The International Swaps and Derivatives Association (ISDA) is collaborating with the digital asset industry (through the ISDA Digital Assets Legal Group) to establish contractual standards for crypto derivatives. In a DerivSource Q&A, Mark New, senior counsel, Americas at ISDA, discusses what the forthcoming standards will look like, how they will cope with digital asset-specific events such as forks and airdrops and what to expect next from the trade association.
Q: What are the current drivers for establishing contractual standards for crypto derivatives?
A: The drivers are much the same as for any asset class. There are clear benefits to having standard documentation. These include addressing basis risk between different types of trades, so firms know they are really trading the same thing when trading with different counterparties. There is also the general efficiency of documentation, so firms do not have to reinvent the wheel every time they want to trade with a new counterparty.
The current push for standardisation is driven by market participants. As more institutional investors enter the crypto derivatives space, they are demanding the same level of standards they are used to in other asset classes, including robust documentation.
While the move towards standardised contracts started last year—ISDA put out a whitepaper on Contractual Standards for Digital Asset Derivatives towards the end of 2021—recent volatility in the asset prices reminds firms of the risks that exist in this industry and reinforces the importance of robust documentation. Our goal is to look at the risks that can exist in these derivatives contracts, because unlike the spot market, the derivatives transactions remain outstanding over time. Firms need to account for things that can happen to the asset during the life of the trade. Our job, together with our members, is to figure out what those risks are and if they should be allocated to one party or the other in the derivatives trade.
Q: How is ISDA (and the Digital Assets Legal Group) working to leverage existing ISDA contractual standards to support the digital asset space?
A: We leverage both the ISDA process as well as previous ISDA products. ISDA has published a documentation framework for trading derivatives, which starts with a master agreement that covers the credit risk allocation between the two parties. Counterparty credit risk is a concern because firms will be in these trades for some time. Firms can layer credit support on top of that using an ISDA credit support annex (CSA), which means collateral will be provided on the entire portfolio of trades. This portfolio may include FX rates, credit, as well as crypto or any other asset.
The framework is completely open—firms can put any kind of trade they like under the master agreements. ISDA provides standard definitions for transactions like interest rates, swaps, equities, credit, FX, or commodities. Crypto is no different in that sense. Firms are looking for a way to define the products; currently ISDA is looking to define terms for non-deliverable forwards (NDFs) and options (NDOs) on crypto underliers.
The current project is to create definitions for NDFs and NDOs on large cap crypto native assets such as bitcoin or ether. When those definitions are published, they can be used within the master agreement framework and the CSA and firms can then just build it into their existing infrastructure.
The standards work also leverages existing ISDA product expertise. While crypto is clearly a new asset class, it is still a financial asset class, and many of the risks involved will be similar to other financial asset classes. For example, if it becomes impossible to hedge the transaction because a firm loses access to the underlying cash market, or if the selected price source goes temporarily offline.
The other point of leverage is around process. ISDA brings together different stakeholders from the buy and sell side so they can negotiate what terms are right for various products. Bringing together that industry knowledge in a common forum is very efficient and avoids the need for multiple bilateral negotiations.
Q: What are some of the ways ISDA is addressing general nuances unique to crypto derivatives?
A: First is the importance of the price source that the parties choose. ISDA is developing NDFs and options, meaning these transactions will be settled with a payment in fiat cash— e.g. in dollars. Counterparties doing an NDF on bitcoin must agree what will be the source of information for the price of bitcoin in dollars on the settlement date.
One of the interesting things about crypto is that the underlying can trade on any number of exchanges so, for instance, there can be multiple versions of truth about the price in dollars of a bitcoin at a given time. A common solution is to choose an index as a price source. There are many such price sources that are indexes of prices from multiple different exchanges.
Leveraging an index’s pricing expertise also helps firms deal with other crypto market nuances such as “forks”—where a permanent change in the underlying blockchain code leads to a split. ISDA is interested in forks because they could result in two or more assets following the fork, where previously there was only one. That is a concern because if a transaction requires valuation of an asset and then that asset essentially splits in two, the parties need to know which asset to value.
In many cases, there will be forks that don’t impact the transaction at all—either because the fork does not result in an asset that lasts for any period of time, or because the whole market moves onto a new asset. The approach currently being developed has an open definition of what can be a fork, but when it comes to the consequences of that, in many cases, firms will just follow what their price source provider does, because they can then be confident they are following the market. The definitions will also allow for cases of more controversial forks, which could conceivably result in the termination of a transaction, but in most cases, firms are expected to follow the lead of the price source provider.
The other nuance is around “airdrops”—where a new cryptocurrency token is deposited into users’ wallets. However, these are probably less relevant for cash-settled transactions like these, and particularly for bitcoin and ether that do not have airdrops built into the current protocol. ISDA documents are about identifying risks that need to be allocated between parties and feedback from market participants suggests that while airdrops could happen, they are unlikely to be significant enough to affect cash-settled transactions.
Q: How do you see the use of standardised contracts benefiting derivatives market participants?
A: Firms are already trading crypto derivatives and currently they must create their own bespoke documentation. We believe they typically use the ISDA structure as a master agreement and develop the trade terms for the specific crypto trade based on other definitions such as ISDA’s equity or FX definitions. They are starting from another place and adapting it to crypto.
Producing standard forms brings two key benefits. The first is making sure a NDF on a digital asset is the same whether transacted with one counterparty or another. There is no central party to define the terms of that trade, so the parties must get it in writing at the time of trade. If a firm thinks it has done the same trade with both party A and party B, but it turns out there is a small difference in the documentation, they could discover they have an unhedged position. Eliminating that basis risk or enabling firms to easily determine where it does exist is very important for risk management and reduction.
The second point is around documentation efficiency. It is expensive to reinvent the wheel every time a firm wants to do a trade with a new counterparty. If firms can take something off the shelf and adapt it for their own purposes that will increase the speed of onboarding and reduce time to market.
Q: What is the next milestone for the establishment of contractual standards?
A: The definitions are due to be released by the end of this year. Apart from that, ISDA will be watching the market and listening to its membership regarding where they see demand for additional documentation or support. It is a fast-evolving space. For the definitions themselves, the demand is there to use these standards, but firms will need a bit of time to adopt them and put them into practice. Market participants are encouraged to continue to engage and participate in working group calls so ISDA can hear about the issues firms are facing and the solutions they are finding so we can bring that together for the benefit of the whole market.
