Following many months of discussion and review by a working group of traditional finance institutions and crypto-native exchanges and platforms led by the International Swaps and Derivatives Association, Inc. (“ISDA”), ISDA published the Digital Asset Derivatives Definitions (the “Definitions”) on January 26, 2023 for use with Bitcoin (BTC) and Ether (ETH) non-deliverable forward and options transactions.
ISDA also published a number of supporting materials including:
(i) A whitepaper on netting and collateral enforceability – these are two vital credit risk mitigation features of derivatives arrangements governed by ISDA documentation, and they impact a number of areas from regulatory capital relief for regulated financial institutions to counterparty default risk, while limiting the risk of contagion in the event of an institution’s bankruptcy.
(ii) A user’s guide to the Definitions’ fork disruption events – these provisions set out the consequences on digital asset derivative transactions if a “protocol change” results in two or more digital assets (emanating from the original blockchain) being available for trading.
Parties have been utilizing bespoke in-house templates, crafted through a combination of existing ISDA publications for documenting derivative transactions where the underlying reference asset consists of other asset classes (namely currencies, commodities and equities) and incorporating provisions specific to the features of the relevant digital asset(s). This is not much of a surprise given the complexity around the nature and legal characterization of digital assets, taking into account their technological and economic features. The publication of the Definitions represents a significant step towards developing industry-wide contractual standards.
As noted, however, that the Definitions are currently limited in scope: they only contemplate non-deliverable forwards and options that reference either BTC or ETH. Market participants will still need to analyze their transactions for appropriate structuring and drafting solutions with respect to other product types (e.g., deliverable transactions, or staking yield swaps), other digital assets, bespoke contractual arrangements (e.g., optional early termination), and where the derivative forms part of a wider financing structure (e.g., secured loans, or staking arrangements).
ISDA has further projects and updates in the pipeline for digital asset derivatives, which will cover, amongst other things, ISDA standard collateral and credit support documentation, custody and intermediary or triparty arrangements, and a detailed jurisdiction-based analysis of netting and collateral enforceability. Analysis is also ongoing regarding the treatment of digital asset derivatives under existing derivative regulatory framework (including, Dodd Frank and EMIR).
All of the above will need to be considered alongside the rapidly evolving regulatory framework for digital assets, which is being accelerated in light of the recent spate of bankruptcy and insolvency filings of crypto-exchanges, lending platforms, investment funds and mining operations. It is clear that the publication of the Definitions is therefore an important, but preliminary step toward a more liquid and secure derivatives trading market for digital assets.