Yesterday the International Swaps and Derivatives Association (ISDA) published standard definitions for digital asset derivatives. It also released one of two whitepapers on what happens in the event of bankruptcy.
The initial set of ISDA definitions covers non-deliverable forwards and options for Bitcoin and Ether. However, the association sees this as a starting point that could also include tokenized securities and other DLT-based assets in the future. The definitions don’t just apply to data but also to processes to enable integration with the Common Domain Model (CDM).
Back in 2018, ISDA first developed the common domain model (CDM), which defines both the data and the processes for derivatives such as interest rate swaps and credit default swaps. While the CDM isn’t designed purely for DLT or smart contracts, it provides a basis for automating derivatives using DLT.
“The new definitions address the unique nature of digital assets settled on DLT and have been designed to be expandable over time,” said Katherine Tew Darras, General Counsel at ISDA. “This work will be relevant to a wide range of digital assets executed on DLT, including tokenized securities, which potentially have wide utility across the financial system. The innovative drafting style, which uses conditional statements that can be translated into code, means the definitions can be used more easily in DLT-based applications, creating significant efficiencies for market participants.”
Last year when the Basel rules were proposed for crypto-assets activities by banks, ISDA lobbied for the rules to take account of hedging when assessing bank exposures. The final Basel rules support hedging, although to a lesser extent than conventional assets.
The crypto crash and numerous recent crypto bankruptcies, particularly FTX, have highlighted several legal issues that don’t arise in conventional markets. For example, legally, who is the asset owner and what happens when an intermediary goes bankrupt? ISDA highlights the important distinction between the ‘owner’ and the ‘holder’ of the private keys that control the digital assets.
ISDA is releasing two papers, the first one published yesterday covers netting and collateral, particularly for native digital assets on permissionless blockchains where there is no centralized entity responsible for keeping ownership records. Later in the quarter, it will release a document regarding the bankruptcy of intermediaries.
Netting is where two parties have multiple bilateral transactions, which can be netted into a single liability. It is legally enforceable for digital assets in some major jurisdictions, such as New York and England and Wales. But it’s not the same everywhere.
In the case of default, the ISDA Master agreement allows the non-defaulting party to terminate all transactions with the defaulting party and perform close out netting regardless of the nature of the asset. Research shows that across all derivatives markets, netting reduces risk by reducing the gross market value outstanding by 80%.
During 2023 ISDA is planning to publish a series of opinions about the enforceability of netting in various jurisdictions, including for digital assets.
Turning to collateral, ISDA explores how it usually works. Sometimes when collateral is provided, the ownership of the assets is transferred to the collateral taker. In other cases, the collateral provider retains ownership but provides a security interest in the assets.
This gets into the relatively complex and evolving issue of how ownership is defined for digital assets and how to ‘perfect’ a security interest in assets. In the United States, the Uniform Commercial Code (UCC) that governs these issues in most states was updated to account for digital assets. However, several bankruptcies happened before the update.
ISDA is by no means the first to explore these issues. In November, the International Securities Lending Association (ISLA) published a whitepaper highlighting the legal issues of digital assets used in securities lending, which covers similar ground.
Several of ISDA’s members are involved in digital assets. The crypto members include Algorand, B2C2, Coinbase, ConsenSys, Elwood Technologies, FTX US, Genesis and OK Coin.