The collapse in November 2022 of FTX, one of the largest and highest profile crypto exchange platforms, sent shockwaves through financial markets. Coming only months after the failure of TerraUSD and the subsequent bankruptcy of Three Arrows Capital and Celsius, the insolvency of FTX and associated companies (including Alameda Research) prompted a cascade of liquidity and solvency concerns across the crypto ecosystem, with crypto lender BlockFi filing for Chapter 11 bankruptcy protection and several other firms suspending redemptions.

At the time of writing, external observers are speculating on the various events that precipitated runs on these exchanges and assets. Insolvency administrators have started to pick their way through the rubble left in the wake of their failure, and regulators are being urged to provide clarity on the regulatory status of cryptoassets and accelerate implementation of an appropriate regulatory framework.

The startling loss of customer assets reported at FTX has highlighted that while the distributed ledger technology backing cryptocurrencies allows for unprecedented transparency in on-chain holdings, many investors have opted to hold their crypto assets via an exchange or similar intermediary. The oft-repeated aphorism ‘not your keys, not your crypto’ suggests that only a party running an on-chain node and possessing the private key associated with a cryptocurrency holding can reliably be considered the owner.

While cynical, this emergent shibboleth does reflect a fundamental question in financial markets: what defines the owner of an asset? And for a party that is not the direct owner, but holds an asset indirectly via an intermediary, what is the impact of an intermediary’s bankruptcy? These questions are generally settled in other financial markets, which have developed standards to protect indirectly-held customer assets by making them bankruptcy remote from the intermediary. The FTX collapse indicates that such norms are still evolving (or may not yet exist) in the cryptocurrency markets. When these issues are not well understood by market participants or the risks are not properly managed, unanticipated and significant loss of capital can emerge.

The treatment of customer assets is not the only legal risk question that needs to be addressed in the cryptocurrency market. The prospect of insolvency of a major market participant requires firms to consider how they manage counterparty credit risk, which intermediated or custodial structures are most appropriate, and whether the tools employed can be reliably enforced in a bankruptcy scenario. Applying existing bankruptcy rules to a new asset class inevitably raises legal characterization and other questions that must be tackled to provide the necessary certainty.

To address these fundamental legal risk questions, ISDA is producing two papers that will help market participants achieve greater certainty on the application of these foundational principles to the nascent digital asset derivatives market.

This first paper will focus on close-out netting and collateral. The second will address issues relating to customer digital assets held with intermediaries, exploring specific questions on how they may be held, how those holdings might be treated in an insolvency scenario, and the relevant documentation and due diligence issues that would need to be addressed to achieve the intended level of customer asset protection. The second paper will be published in the first quarter of 2023. Together, the two publications will inform market participants of the legal and documentation questions that need to be addressed to establish ownership of digital assets, the posting of those assets as collateral and the enforceability of netting, which will enhance certainty and reduce risk.