ISDA’s Digital Asset Definitions: An Overview

Chris Magee
April 17, 2023

In January 2023, ISDA published version 1.01 of its new Digital Asset Derivatives Definitions – a booklet of legal terms capable of being integrated into the established ISDA documentation architecture. Much like other definition booklets – such as the Collateral Agreement Interest Rate Definitions or Equity Derivatives Definitions – the intention of the new publication is to provide a standardized framework for the trading of a specific asset class, in this case covering non-deliverable options and forwards on Bitcoin and Ether.

Given that derivatives referencing cryptocurrencies are a relatively new type of financial transaction, many market participants record these trades on bespoke paper, or within a trading platform’s Terms and Conditions. ISDA’s new definitions seek to provide a common structure, standardization and enhanced clarity on important contractual provisions already well-established within traditional financial services, for the rapidly growing and continually evolving digital assets market.

Crypto market growth: a sharpening regulatory focus

The rapid growth of digital assets from a niche interest towards becoming an integral part of the mainstream financial world has led to retail customers having the option to buy, sell and store cryptocurrencies through digital banking apps and even through traditional government-backed retail banks. As this new asset class enters the world of more established financial products, it remains necessary – and becomes increasingly important – for market-makers to apply basic principles of risk management and hedging to support market integrity.

That necessity is driven not just by good market practice. As digital assets move towards the mainstream, they are attracting increasing regulatory attention, pushed by their rise up the political agenda, as their real-world impact increases.

The fallout from the November 2022 bankruptcy of FTX, which at one stage was one of the world’s largest cryptocurrency platforms with a peak valuation of $32bn, has led to increased demand for regulatory oversight of digital asset markets, putting a sharper focus on the possibility of developing stronger risk management frameworks around such transactions. ISDA’s documentation, although in the works before FTX’s collapse, is helpful in its wake, because it promotes the same kind of clarity for digital assets that ISDA documents have provided more generally in financial markets for over 30 years, and indeed through many global crises. That clarity, which will help protect cryptocurrency users in the event of a default, may well help build legitimacy and credibility for digital assets and better align the market with the likely direction of political and regulatory sentiment.

Legal features

Market participants can, as with other definition booklets, incorporate the Digital Asset Derivative Definitions by reference into their existing documentation. This can be done either at Confirmation or Master Agreement level, specifying that the agreement (or specific Transactions thereunder) will be subject to the application of the new terms. 

A notable feature of the new definitions is that whilst they have initially been drafted for specific use on non-deliverable options and forwards on Bitcoin and Ether, this is considered a starting point and has deliberately been left open-ended to allow for further asset classes and transaction types to be added in the future.

ISDA has not yet expanded documentation architecture to include digital assets in collateral agreements, although plans are underway to consider this in 2023. Also under immediate review are all-important legal opinions, with coverage for close-out netting aiming to be expanded to cover the asset classes supported by the Digital Assets Definitions. Coverage is expected to be positive in major jurisdictions (English and New York Law).

Novel challenges

In attempting to produce a standard framework for a nascent market, the working group tasked with writing the new definitions faced several intriguing challenges in tailoring the documentation for its intended market, among them:

  • Valuation source – how to create a robust waterfall of fallbacks given the variety of pricing sources available for digital assets, with no established “screen” or time publication conventions. The potential for high volatility in pricing, even at daily or hourly intervals, is a differentiating factor from established derivative reference points.
  • Blockchain Fork – a unique event to cryptocurrencies, comparable perhaps in most simple terms to a version upgrade of the technology supporting the coin that results in multiple divergent assets with potentially different valuations. Notably, there have been over 45 “forks” in the blockchain supporting Bitcoin since its inception in 2009, thus creating the need for Fork Disruption fallbacks within the definitions. ISDA are soon due to publish guidance notes on this novel issue.
  • Change in Law – given the rapidly developing legal and regulatory framework surrounding digital assets, it is conceivable that a party’s obligations under a Transaction (or indeed, their hedging position of that Transaction) could become frustrated by a change of law in their relevant jurisdiction. Remedies to address such situations are included for users of the definitions.
  • Continuous Market – Many institutions in the digital assets market operate on a 24/7 basis, with price sources for reference assets published on what are traditionally non-business days. To account for this, the definitions interestingly offer the option to turn off the standard ISDA Business Days concept for valuation and settlement, albeit in isolation for cryptocurrency derivatives.

Market implications

The publication of the Digital Assets Definitions makes it likely that at some point existing trading relationships – and future trade expansion – will happen under the umbrella of Confirmations or Master Agreements. That move, in turn, should bring new players to the world of ISDA documentation, as crypto-firms enter a field hitherto the preserve of “trad-fi."

While it will be interesting to see, over the medium term, what impact the expected arrival of the “disruptor” culture of the crypto companies will have on the market, in the short term there’s a live question about how the market will resource the negotiation and papering of trading under the new definitions. Many crypto firms have relatively tight capacity to take on the kind of documentation at the scale that the new definitions might trigger. At the same time, the “trad-fi” documentation teams, while well-schooled in the art of ISDA documentation, may not be so deeply steeped in the understanding of how digital assets work, and the specific risk issues that arise.

Market participants exploring a move into the digital asset space might be well-advised to give thought early to the kind of internal structure, knowledge base and skills required to make it work in practice. It may make sense to consider alternative approaches to the traditional in-house model, because these allow for iterative development of best practices in a way that doesn’t disrupt the main business, and, given flexibility of scale and scope, allow for the kind of lean, “fail fast” approach that aligns to the nature of the underlying assets.