The International Swaps and Derivatives Association published a paper that identifies the key legal questions arising from the FTX insolvency and their application to the emerging digital asset derivatives market. ISDA’s intention is to support derivatives market participants by providing additional clarity on the legal and property characterization issues that exist for this asset class.
The papers will be relevant to service and infrastructure providers, particularly those that are actively involved in the transfer and intermediated holding of digital assets and are now seeking to restore confidence in the integrity and robustness of this market. The analysis will also be of interest to international legal standard setters, legislative bodies and regulatory authorities that are developing global and national rules that will ultimately underpin the use of digital assets within the global financial markets.
It is important to note that cryptocurrencies are only one example in a broader class of digital assets. While the crypto-asset markets are experiencing profound issues – due in large part to the absence of risk management, customer protection and operational controls – the underlying technology is being applied to create other forms of digital assets, including those that serve as digitized forms of equity or debt instruments, which have very different economic characteristics and risk profiles.
Indeed, within the broader category of digital assets, there are many applications that could fundamentally enhance the operation of global financial markets.
Regardless of the precise nature and purpose of any specific digital asset or platform, it is vital that market participants have a clear understanding of the legal rights and obligations that result from entering into transactions that reference digital assets (or transacting in the digital assets themselves) so they can manage the risks of those transactions.
This is true of derivatives markets generally, but the swift succession of insolvencies in the digital assets market in the second half of 2022, the recourse to bankruptcy courts and the broader impact on the accessibility and ongoing protection of customer assets indicates there is a lack of such clarity in the digital assets market.
As the digital asset derivatives market continues to evolve, it is clear work is needed to establish appropriate operational and risk management frameworks that will underpin the safe and efficient expansion of this market. Designing these systems and processes will require consideration of the applicable legal and contractual frameworks that will mandate or govern their operation.
The paper considers a number of legal issues relating to netting of derivatives transactions referencing digital assets and the use of digital assets as collateral. Due to the large number of relevant jurisdictions and legal regimes, and the even larger number of digital asset types, it is impossible to define a comprehensive or one-size-fits-all approach to many of these issues.
However, this paper does identify a number of common features and challenges that will need to be considered and resolved by market participants seeking to implement digital-asset-based collateral management solutions. Many of these issues are not necessarily unique to digital assets. For example, questions concerning the precise legal characterization of other forms of intangible asset have historically been raised and have generally been resolved. There is no reason to suggest similar positive outcomes cannot be achieved for digital assets.
It is clear, though, that the use of digital assets raises some novel issues that will need to be resolved. From a technological perspective, it is vital the developers of new digital assets (and associated platforms and protocols) that are designed to be used within a collateral management solution acknowledge certain requirements and restrictions associated with the creation of legally robust and effective security interest, and they are not designed in a way that is incompatible with applicable laws.
To achieve this, collaboration among technology developers, legal practitioners and other key stakeholders will be necessary. From a legal and property characterization perspective, it is recommended that international standard setters and national legislators continue their efforts to create harmonized model laws that recognize digital assets as a form of property capable of being the subject of security interest. Work by bodies such as the sponsors of the Uniform Commercial Code in the US46 and the Law Commission47 in the UK (which ISDA has contributed to) is very welcome.
Finally, the development of contractual standards will be crucial. Work is underway by ISDA and its members to develop contractual standards for digital asset derivatives. These contractual standards may ultimately expand to cover use of digital assets within ISDA’s suite of collateral documentation. Whether using fiat currency to collateralize digital asset trades, digital assets to collateralize trades in traditional assets or digital assets to collateralize digital asset trades, certain adjustments will inevitably be necessary to accommodate some of the unique and novel features of these assets. ISDA hopes this paper will support market participants as they advance toward the development of a safe, efficient and digital collateral management ecosystem within the derivatives market.