On January 26, 2023, the International Swaps and Derivatives Association Inc. (ISDA), the leading trade organization for over-the-counter (OTC) derivatives markets, published the ISDA Digital Asset Derivatives Definitions (the Digital Asset Definitions). As ISDA CEO Scott O’Malia observed, the Digital Asset Definitions are intended to “establish an unambiguous, standardized contractual framework for digital asset derivatives under the umbrella of the ISDA Master Agreement that, among other things, spells out the rights and obligations of both parties following a market disruption.” Launching in the wake of recent market turmoil, the Digital Asset Definitions were accompanied by the first in a series of two planned ISDA white papers, which are intended to assist the market in navigating the novel legal and commercial issues posed by bankruptcies in the digital asset markets.
The Digital Asset Definitions
The recent growth of digital asset markets has seen the emergence of a robust market for OTC derivatives on digital asset underliers. Unsurprisingly, participants in this market have looked to the derivatives industry standard architecture of the 1992 and 2002 ISDA Master Agreements to document their trading relationships. In the absence of a definitional booklet specific to digital assets, market participants have relied on bespoke and often time-consuming negotiated amendments to tailor existing ISDA definitional booklets — such as the 1998 ISDA FX and Currency Option Definitions (the FX Definitions), the 2005 ISDA Commodity Definitions (the Commodity Definitions), and the 2002 ISDA Equity Derivative Definitions (the Equity Definitions) — for use in the digital asset context. For example, market participants have modified the concept of a Potential Adjustment Event under the Equity Definitions to address forks and airdrops, adapted Price Source Disruption and Trading Disruption concepts from the Commodity Definitions, and borrowed Inconvertibility/Non-Transferability Disruption Events from the FX Definitions.
The Digital Asset Definitions will allow market participants to document their transactions under a definitional framework specifically designed with the novel features of digital assets in mind. In this regard, the Digital Asset Definitions provide, among other things, the following:
- Digital Asset Specific Disruption Events. In particular, the Digital Asset Definitions lay out a robust contractual framework that provides a standardized definition of a Fork Event and allows parties to elect when and what consequences should flow from such an event. Given the initial focus on cash-settled transactions, airdrops are not addressed in the Digital Asset Definitions.
- Other Disruption Events. These are a range of modular Disruption Events that parties can elect to address potential price source disruptions, hedging disruptions, and change in law events.
While the current version of the Digital Asset Definitions is intended to cover only cash-settled nondeliverable forwards and options on bitcoin (BTC) and etherium (ETH), the definitions are ripe for further development and expansion to other transaction types and underliers in the future. The Digital Asset Definitions are supplemented by suggested template transaction confirmations and a matrix of standardized references to commonly used BTC and ETH pricing sources, which will further foster standardization and legal certainty for digital asset derivatives.
White Paper on Navigating Bankruptcy in Digital Asset Markets
Accompanying the Digital Asset Derivative Definitions, the first of ISDA’s white papers on navigating bankruptcy in digital asset markets focuses on fundamental legal risk considerations concerning close-out netting and collateral enforceability in the context of digital asset derivatives. After introductory observations on unique features of digital assets and their legal nature, the white paper examines the following subject matter:
- Close-Out Netting. The white paper provides a preliminary high-level analysis of the arguments in favor of the validity and enforceability of close-out netting for digital asset derivatives. Close-out netting is important in derivatives markets because it gives counterparties the ability — following a default or similar termination event — to determine a single net amount due between the counterparties following the termination and valuation of all their transactions.
- Collateral. The white paper then canvasses a range of important legal questions concerning the use of digital assets as collateral, including the meaning of ownership in the digital asset context, how security can be taken over digital assets, and what it means to perfect a security interest in digital assets.
As the white paper indicates, ISDA intends to begin updating its library of close-out netting opinions in 2023 to include coverage of digital asset derivatives.
Adam Bruce FoventAssociate