On 26 January 2023, the International Swaps and Derivatives Association, Inc. (ISDA) published new standard documentation for the trading of digital asset derivatives (the Digital Asset Definitions), and a whitepaper titled Navigating Bankruptcy in Digital Asset Markets: Netting and Collateral Enforceability (the Whitepaper) that addresses certain legal issues in the context of bankruptcy proceedings. We set out a few key points in respect of each document below.
Digital Asset Definitions
The Digital Asset Definitions intend to allow for the adoption of standard terms across the market, under the umbrella of the ISDA Master Agreement, to reduce credit risk and increase market confidence.
Underlying Assets
While ISDA has clarified that the scope of the Digital Asset Definitions might be expanded in future to cover various digital assets, this version has been drafted to document non-deliverable forwards and options referencing Bitcoin and Ether only.
Settlement
The settlement mechanics applicable to forwards and options therefore do not envisage physical delivery of the underlying digital assets.
Disruption Events
Section 4 is probably the most significant clause in the Digital Asset Definitions as it covers fallbacks and remedies upon the occurrence of various disruption events applicable to digital assets.
Price Source Disruption Event
A Price Source Disruption Event will be triggered in any of the following cases: (i) automatically (a) on the valuation date, if the settlement price in respect of the applicable price source is not published in a timely manner; or (b) if the entity responsible for publishing the settlement price (the Settlement Price Source Provider) makes a public statement to unambiguously communicate that it has ceased or will cease to provide the settlement price prior to the relevant valuation date and a successor source provider has not been appointed; or (ii) if there has been a material change to the formula used to calculate the settlement price, or to the policy for the settlement price source in relation to forks, or that otherwise materially modifies the calculation of any settlement price, and notice of such event has been given by the determining party to the other party.
The Digital Asset Definitions set out certain fallbacks that can be followed in a predetermined order upon the occurrence of a Price Source Disruption Event. The first fallback provides, amongst other things, that the settlement price source should be replaced and the valuation date and time adjusted, all with pre-agreed replacements. Secondly, either party may terminate the transaction. Finally, should the fallbacks described above not apply, the calculation agent might make adjustments to the transaction, acting in good faith and using commercially reasonable procedures. Of course, the parties can by mutual agreement eliminate a fallback or reorder or supplement those that are retained.
Hedging Disruption Events
The Digital Asset Definitions identify two hedging disruption events, Hedging Disruption and Increased Cost of Hedging.
A Hedging Disruption may occur if the hedging party is unable to either hedge the price risk of its obligations or freely realise the proceeds of its hedge positions. An Increased Cost of Hedging may occur if, for example, taxes or fees to hedge the transaction have materially increased. These definitions, particularly Hedging Disruption, highlight a point that practitioners should keep in mind. It makes sense to reference the hedging party’s inability to hedge the price risk or freely realize the proceeds of its hedge positions when there is a liquid market for such digital asset, as has generally been the case with Bitcoin and Ether. However, as recent events have shown, other digital assets may not have the same liquidity or ability to be realized. Therefore, practitioners should not assume that these definitions, which ISDA has intended only for use with Bitcoin and Ether, can be redeployed for every other digital asset.
The hedging party will become entitled to (i) terminate the transaction upon the occurrence of a Hedging Disruption, or (ii) following an Increased Cost of Hedging, deliver a notice to the other party (the Increased Cost Notice) setting out any proposed amendments to the transaction to account for such increased costs and the upfront payment amount to cover such costs.
In response to the Increased Cost Notice, the non-hedging party may give a Price Adjustment Election Notice to the hedging party to agree to (i) the amendments set out in the Increased Cost Notice, (ii) pay the upfront payment amount, or (iii) terminate the transaction. Should the non-hedging party fail to respond to the Increased Cost Notice in a timely manner, the hedging party shall then be entitled to terminate the transaction.
Fork Disruption Event
The splitting of the technology protocol underlying the blockchain applicable to a digital asset may create two or more digital assets available for trading on one or more exchanges (the Successor Assets). In turn, this may trigger a Fork Disruption Event if the determining party specified as such in the transaction documents (the Fork Determining Party) determines that the following conditions have not been satisfied:
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- The settlement price is based on data derived from more than one exchange or other price source and either (i) the Settlement Price Source Provider continues to publish one price with respect to the Successor Assets or (ii) the Settlement Price Source Provider provides more than one price and publicly communicates that one of them is the continuation of the applicable settlement price source for the transaction; or
- The settlement price is not based on data derived from more than one exchange or other price source and either (i) the Settlement Price Source Provider continues to publish one price with respect to the Successor Assets or (ii) the Settlement Price Source Provider lists more than one Successor Asset and publicly communicates that one of them is the continuation of the digital asset underlying the transaction.
The above conditions need to be satisfied for a Fork Disruption Event not to occur as otherwise there would be confusion with the pricing of the digital asset referenced in the transaction.
The Fork Disruption Event will be deemed to occur following a notice from the Fork Determining Party to the other party. At this point, under a potential fallback, the calculation agent may determine whether it might be commercially reasonable to adjust the terms of the transaction. If this is not possible, either party may terminate the transaction. Alternatively, the parties may have pre-agreed an alternative fallback simply allowing either of them the right to terminate.
Conversely, if either of conditions (a) and (b) above is satisfied and the underlying digital asset or settlement price source is inconsistent with any determination by the Settlement Price Source Provider, then the calculation agent will propose any amendments that might be necessary to reflect the determinations of the Settlement Price Source Provider.[1]
ISDA Whitepaper
The Whitepaper set outs various issues that need to be addressed regarding close-out netting of digital asset derivatives and the use of digital assets as collateral in derivative transactions.
Close-out netting
The Whitepaper underlines the importance of close-out netting and takes the view that netting arrangements in respect of digital asset derivatives should be enforceable in certain major jurisdictions. However, because the counterparty’s local insolvency law is critical to ensure netting provisions can be enforced, ISDA intends to begin to update its netting opinions in 2023 to reference digital asset derivatives.
Use of Digital Assets as Collateral
The Whitepaper highlights that short settlement periods might be a real benefit of posting digital assets as collateral, when compared to more traditional non-cash assets, where settlement periods are typically at least two business days. At the same time, it also identifies various points, including the following, as issues that will need to be taken into account when using digital assets as collateral:
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- the interconnection between technology and the law to determine ownership of digital assets;
- whether the transfer of collateral constitutes title transfer or creates a security interest in the collateral;
- the steps required to perfect a security interest and the related enforcement; and
- how to establish control over collateral.
What Next?
The Digital Asset Definitions are an important step in creating contractual standards for this new and developing asset type. Considering the evolving nature of the market they will need to be reviewed and updated on an ongoing basis and ISDA is already engaging with members on next focus areas.
ISDA will be publishing a second whitepaper, expected in the first quarter of 2023, addressing issues relating to customer digital assets held with intermediaries.
Updated netting opinions will also be critical to ensure parties can rely on close-out netting arrangements.
[1] For further details on Fork Disruption Events, see the ISDA Digital Asset Derivatives Definitions: User’s Guide to Fork Disruption Event available on the ISDA MyLibrary platform.
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