Growing up: crypto derivatives

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.