Following the publication of “Tokenized collateral model provisions in ISDA 2016 Credit Support Annexes for Variation Margin (VM)” in December 2023 (the Model Provisions), ISDA published a guidance note on tokenized collateral on 21 May 2024.
The Model Provisions allow users to exchange collateral in the form of digital assets under a VM CSA by specifying digital assets as Eligible Credit Support and characterizing those digital assets as either “DLT Cash” or “DLT Securities”.
Reed Smith’s team considers some of the issues for users to be aware of in choosing whether to treat digital assets (in particular, stablecoins) as “DLT Cash” or “DLT Securities” and the unintended consequences that may follow from this election.
It is left to the parties to agree whether a particular digital asset is treated as “DLT Cash” or “DLT Securities”, which, in each case, is defined as collateral transferable by entry in a distributed ledger. The decision as to whether a particular digital asset is treated as “DLT Cash” or “DLT Securities” seems unnecessarily important.
The Model Provisions specify that in the case of “DLT Cash” or “DLT Securities”, transfers are made by causing such changes to the entries in the distributed ledger sufficient to result in a legally effective transfer of the relevant right or interest to the recipient or its agent.
In relation to all other provisions, “DLT Cash” is treated as cash or currency, and “DLT Securities” as securities. This raises an odd issue relating to valuations.
In the case of a digital asset that is specified as Eligible Credit Support and “DLT Cash”, the value of an amount of that digital asset will be the “Base Currency Equivalent” of such amount subject to a haircut based on an agreed valuation percentage and FX haircut percentage.
In the case of an “amount denominated in the Base Currency”, the “Base Currency Equivalent” is such “Base Currency” amount, whereas in the case of an amount denominated in a currency other than the Base Currency, there is a currency conversion process. In the case of an amount of a stablecoin that is intended to track the Base Currency, it raises an interesting question: Is the amount of the stablecoin “denominated in the Base Currency” or “in a currency other than the Base Currency”?
If it is denominated in another currency, everything is fine – there is a currency conversion process. If it is regarded as denominated in the Base Currency, there is no currency conversion process, so 5,000 USDT is identical to US$5,000.
One would have thought the intention would be that 5,000 USDT is denominated in a different currency to US$5,000, otherwise, any tracking error or difference in value between the stablecoin and the Base Currency would not be accounted for in the value of the Credit Support Balance. However, the point is not specifically addressed in the Model Provisions and it is not as clear as it should be. This could lead to unintended consequences if the treatment of a stablecoin as “DLT Cash” versus “DLT Securities” is not considered and addressed by the relevant parties.
To address this issue, parties could specify that the relevant stablecoin should not be regarded as being denominated in the Base Currency. Alternatively, parties could instead provide that the stablecoin is Eligible Credit Support that should be characterised as “DLT Securities”, since in that case, its value will be its bid price subject to a haircut based on an agreed valuation percentage and FX haircut percentage.