United States: Growing Up: Crypto Derivatives
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In terms of exponential growth, surely the only recent
phenomenon to match the spread of COVID-19 around the world is the
explosive growth of cryptocurrencies and their spread into the
established financial markets. Central banks, regulators and public
authorities worldwide are grappling with how cryptocurrencies fit
into existing legal and regulatory frameworks, from the tax
treatment of gains (or losses) on trading in cryptocurrencies to
the marketing of cryptocurrencies to members of the public.
The derivative market is in the midst of the same exercise, with
ISDA naturally taking the lead. There are two important work
streams: (i) identifying and managing legal issues which may arise
from derivative contracts referencing cryptocurrencies and (ii)
developing contractual standards and template documentation for
cryptocurrency derivatives. The ultimate aim of both endeavours is
to promote market access, liquidity and risk management in
cryptocurrency derivatives.
In December 2021, ISDA published a paper on the key legal issues that arise from
integrating digital assets (i.e. cryptocurrencies and other assets
relying on blockchain or distributed ledger technology) into the
legal infrastructure of derivative markets. The paper identified
three leading issues:
- Disruption Events: digital assets have their
own universe of events which may interrupt or disrupt the operation
of the asset or its valuation, such as forks (changes to the
underlying technology which result in amendments or completely new
versions of the relevant asset), airdrops or cyberattacks. ISDA is
considering whether existing disruption or adjustment events can be
applied to digital asset derivatives or whether amended or
completely new standards are required. - Valuation: market participants will need to
determine which valuation sources and valuation methodologies are
appropriate for digital assets. ISDA note that, due to lack of
liquidity or manipulation, the price of certain digital assets on
certain exchanges might not be accurate and suggest that it may be
prudent to rely on valuations from more than one exchange or
exclude exchanges with insufficient volumes. Given the nascent
nature of the technology and the supporting market infrastructure,
consideration should be given to the role of calculation agent
discretion in valuations. - Interaction with ISDA documentation: given the
ISDA Master Agreements were written before the founding of digital
assets, trading in digital asset derivatives raises the question of
whether the existing master agreements can accommodate such assets.
Potential interpretative issues include: where is the location of
performance of a payment or delivery of a digital asset, whether
transfers of digital assets are payments or how they could be
delivered and how interest is calculated on digital assets.
On 18 January 2022, ISDA published a blog stating that developing legal standards
to support the crypto derivatives market is a priority for it this
year. ISDA has noted the need for such contractual framework to
facilitate greater automation, allow for interoperability between
different technologies and integrate into existing and emerging
market infrastructure. In 2022 ISDA expect to focus on
documentation (such as long-form confirmations) for cash settled
products in native digital assets such as Bitcoin, and any updated
documentation will be available on the ISDA MyLibrary platform.
As COVID-19 is (hopefully) moving to an endemic phase,
cryptocurrencies and their derivatives will surely become a more
day-to-day feature of global markets. Please speak to your Mayer
Brown derivatives contact if you require any assistance with such
products.
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Mayer Brown article provides information and comments on legal
issues and developments of interest. The foregoing is not a
comprehensive treatment of the subject matter covered and is not
intended to provide legal advice. Readers should seek specific
legal advice before taking any action with respect to the matters
discussed herein.
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