The shocking collapse of crypto exchange FTX with the apparent loss of billions of dollars of customer assets, and the subsequent failures of several other high-profile crypto firms, have raised some fundamental legal questions. Questions like what rights investors have following a bankruptcy and who legally ‘owns’ customer assets held by a crypto exchange or other intermediary. These questions should have clear answers, and our work to develop legal definitions for the trading of digital asset derivatives, alongside the publication of new whitepapers that explore the legal issues exposed by the collapse of FTX and others, are important steps towards achieving that for the digital asset derivatives market.
Fundamentally, we believe investors should always be clear on the rights they have following a default and should be confident their assets are protected. In most derivatives markets, many of these rights are set out in industry standard documentation, including the ISDA Master Agreement, which establishes a globally consistent contractual framework with clear provisions for execution, close out and settlement. We’ve now extended that to the nascent digital asset derivatives market with the publication last week of ISDA’s Digital Asset Derivatives Definitions. These establish an unambiguous, standardized contractual framework for digital asset derivatives under the umbrella of the ISDA Master Agreement that, among other things, spells out the rights and obligations of both parties following a market disruption.
We also published the first of two whitepapers that delve into legal issues exposed by the recent crypto market failures. The first paper focuses on the importance of close-out netting and collateral arrangements for digital asset derivatives as a means of reducing counterparty credit risk. Along with recommending use of standardized contractual frameworks like the ISDA Digital Asset Derivatives Definitions, the paper highlights areas where further legal clarity may be needed from national authorities, including on the property status of digital assets and how to create valid, enforceable security interests over them. The second paper, due for publication later this quarter, will focus on digital asset intermediaries and customer asset protection.
The new definitions initially cover non-deliverable forwards and options on Bitcoin and Ether, but we think they have much broader utility and could be extended to a wide range of digital assets executed on distributed ledger technology (DLT), including digitized forms of equity or debt instruments. Thanks to innovative drafting that uses conditional statements that can be translated into code, the definitions can easily be applied in DLT-based applications, including smart contracts. ISDA has already published a series of papers on legal issues relating to smart contracts using DLT – having a specific contractual framework for digital assets that can be seamlessly integrated with DLT infrastructure should give a boost to this technology.
The crypto rout left investors holding certain coins facing significant losses or worse – a total vanishing of their assets. Publication of the ISDA Digital Asset Derivatives Definitions will provide greater clarity to investors on their rights in the event something similar happens in the digital asset derivatives market in future. One of ISDA’s most important roles over the past 38 years has been to develop standardized legal documents as individual derivatives markets have grown in maturity, helping to ensure they function safely and efficiently. Our new definitions and the accompanying whitepapers are an extension of that critical work.
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