theirprofit. The current method investigates the mid point under possibly transparentmanner. We proposed an auction method to calculate the termination amountsand look for new trades so that the involved parties can process more algorith-mically and each participant can find merits.
Our discussion focuses on uncleared collateralized OTC derivatives. When twoparties start to trade OTC derivatives, they usually sign a ”master agreement”,which governs all derivatives contracts between them. ISDA (International Swapand Derivatives Association) provides templates for the master agreement. Mas-ter agreements treat governed individual transactions as one contract, whichmake netting settlements possible. The definition of jurisdiction and basic poli-cies for resolving disputes are also described in master agreements. Schedule andcredit support anex (so called ”CSA”) are the related documents for precise in-formation and the rule for collateral management, which complement the masteragreement.From here, we review the basic process after events of default. See [16] formore details. Master agreements define events of default as below. uction Type Resolution on Smart Derivatives 3
Fig. 1.
Trading scheme ♦ Events of Defaults – Failure to pay or deliver – Breach/ repudiation of agreement – Credit support default – Misrepresentation – Default under specified Transaction – Cross-default – Bankruptcy – Merger without AssumptionGenerally speaking, an event of default occurs if one of the parties is at fault.If an event of default occurs (the party at fault is called ”defaulting party”),the other party called ”non defaulting party” has a right to terminate the con-tracts under their master agreement. The legal enforceability of this right de-pends on the jurisdiction. The party usually request legal opnions. This point isdiscussed in [7].When the right is exercised, both parties enter into ”Early Termination” asthe agreement describes.1. Designation of early termination date2. Cessation of payment and delivery obligations3. Occurence of early termination4. Calculation of early termination amounts5. Delivery of statement detailing net termination amount payable6. Payment of termination amountAs described precisely below, the termination amount is the summation ofdefined payments and present values of defaulted transactions. Since someonehas to calculate the present value, it is usually expected that the non defaultingparty asks ”Reference Market Makers” to quote from neutral positions.
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If an event of default occurs (and the right is exercised), the non defaultingparty loses its risk exposure coming from those defaulted transactions. The nondefaulting party will cover the exposure in the market. If there are only a fewdefaulted transactions, it is easy to cover at once. Otherwise it takes time toreconstruct the exposure as there might be concerns on market impact andliquidity. This is why initial margin is required. IM is theoretically designed toabsorb such timing and liquidity risk. But we should understand that the costmight exceed the margin depending on market conditions even though the modelexplains we rarely face excess loss.
Fig. 2.
Covering the defaulted exposures
Especially for early termination, the parties should – terminate transactions under the agreed value. – close the process as soon as possible – reduce the effect to the financial systemThe master agreements give a policy for these points but the exact way is upto the involved parties. There could be conflicts at termination amounts betweenboth parties because the profit of one party means the loss of the other. Unfortu-nately there were some cases the defaulting party started disputes even thoughthe quoted amount should have been accepted according to the agreement.Since the market circumstance might be stressed after events of default, itis helpful for stakeholders to reconsider the process depending on the situation.We should investigate the way satisfying1. the predefined process will be executed algorithmically within expectation.2. the process can be paused if unexpected loss would happen.3. each participant can cooperate in a constructive manner. uction Type Resolution on Smart Derivatives 5 The price movement in financial markets affects the valuation ofcontracts like other financial products. Unrealized profit (or loss) would be lostif the counterparty fails to continue. In other words, derivative contracts includecounterparty’s credit risk.If markets move significantly, we should take care of not only our profit orloss but also how counterparties are working.
Margin
New York Fed describes the history of the regulation of derivativesas below; In 2009, the G20 Leaders agreed to reforms in the OTC derivativesmarket to achieve central clearing and, where appropriate, exchange or electronictrading of standardized OTC derivatives; reporting of all transactions to traderepositories; and higher capital as well as margin requirements for non-centrallycleared transactions . The margin requirement on uncleared OTC derivativesis yet on the way.There are two types of margin. One is called ”variable margin”(VM), whichcovers present values of contracts. If your position has profit, you will receivesome assets as collateral whose value matches your profit. If loss, you will haveto transfer to your counterparty.The other one is called ”initial margin”(IM), which is the cost for reconstruct-ing the positions. Under the margin requirement for uncleared OTC derivatives,IM are required to be deposited into segregated accounts from each party, suchas custodians. We need statistical models to calculate this amount. The SIMM,which is now regarded as a standard margin model for uncleared OTC deriva-tives, is designed to ”meet a 99% confidence level of cover over a 10-day standardmargin period of risk”. [6] The calculation includes defined unpaid amounts that were due before the earlytermination date and present values of contracts at the early termination date.The early termination amount is usually calculated by the non defaulting party.(There are some other cases which both parties agreed.The ”Market Quotation” is used for calculation of the amount to protect eachprofit . The master agreement defines that “Market Quotation” is an amountdetermined on the basis of quotations from Reference Market-makers. ”ReferenceMarket Makers” is also defined as following; “Reference Market-makers” meansfour leading dealers in the relevant market selected by the party determininga Market Quotation in good faith (a) from among dealers of the highest creditstanding which satisfy all the criteria that such party applies generally at thetime in deciding whether to offer or to make an extension of credit and (b) to the extent practicable, from among such dealers having an office in the same city.[1] In short, ”Reference Market Makers” are those trusted third parties whocan provide fair calculation of derivative transactions. We can imagine whichcompanies are suitable for this role but it is uncertain that those companies arewilling to join the liquidation process.Even though the process does not permit claims from default parties, therewere some cases that a defaulting party had disagreed with the amount, whichcaused long lasting disputes. Since the defaulting party can be motivated to raisetheir value at the events of default, it is effective to provide the party anotherincentive so that they can close smoothly. In case of centrally cleared trades, the derivatives transactions of defaulted mem-bers could be transferred to other clearing members via the auction process ina few days.For example, LCH, one of the largest clearing house, maintains the defaultprocess as below ;(1) Risk neutralisation & client porting:After a Clearing Member default, LCH immediately begins porting non-defaulting clients to non-defaulting Clearing Members. Alongside this, wehedge the defaulter’s trade portfolio with the assistance of our Default Man-agement Group (DMG), senior executives with appropriate skills and ex-pertises from its clearing members and certain other members as the DMGconsiders appropriate, that are seconded to LCH in the event of default.(2) Portfolio auction:Once the risk of the portfolio is substantially reduced by the DMG, LCHsplits the defaulter’s portfolio by product and currency. An auction is thenconducted for each portfolio. The ability to receive and price an auctionedportfolio is one of the criteria we verify prior to granting firms membershipto SwapClear.(3) Loss attribution:In the event that losses are greater than the financial resources of the de-faulting member and of LCH, the funded Default Fund contributions ofnon-defaulting SwapClear members are used. There are several types of auctions implemented on the smart contracts.[2, 12]The main purpose in this case is to investigate the fair mid value of transactionsand liquidity in the market. We use the same algorithm for the mid value as the”Market Quotation”. A second price sealed bid auction is applied to choose thewinner of trade value. We require a stopping condition about the trade cost andIM, which each participant finds beneficial to cooperate. Fig. 3.
Initiate an auction
Based on the current workflow, we would like to open an auction to investigatethe fair values for termination amounts. – When the non defaulting party exercises the right, the auction contract isexecuted. – The non defaulting party asks tradable entities from its relationship to jointhe auction, – Bidders are required to show the mid valuation. If possible to trade, theycan also show the tradable value. – After bidding, the smart contract calculates the mid valuation (=MQ) in thepredefined manner. (For example, averaging excluding outliers for the midvalues.) – The defaulted trades would be terminated at MQ. – As for the trade value, the second highest bid is chosen.(second-price sealed-bid auctions) – If the trade cost (:= | the mid value − the trade value | ) is more than IM, thenon defaulting party has a right to avoid to trade. • As described before, IM is supposed to compensate for the potential loss,which can be understood as a cost to reconstruct the exposure. • In this auction, the difference between the mid value and the trade costsis the cost that the non defaulting party has to pay for. • If the cost is more than IM, the non defaulting party might find it ad-vantageous to cover in the market directly. • If the cost is less then IM, the residual can be reverted to the defaultingparty, which could incentivises the defaulting party to agree with thisauction process.
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Since the optimal strategy in second bid auctions is showing the maximumvalue which they are willing to pay, the non defaulting party can redeem therealistic value for package trades.It looks curious to revert the residual to the defaulting party because IM issupposed to transfer to the non defaulting party by nature. As described beforeIM is the potential loss to cover exposures arising from defaulted trades. If thenew trades are given without costs, the non defaulting party does not requirethis margin for that purposes. We can think it to revert the residual to thedefaulting party if the termination amounts are payable.
Fig. 4.
Settlement of termination amounts
The following Table 1 shows some sample cases. Each value represents thetransactions value from A (the defaulting party). There are four or five biddersdepending on the cases. The ”mid” value is quoted for the ”Market Quotation”and the ”trade” value is the price at which the bidder is willing to trade. The”aggregate” value means the ”Market Quotation” for mid values and the secondprice auction winner and the price for trade values, leaving IM amount aside.
Table 1.
Sample auction scenarios.biddersNo A B value 1 2 3 4 5 aggregate1 100 80 mid 90.00 95.00 85.00 100.00 90.00 91.67trade 85.00 - 80.00 90.00 - ( ♯
4, 85.00)2 100 80 mid 90.00 95.00 85.00 100.00 - 92.50trade - - 80.00 - - ( ♯
3, 80.00)3 100 80 mid 95.00 95.00 75.00 105.00 - 95.00trade 90.00 - - 95.00 - ( ♯
4, 90.00)4 100 80 mid 90.00 90.00 100.00 100.00 90.00 93.33trade - 75.00 80.00 - - ( ♯
3, 75.00)5 100 80 mid 90.00 90.00 90.00 90.00 90.00 90.00trade - - 88.00 - - ( ♯
3, 88.00)uction Type Resolution on Smart Derivatives 9
Depending on the market liquidity, B might want immediate counterpartiesto cover its exposure. In such a case, B could ask the bidder after the processbecause the cancel is a result of algorithm. Though there could be some criticsthat this is not fair for the defaulting party, IM covers these covering risk by itsdefinition. The residual is a bonus for the defaulting party.
Since bidders have to calculate the value oftransactions by themselves, it is important to share the transactions and relatedinformation. – Both parties names – Master agreement and related documentsThe content of master agreement and related documents depends individu-ally. For example, collateral information affects valuation directly. – Details of each transactionExotic trades might be included among the defaulted trades as they are notcleared.If we could record this information in the same manner, it would be help-ful to share. There are some formats such as FIX and FpML to describe thetransactions. The booking system records the transactions in its original formatbased on these common formats. Sharing details of transactions require somekind of transformation.When two parties start to trade OTC derivatives, they negotiate the detailsof master agreement based on the template. The amendment of template causesa potentially infinite pattern of master agreement and the customization makesthe initial negotiation annoying.Under the digitization of derivatives, ISDA develops ”Common Domain Model”(so-called ”CDM”) and ”Clause Library”.[3, 13, 14] CDM helps the users to de-scribe the transactions in a unified manner and Clause Library will reduce thecost of legal negotiations.
Invitation of bidders
Bidders with good faith are essential to make theseauctions successful. We can not exclude the case of no bidder cases and manip-ulations by bidders.In the current process, reference market makers are assumed to quote marketquotations. We can assume they will join to quote the mid values faithfully.In other words, the existence of reference market makers is the trust point ofthis process. If both parties could not find out such parties, they would have tonegotiate their termination amounts by themselves. They might need enforceableauthority such as a court.
If both parties involved in OTC derivatives As this auction satisfies the currentprice decision process ( ”Market Quotation”), this can be understood as theimprovement.If the tradeable value is available, the non defaulting party can avoid liquidityconcerns and the defaulting party may be able to retrieve some of the IM.Bidders may find it attractive to take part in this auction if they can reducetheir risk exposures at lower cost. Though this depends on the market situation,their stance could send a signal of liquidity to the non defaulting party.It is basically beneficial for each participant to open an auction as a part ofthe liquidatuin.
We select the second price sealed auction for trade value to clarify the meaningof bids. The policy is bit different from calculation of the mid value, which inves-tigates the average value. Those participants whose calculate relatively higherare likely chosen as the winners. Higher price is nice as the defaulting partygains more residual and it costs less for the non defaulting party to cover theexposure at once. The difference of the valuation could cause another problem,for example collateral process. Under the collateral exchange, two parties arerequired to exchange VM reflecting each exposure calculation. If the valuationis far, they meet disputes. There are some temporal resolution such as averagingor undisputed amount.[19]Since CCP can not keep the defaulted trades, they have to immediatelytransfer the portfolio to another member chosen by an auction. In this case, VMand IM are alos transferred to the new party at the same time. If we totallyimitate this, the situation is very simple but we could not find out the meritfrom the defaulting party. CCP scheme is strongly supported by the duty ofclearing members.OTC trades are basically closed bilaterally. It is difficult to define the ”fairvalue” in OTC markets because the contract data is private by nature so thatwe have to rely on the market participants at both entry and exit points. As themaster agreement assumes reference market makers, it is important to managerisk in the community.
Electronic platforms (e.g., TradeWeb) support efficient executions, on whichusers can request for a quote of not only one trade but also several trades. Somemay wonder if the non defaulting party could request for ”Market Quotation” viathese platforms efficiently instead of opening an auction. What we emphasise is uction Type Resolution on Smart Derivatives 11 the predefined process to gain the fair value on the smart contracts. Using smartcontracts do not depend on a going concern principle, which could eliminate akind of trust. Of course there may exist the more efficient way to combine theexecution platform with smart contracts.
We assume that the process is governed by the smart contract. Inputs and de-cisions are given by participants. We must rely on the bidders to succeed in theauction. As the current procedure assumes there are referenced market makers,we also assume trusted quotes here.
If eligible tradeable prices do not appear in the auction at all, the non defaultingparty has to trade in the market directly. In this case bidders know the defaultedrisk exposure, which might make it difficult for the party to trade efficiently. Aswe assume the non defaulting party invites the bidders in this scheme thoseparties are unlikely do so. Though this is a kind of morality, we should takesome measure against such immoral players in future.On the other hand, this information might have a kind of signaling effects,so that some faithful market makers support to close the position.Pricing OTC derivatives can be expressed as a real-valued mapping whosedomains are transactions, valuation models and market data. If there were acontract which could calculate the value from transactions (provided by the nondefaulting party) and the pair of a valuation model and market data (provided bythe bidders), we would not concern the privacy. From this point, standarzationof valuation matters.
Since we discussed the concept to improve the process in this paper, we shouldimplement this idea to investigate more practically.For efficient valuation, it is more convenient to assume trusted valuationagents independent from dealers; in other words, oracles pricing the transactions.If it is difficult to set up agents which calculate automatically, we may preparefor the shared calculation methodologies in advance. Fries et al [9] also pointedout this point.Decentralised finances (so called ”DeFi”) provide derivatives for crypto as-sets. They are usually overcollateralized and lock the potential cash flow at firstto avoid any disputes. If users request more flexibility as traditional derivatives,the similar issues including dispute resolutions are required. In this area, thealgorithmic methodology would be prefered.We assume some parties would quote the tradable value because the currentprocess also assumes ”reference market makers”. As financial markets might face less liquidity at events of defaults, the non defaulting party would not find outthe candidates for its auction. In such a case, the IM could not compensate forthe cover cost. We have to continue monitoring how the situation will change infuture. Even though we could define reasonable resolutions, the involved partiesmight change their mind at the liquidation. We would also rely on other enforce-able resolutions which work with the algorithm. Under the context of digitaltransformation, smart contracts would play important roles to automate andredefine many workflows. It is important to not only enjoy its efficiencies butalso scrutinize its potential disputes and resolutions from practical viewpoints.
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