The collapse in November 2022 of FTX, one of the largest and highest profile crypto exchange platforms, sent shockwaves through financial markets. 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.

Close-out netting and collateral are two of the most effective credit risk protections within ISDA documentation. Close-out netting allows parties to reduce (potentially unquantifiable) exposure to an insolvent counterparty by consolidating all economic exposures relating to their derivatives transactions into a single net sum. Timely and regular provision of collateral allows parties to further reduce credit risk on a day-to-day basis by ensuring they have sufficient assets to apply against any future unexpected losses that may arise due to their counterparties’ default. Each of these protections significantly reduces the credit exposure of a party to a failing institution and provides insulation against the contagion effects of broader market failures by limiting potential unsecured exposure to an insolvent entity. ISDA analysis indicates that netting arrangements relating to digital asset derivatives are likely to be enforceable in certain major jurisdictions (including England and Wales and New York). However, the enforceability of netting in each jurisdiction will depend on the counterparty’s local insolvency law, some of which may exclude or omit digital assets from their scope of application. ISDA will therefore begin work in 2023 to update netting opinions in relevant jurisdictions to cover digital assets. When it comes to collateral, it is likely that most (if not all) developed jurisdictions9 will recognize digital assets as property that will be capable of protection under local law, including for posting as collateral. However, the precise nature and extent of any rights associated with that property interest, the strength of legal certainty and certain technical issues, such as the methods by which that property can be posted as enforceable collateral, will vary based on the applicable jurisdiction(s).