Private international law aspects of smart derivatives contracts utilising distributed ledger technology
The challenges in identifying the situs of the token.
06 July 2020
This article considers the private international law, or conflict-of-law, aspects of derivatives contracts entered into using distributed ledger technology (DLT). DLT systems are often borderless, allowing multiple users or participants to modify records in a shared database whilst the users or participants may be located in different jurisdictions. This could result in a number of conflict-of-law issues arising in respect of a derivatives transaction entered into using DLT.
For the purposes of this article we will consider two different types of derivatives transaction, an uncollateralised interest rate swap transaction and a collateralised interest rate swap transaction, each of which has been entered into under ISDA documentation and implemented on Corda. Corda is an open-source blockchain platform developed by R3 for recording and processing financial agreements and is a private permissioned ledger, meaning only authorised parties may view and use it.
UNCOLLATERALISED INTEREST RATE SWAP TRANSACTION
The first type of transaction that we will consider is an uncollateralised interest rate swap transaction entered into on Corda. In this example, the parties to the transaction have also entered into an ISDA Master Agreement (governed by the laws of England and Wales) and have entered into a swap confirmation documenting the terms of the transaction between them. The uncollateralised interest rate swap transaction is implemented on Corda with the parties becoming “nodes” on the Corda distributed ledger.
We will focus on three key questions in respect of such a transaction:
- first, how an English court would determine the governing law of the transaction;
- second, how an English court would determine whether it has jurisdiction in respect of a dispute arising in respect of the transaction; and
- third, whether a transaction entered into using a DLT platform such as Corda would be admissible in evidence.
In respect of the first of these questions relating to governing law, we will start by considering the general rules that apply under English law in respect of determining the governing law of a contract. We will then consider how these rules would apply to an uncollateralised interest rate swap transaction that has been entered into on Corda.
HOW A COURT DETERMINES THE GOVERNING LAW OF A CONTRACT
The position in England and Wales is currently governed by the Rome I Regulation (Regulation (EC) No 593/2008). In general, the parties to a contract are free to choose the law that will govern their contract. There are certain limited cases, however, in which provisions of the parties' chosen law may not be applied. In particular:
- If all the elements relevant to the situation at the time of the choice are located in a country other than the country of the law that was chosen, then the choice of law cannot prejudice the application of mandatory laws of that other country.
- If all the elements relevant to the situation at the time of the choice are located in one or more EU member states, then the choice of a law other than that of a member state cannot prejudice the application of mandatory EU law.
- Any overriding mandatory provisions of the law of the forum must be given effect. Overriding mandatory provisions are those “the respect for which is regarded as crucial by a country for safeguarding its public interests”.
- Effect may be given to overriding mandatory provisions of the law of the country where contractual obligations have to be or have been performed, if those provisions render the performance of the contract unlawful.
The uncollateralised interest rate swap transaction that we are considering may have little connection with England (as the country of the governing law of the ISDA Master Agreement). For instance, the parties and the DLT system may have no connection to the UK. Notwithstanding this, an English court would not consider this to be a sufficient ground to disapply the parties' express choice of law. For a court to disregard provisions of the parties' chosen law, it would have to find that all the elements relevant to the situation are located in a country other than the choice-of-law country.
In Dexia Crediop SpA v Comune di Prato  EWCA Civ 428 at -, CA (England and Wales), the Court of Appeal rejected an argument based on the equivalent of this rule in the 1980 Rome Convention that the choice of English law in the ISDA Master Agreement by the parties, which were both Italian, was inapplicable because all the elements relevant to the transaction were located in Italy. The court ruled that the phrase “elements relevant to the situation” includes elements that indicate an international situation, and not just elements that are local to another country. Since the parties had opted to contract on the basis of the ISDA Master Agreement, which is not intended to be associated exclusively with any country, and the transaction involved back-to-back contracts with banks outside Italy, there was an international dimension to the situation.
The uncollateralised interest rate swap transaction that we are considering shares similarities with the situation in Dexia. The transaction is entered into under an ISDA Master Agreement and, like the back-to-back contracts involved in the Dexia situation, the use of a Corda distributed ledger based in another country brings an additional international dimension to the transaction. As a result, taking into account the court's reasoning in Dexia, there is no reason to believe that the parties' express choice of law under the ISDA Master Agreement would be disregarded.
As noted above, the uncollateralised interest rate swap transaction that we have envisaged is entered into using Corda, which is a private permissioned ledger, and where the parties have also separately entered into an ISDA Master Agreement off-ledger. There could be a greater degree of uncertainty over the governing law of a transaction taking place on a public, permissionless distributed ledger or in respect of the ability to enforce a judgment obtained in respect of any such transaction. Transactions entered into on such platforms may not be backed by an off-ledger agreement (such as an ISDA Master Agreement) and it may not always be possible to identify the real-world identities of the participants. Such platforms do not usually have any central authority that is empowered to enforce the rules of the platform or any court judgment. Given these issues, it would seem unlikely that this type of DLT model would be suitable for the trading of derivatives transactions on a cross-border basis without greater certainty among all participants over which governing law will apply in all circumstances.
HOW A COURT DETERMINES THE APPROPRIATE JURISDICTION FOR A DISPUTE REGARDING CONTRACTUAL OBLIGATIONS
The ISDA Master Agreement contains a jurisdiction clause which provides (in respect of an ISDA Master Agreement governed by English law) for the English courts to have non-exclusive jurisdiction (or, in certain scenarios, exclusive jurisdiction) in respect of any disputes arising under the agreement.
When the parties to a dispute have contractually agreed that the English court has jurisdiction over the matter, the English court will generally give effect to this agreement. Alternatively, the parties may have contractually agreed that a foreign court has jurisdiction over disputes. In this scenario, an English court will generally stay any claims brought in England in breach of this agreement unless the claimant can prove there are strong reasons for the English proceedings to continue.
Under the common law, an English court will only order a stay of proceedings if the defendant demonstrates there is a foreign court that is clearly or distinctly more appropriate than England for the trial of the action, and it is not unjust that the claimant be deprived of the right to trial in England (forum non conveniens).
The common law position described above has been supplemented by the Recast Brussels Regulation (Regulation (EU) No 1215/2012) on the enforcement of judgments within the EU and the Lugano Convention 2007 (in respect of Norway, Iceland and Switzerland). The Recast Brussels Regulation and the Lugano Convention will cease to apply after the expiry of the UK-EU transition period, which is scheduled to expire on 31 December 2020, although the UK has expressed its intention to accede to the Lugano Convention in its own name after the expiry of the transition period (which will require the consent of the other parties to the Lugano Convention).
The common law position has also been supplemented by the 2005 Hague Convention on Choice of Court Agreements. This convention came into force in the European Union on 1 October 2015. Under the convention, a judgment that is required to be recognised and enforced under the Hague Convention may be registered, for the purposes of England and Wales, in the High Court, and will have “the same force and effect […] as if the judgment had been originally given by the registering court”.
The EU is a signatory to the Hague Convention and the UK has been bound by the Hague Convention as a result of its EU membership (and will continue to be bound during the UK-EU transition period). The UK is expected to accede to the Hague Convention in its own name with effect from 1 January 2021.
The Hague Convention states that where the parties to a contract have concluded a choice of court agreement designating that contractual disputes should be decided exclusively in a court of a contracting state (which does not include an asymmetric jurisdiction agreement), that court shall have jurisdiction to decide a dispute that arises in relation to the contract, and shall not decline to exercise jurisdiction on the ground that the dispute should be decided in another court. The judgment by the court designated in an exclusive choice of court agreement must then be recognised and enforced in other contracting states. The application of the Hague Convention to England therefore has the effect of upholding an exclusive choice of court made by contracting parties, where the choice is a court in a contracting state.
The non-exclusive aspect of the standard form jurisdiction clauses in the ISDA Master Agreements makes it unlikely that they satisfy the requirement of the Hague Convention for an exclusive jurisdiction clause. ISDA has published the 2018 ISDA Choice of Court and Governing Law Guide which, amongst other things, contains a form of exclusive jurisdiction clause for use in ISDA Master Agreements governed by English law which would comply with the requirements of the Hague Convention. This clause is often incorporated by parties into their ISDA Master Agreements in place of the default jurisdiction clauses.
As a result of the above, in the event of a dispute between the parties to an uncollateralised swap transaction, given the relevant ISDA Master Agreement provides that the English courts have jurisdiction, it is unlikely than an English court would determine that it does not have jurisdiction to consider a dispute arising under the transaction. If an exclusive jurisdiction clause is used, this would also ensure that the courts of any contracting state to the Hague Convention would recognise and uphold the exclusive jurisdiction of the English courts to hear the relevant dispute, and therefore enforce any English court judgment.
ADMISSIBILITY OF EVIDENCE IN ELECTRONIC FORM
Once the governing law of a contract has been determined together with the courts that will have jurisdiction to hear a dispute in respect of the contract, the ability of one of the parties to enforce the terms of the contract, such as a derivatives transaction that is documented on a DLT platform such as Corda, will depend on:
- whether a contract in such electronic form is enforceable under the laws of the governing law of the contract; and
- whether a contract in such electronic form will be admissible as evidence in the relevant courts.
Whilst this should not be a concern in respect of the uncollateralised interest rate swap transaction that we are considering where there is an off-ledger ISDA Master Agreement and swap confirmation, this would be a more significant consideration if there was no such off-ledger agreement.
In England and Wales, other than in respect of certain limited types of document (which should generally not be relevant for a standard derivatives transaction), there is no requirement for a contract to be in writing or in any other form, and even oral contracts are enforceable provided that the requirements under English law for a contract are present (such as offer and acceptance, consideration, certainty of terms and an intention to create legal relations). As a result, provided a derivatives transaction documented in electronic form (such as on a DLT platform) has these basic constituents and they can be evidenced, it will in principle be enforceable under English law.
The admissibility of electronic documents in court proceedings in England and Wales is governed by the Electronic Communications Act 2000 (ECA 2000). The ECA 2000 allows for an electronic document to be admissible as evidence in relation to any question over the authenticity of an electronic transaction. As a result, a derivatives transaction that is documented on a DLT platform should in principle be admissible as evidence in the courts of England and Wales, so long as the transaction and its terms are capable of being reproduced in a format that the court can read.
COLLATERALISED INTEREST RATE SWAP TRANSACTION
In the second half of this article, we will consider an interest rate swap transaction entered into under an ISDA Master Agreement (governed by English law) where one or both parties' obligations have been collateralised (such as using one of the forms of the ISDA Credit Support Annex or Credit Support Deed) and the collateral relationship is implemented using DLT. This raises a number of additional conflict-of-law issues in comparison to an uncollateralised transaction.
WHERE TOKENS RECORD REAL-WORLD ASSETS
Under the most straightforward implementation of a collateralised transaction using DLT, the real-world collateral assets (such as cash or securities) would not be replaced with on-ledger tokens or digital assets that possess intrinsic value. Instead, the tokens on the ledger merely record the various forms of collateral provided and exchanged. As a result, the distributed ledger effectively serves a record keeping function.
If a dispute arose over the entitlement of a party to securities used as collateral, this would be decided by the situs of the securities. Depending on the particular situation, this could be the lex incorporationis (including the law of some place other than the lex incorporationis if the latter allows the securities to be dealt with there) or, where the securities are held in a centralised deposit system, the law of the country where the register, account or centralised deposit system is situated. The use of the DLT system in this example should not be relevant to the determination of the situs of the securities and therefore should not introduce additional conflict-of-law considerations.
WHERE TOKENS POSSESS INTRINSIC VALUE
A more complex implementation of a collateralised transaction could involve the replacement of real-world collateral assets with a form of token or digital asset that possesses intrinsic value (such as a stablecoin or cryptocurrency).
In this scenario, determining the situs of the token is more difficult as, depending upon the nature of the token, there may be no lex incorporationis. Nor is the token likely to be held in a centralised deposit system or in an account with an intermediary.
One solution would be for the situs of the token to be the “law of the platform” that the parties have agreed will govern all on-ledger transactions on the relevant DLT system, or for the agreements between individual parties to make provision for the governing law applicable to collateral in respect of their transactions.
Alternatively, where national authorities and regulators are concerned that allowing parties an unfettered choice of a governing law (including through the use of the law of the platform) is undesirable, they might wish to consider whether they should require the choice of law to be restricted to the laws of countries where parties such as the issuer of the token, the system administrator and market participants are subject to sufficient legal and regulatory oversight. This would reduce flexibility however and could prove challenging to implement.
If the approach of using the law of the platform were to be adopted then, conceptually, the situation where the value of the collateral is represented by tokens on the distributed ledger would not be very different to that based on real-world assets such as cash and securities. Despite the novelty of such tokens, the principal issue would be whether a court order requiring one party to compensate another could be obtained and whether it would be enforced. So long as the judgment debtor compensates the judgment creditor in accordance with the court order, the judgment creditor is unlikely to be concerned about whether the compensation takes the form of tokens on a distributed ledger, or cash or other traditional asset.
If an order is obtained, a question could arise over the enforceability of a judgment in the jurisdiction of the judgment debtor if this differs from the jurisdiction in which the judgment has been obtained. In determining the answer to this question, there seems to be little conceptual difference between a scenario where the parties have used tokens, cash or securities when exchanging collateral assets.
There are also means of addressing this issue on the platform itself. For example, each transaction on Corda is validated by a “notary”. In this context, a notary is a network service which validates a transaction prior to it becoming effective to ensure uniqueness and address the “double-spend” concern (where a holder attempts to transfer the same token more than once). It would be possible to create an agreement between the participants to a DLT system empowering such a notary to implement a court order obtained from a court of the contractually agreed jurisdiction, potentially avoiding the need for the relevant judgment to be enforced against the judgment debtor in its home courts. Accordingly, in the event a court order (of a court with jurisdiction) states that a participant is not the proper party to hold tokens, the notary (as a result of the platform agreement) could be empowered to deny the transferability of such tokens. Further, the issuer of the tokens, through a contractual arrangement, could then issue replacement tokens to the proper party that should be the owner of these tokens.
Assuming the agreement the parties have entered into contains express choices regarding the law of the platform and the court before which disputes are to be litigated, a judgment creditor faced with an unco-operative judgment debtor would simply serve the court order on the notary to invalidate the tokens of the debtor and require the issuer to issue new tokens to satisfy the order. A distributed ledger structured in this way would reduce the difficulties that may arise when a judgment creditor tries to enforce a foreign judgment before a court.
CONCLUSIONS AND RECOMMENDATIONS
In this article we have considered the key private international law issues in respect of both an uncollateralised and a collateralised interest rate swap transaction entered into using DLT.
In the case of an uncollateralised transaction entered into using DLT, or a collateralised transaction entered into using DLT but where any tokens on the DLT merely record real world assets and therefore the DLT serves a record keeping function, we do not consider it likely that an English court would disapply an express choice of law nor that the use of the DLT would affect the determination of the situs of the real world assets.
Where the parties use tokens on the DLT platform as a medium of value however, or to effect payments or exchanges of collateral, this would raise additional conflict-of-law issues arising from the challenges in identifying the situs of the token. In this scenario, it would therefore provide greater clarity for all parties to agree that their transactions should be subject to a common “law of the platform” or elective situs — that is, a uniform choice of law that the parties agree will govern all on-ledger transactions. Such common law of the platform could then be used as the situs of any tokens which are native to that DLT system.
There is a risk that different jurisdictions could adopt differing rules in respect of the situs of such a token which would result in a risk of judicial conflicts. As a result, it is important that a harmonised approach is taken to these issues across jurisdictions.
Where national authorities and regulators are concerned that allowing parties an unfettered choice of a governing law of the platform is undesirable, the choice of law could be restricted to the laws of countries where parties such as the issuer of the token, the system administrator and market participants are subject to sufficient legal and regulatory oversight.
Establishing this system will require national governments, judiciaries, regulators and international standards-setting bodies (such as the Hague Convention, UNIDROIT or UNCITRAL) to work on adapting or developing global legal standards aimed at ensuring the safe, transparent and consistent regulation of DLT-based financial transactions, and to ensure that parties are unable to elect for their relationships to be governed by the laws of countries with inadequate policy, legal or regulatory oversight.
This article was first published in Journal of International Banking & Financial Law – (2020) 5 JIBFL 325 . It is a shortened and adapted version of the paper Private international law aspects of smart derivatives contracts utilizing DLT, which was published in January 2020 by Clifford Chance, ISDA, R3 and the Singapore Academy of Law, each of whom have kindly reviewed and contributed to this article and have consented to its publication. That paper also considered the position under Singaporean law and the analysis and conclusions were similar to those set out in this article in respect of English law.