First Steps to Crypto Derivatives Standards

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

Crypto assets have grown at a ferocious pace in recent years, but banks and institutional investors have only played a bit part in that growth. That’s now starting to change, with financial institutions showing more interest in crypto and derivatives linked to these assets. Further growth is all but certain, but the challenge will be to guarantee the nascent market for digital asset derivatives is built on firm foundations. This should be based on standards that respect the unique aspects of this asset class and can be applied in a fully digital format – an issue that ISDA is uniquely placed to tackle.

We’ve now established a new digital asset legal and documentation working group to explore this, and I’m looking forward to engaging with the crypto community as we thrash out the various issues. As it stands, institutions trading digital asset derivatives typically use an amended version of existing ISDA definitions and templates (for instance, ISDA’s equity or FX definitions) or entirely bespoke documentation they’ve developed internally. That’s not ideal: it results in a lack of standardization that may ultimately hamper transparency and liquidity and lead to higher levels of risk.

Crypto derivatives also have a number of unique characteristics that may mean existing definitions do not fully address specific events and risks that may arise. As an example, a blockchain used for a crypto asset might be upgraded or modified to fix bugs, known as a ‘fork’. This might be a ‘hard fork’, where a new blockchain is created that might co-exist with the old one, or a ‘soft fork’, where the established blockchain continues but under revised rules. This could fundamentally alter the nature of the blockchain or result in two distinct crypto assets with different values.

Our new working group will focus on developing specific legal standards for crypto derivatives, in the same way we have for interest rate, FX, equity, credit and commodity derivatives. As well as looking at unique adjustment and modification events like forks, the working group will also think through other critical legal issues – for example, product scope, timing of valuation given digital assets trade 24 hours a day, the impact of transaction fees and the implications of whether a trade is physically or cash settled.

Addressing these topics is the starting point for developing the market-standard documentation that is critical for legal certainty, as well as ensuring robust processes are in place to deal with market disruptions or defaults. While crypto derivatives may be different to other asset classes, the process of bringing market participants together to reach consensus on industry standards is the same and has a long history of success within ISDA. Participants from the crypto markets will therefore have an important role to play. We will also look to ensure these standards are suitable for integration with existing data models to the greatest extent possible. Work on these issues has already begun, and we expect to publish a paper identifying a path forward by the end of this year.

As the market for crypto derivatives continues to grow, it will become increasingly important that a robust framework is in place that enhances transparency and consistency and reduces risk. For more than 35 years, ISDA has drafted standards and documentation to support the development of derivatives markets and ensure they function safely and efficiently. Our forthcoming paper will help us determine how best to bring that standardization and efficiency to the digital asset derivatives market in a way that is consistent with the digital platforms being developed today.

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