The publication by the International Swaps and Derivatives Association, Inc. (ISDA) of the ISDA Digital Asset Derivatives Definitions (the Definitions) marks the first set of standard documentation for trading digital asset derivatives. The collapse of the crypto exchange FTX and other recent failures in the crypto market have thrown into sharp relief the need to have a clear framework as regards the rights and obligations of both derivatives counterparties following a default. By providing standardised provisions for execution and settlement, the intention is that these new Definitions will reduce credit and market risk and facilitate more efficient digital asset derivatives trading. In addition, the inclusion of robust fallbacks, which contemplate different scenarios, should further reduce risks for all market participants.
Alongside the Definitions, ISDA has also published a whitepaper that explores the legal issues arising from the collapse of FTX and several other high profile crypto firms and specifically considers issues in relation to netting and collateral.
Which products do the new Definitions cover?
The Definitions have been drafted for use with non-deliverable digital asset forwards and non-deliverable digital asset options referencing Bitcoin or Ether.
In order to ensure that the Definitions can easily be expanded over time, the Definitions have been designed in a modular way. ISDA’s intention is that the Definitions will be updated over time to cover transactions referencing other product types including tokenised securities and other digital assets executed on distributed ledger technology (DLT).
The Definitions also have been drafted so as to be more easily used in DLT-based applications, including smart contracts. For example, conditions and variables within clauses are customised by reference to a menu of standardised elections that could be switched on or off in the confirmation and that could be translated into code.
Where have the Definitions been published?
Version 1.01 of the Definitions has been published in electronic format on ISDA’s MyLibrary electronic documentation platform. Any changes will be made by publishing a new version of the Definitions.
In addition, there are forms of Confirmations and a Settlement Price Source Matrix, which contains standardised information relating to certain Bitcoin and Ether price sources so that this information can be easily incorporated into documentation. Parties are of course still free to customise these documents by agreeing bespoke drafting bilaterally.
How have the unique characteristics of digital assets been addressed in the Definitions?
Digital assets have certain novel features that ISDA has sought to address in the Definitions. These include “Forks”, an event where an underlying DLT network protocol is amended, resulting in a split upon which a single digital asset may become two or more distinct assets that are available for trading simultaneously on one or more exchanges. The Definitions include the concept of a “Fork Disruption Event”, which sets out the circumstances in which such an event may occur and allows the parties to specify what the consequences should be.
In addition, the Definitions also reflect the 24/7 nature of the digital asset markets by including a concept of “Relevant Day” rather than “Business Day” so that important trade events such as valuation and settlement can take place on any day.
As a variety of different price sources and approaches are used by digital asset market participants, ISDA has put together a list in the form of a Settlement Price Source Matrix, which contains the most commonly used price sources for Bitcoin and Ether and may be expanded over time. Agreeing the relevant price source is an important contractual term that each party will need to ensure is appropriate for any given transaction.
The current version of the Definitions only caters for transactions referencing a single settlement price source, valuation date and valuation. The Definitions may be expanded to cater for more complex valuation methodologies in the future.
Other novel features of digital asset markets such as “airdrops” and “staking” were also considered by ISDA but ultimately not included on the basis that they are not relevant in the context of non-deliverable digital asset forwards and options referencing Bitcoin and Ether or because they are sufficiently covered by the other disruption events already included in the Definitions.
What about netting and collateral?
Alongside the Definitions, ISDA has also published a whitepaper that discusses the importance of close-out netting and collateral arrangements for derivatives referencing digital assets and identifies several areas of focus for policymakers and market participants to ensure greater certainty: Navigating Bankruptcy in Digital Asset Markets: Netting and Collateral Enforceability.
The paper notes that whilst ownership of assets (including where a party holds an asset indirectly via an intermediary) is fairly well settled in other financial markets, this is currently not the case in relation to the digital asset market given the role of private keys in relation to the control of the relevant asset and the alternative custody and intermediary models available.
Although the enforceability of netting in a particular jurisdiction will depend on the relevant local insolvency law and some jurisdictions may exclude digital assets, ISDA’s initial analysis suggests that netting arrangements in relation to digital asset derivatives are likely to be enforceable in certain major jurisdictions such as England and Wales and New York. ISDA intends to expand its netting opinions this year in order to cover certain digital asset derivatives.
As regards collateral, broadly, ISDA is of the view that most major jurisdictions will recognise digital assets as property that will be capable of protection under local law, including for posting as collateral, although the precise nature of any legal rights will depend on the particular jurisdiction in question. One benefit of using digital assets as collateral is that settlement can occur almost instantaneously although consideration needs to be given to a variety of issues including the type of digital asset that might qualify as eligible collateral, how security in digital assets could be perfected and enforced and how control in the digital asset can be established.
ISDA is planning to publish a second whitepaper later this quarter, which will focus on issues related to customer digital assets held with intermediaries and will explore specific questions on how they may be held and how they might be treated in an insolvency scenario.
Final Thoughts
The Definitions bring much welcome standardisation and have sought to bring about greater common understanding by providing definitions for novel features connected to this area of the market. They are, however, notably limited as to the type of digital asset that can be referenced and the derivatives products available. ISDA will monitor the uptake of the Definitions and, in terms of expanding the Definitions to other products, consider where to focus next following feedback from ISDA members.
Market participants who are entering into digital asset derivatives documentation should consider how they intend to reflect the aspects unique to digital assets, whether they have appropriate provisions in place to deal with anticipated trading patterns, reliable price sources and volatility in their contractual documentation and an understanding of any residual counterparty risk given the specific features of the transaction being entered into
In addition, counterparties should take note of the issues raised in the ISDA whitepaper in relation to the ownership of digital assets, enforceability of netting and the posting of digital assets as collateral. It will not be possible for ISDA to expand significantly the range of digital asset derivatives that are available until some of these key challenges can be overcome.
This note is for guidance only and should not be relied on as legal advice in relation to a particular transaction or situation. Please contact your normal contact at Hogan Lovells if you require assistance or advice in connection with any of the above.
Authored by Isobel Wright, Bryony Widdup, and Jennifer O'Connell.
