ISDA Identifies Documentation Issues In Derivatives On Digital Assets – Finance and Banking – United States – Mondaq News Alerts

United States: ISDA Identifies Documentation Issues In Derivatives On Digital Assets

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In a white paper, ISDA sought to identify the key
issues that need to be addressed in order to create common
contractual standards for use by market participants transacting in
digital asset derivatives.

Among other things, the white paper:

  • identifies certain key characteristics and features exhibited
    by the two different types of digital assets: (i) native digital
    assets (which exist solely as a digital record on a specific
    technology platform, such as Bitcoin or Ether) and (ii)
    asset-referencing digital assets (which reference an underlying
    asset or right, such as a central bank digital currency);
  • identifies potential market disruption events that could occur
    with respect to a digital asset that is the subject of a derivative
    transaction, such as:
    • technology-related events, including cyberattacks,
      technological disruptions, or modifications in respect of the
      software of the specific platform through which the digital asset
      holder “holds” the digital asset, and
    • market-related events, including changes in law or regulation,
      disruptions to core technological infrastructure or service
      providers, and market abuse in the underlying digital asset
  • provides general principles for market participants to consider
    when contemplating the consequences that may result from the
    occurrence of specific market disruption events (e.g.,
    defining the circumstances in which a specific technology- or
    market-related event will give rise to a fallback provision or a
    termination right);
  • identifies issues relating to the mechanics used in the
    valuation of digital assets and the derivatives that reference
    them, with a specific focus on:
    • valuation sources, since many trading venues are subject to
      market manipulation, and valuing a digital asset derivative can be
      complicated by the fact that trading of a specific digital asset
      occurs across many (often unregulated) decentralized
    • valuation methodologies, since in the absence of reliable
      valuation sources it may be necessary for parties to permit a
      degree of discretion by a calculation agent, thereby limiting the
      utility and scalability of standardized automated technology
      solutions for digital asset derivatives, and
    • the volatility that is inherent in the observed prices of
      digital assets;
  • identifies certain terms of the ISDA Master Agreement that may
    pose interpretative issues in the context of digital asset
    transactions, such as those with implications for the application
    of payment netting provisions under the ISDA;
  • highlights certain issues to consider when collateralizing
    digital asset derivatives, including:
    • regulatory barriers that parties will encounter if seeking to
      use digital assets as collateral for derivative transactions,
    • the nature of any security interest granted over digital assets
      which are used as collateral, which depends on a variety of factors
      (e.g., the location of the asset and the forms of security
      that can be granted under the applicable law); and
  • seeks to promote discussion among traditional market
    participants, the digital asset community and other relevant
    stakeholders to achieve common contractual standards for digital
    asset derivatives.

Commentary – James Goodall

ISDA recognizes the imperative for common contractual standards
in order to provide a solid foundation for the development of a
robust, liquid market in digital asset derivatives. While much work
remains, this white paper represents a good first step in
facilitating collaboration between traditional market participants
and the crypto community in order to produce contractual standards
that are responsive to the needs of active participants in the
digital assets market.

Given the novelty and rapid pace of development within digital
asset markets, new issues will continuously emerge that market
participants will have to consider. To ensure that a robust
foundation underpins the digital asset derivatives market, it is
important that common contractual standards strike the right
balance between standardization and customization. Product
templates must be sufficiently uniform to enable market
participants to transact in confidence using clearly established
provisions, and flexible enough to be adaptive in response to
product and market developments.

In the near term, further consideration should also be given by
market participants to: (1) how standardized, deterministic
valuation sources and methodologies can be developed for digital
assets, in order to improve efficiency in valuation mechanics used
for digital asset derivatives; and (2) establishing contractual
standards for identifying and mitigating the impact of market
disruption events that could occur with respect to digital assets
that are the subject of derivative transactions.

Primary Sources

  1. ISDA White Paper: Contractual Standards for
    Digital Asset Derivatives
  2. ISDA Supplement: Analysis of Existing ISDA
    Definitional Booklets

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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