The International Swaps and Derivatives Association, Inc. (“ISDA”) continues to press forward with its digital asset working group, following the publication[1] in January this year of (i) the Digital Asset Derivatives Definitions (the “Definitions”) and (ii) the whitepaper on netting and collateral enforceability.

On May 3, 2023, ISDA published the second[2] of its two whitepapers relating to digital assets – this paper examines the key legal issues, under New York law and English law, in relation to digital assets that are held by a digital asset intermediary for or on behalf of a customer.

Although existing private law concepts and traditional financial market principles can be applied to digital assets, and existing insolvency regimes will apply to digital asset intermediaries, distributed ledger technology (DLT) or similar technology raises incremental legal and operational questions compared to traditional financial instruments. For example, if the use of a private key is the only means of achieving a transfer of digital assets, control of the private key is necessary to ensure proper management and safeguarding of the custodied asset.

The whitepaper highlights a number of key distinctions, such as digital assets being held in omnibus versus individual client segregation, prohibitions on re-use, and sub-custody arrangements – while not necessarily unique to digital assets, these issues can affect the nature of the legal relationship between custodian and customer, as well as the application of legal and statutory regimes that determines the level of the customer’s protection.

Broadly speaking, a customer’s rights can be described as a proprietary claim, which gives rise to priority claims to specific custodied assets – whether through the operation of a contractual, legal or statutory framework – and the nature of the custodial relationship is such that the relevant digital assets will not be considered part of a debtor’s estate in a digital asset intermediary’s insolvency proceeding, i.e. bankruptcy remote. Alternatively, a customer might only have a contractual claim, which does not give rise to a proprietary claim, and a customer will likely have a claim as a general unsecured creditor.

Ultimately the recovery of digital assets will likely involve a cross-border analysis as to the legal and regulatory treatment under the relevant jurisdictions, as well as a detailed review of the contractual terms between the customer and the digital asset intermediary.

Furthermore, the ISDA working group is pressing forward with its initiatives in further developing contractual standards in the digital asset market. Draft language currently out for review with respect to proposed amendments to the ISDA collateral and credit support documentation in order to cater for the use of tokenized assets as collateral. While such initiatives are specific to the derivatives market, certain principles are relevant to wider financing structures and arrangements, and to collateralization, holding and custody of digital assets.