ISDA releases standard definitions for digital asset derivatives

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The Inter­na­tion­al Swaps and Deriv­a­tives Asso­ci­a­tion (ISDA) is work­ing on two papers to address fun­da­men­tal legal risks in the cryp­to mar­kets, such as the insol­ven­cy of cryp­to exchange firms, accord­ing to a state­ment released on Jan. 26. 

The ini­tia­tive was moti­vat­ed by the col­lapse of cryp­to exchange FTX and pre­vi­ous bank­rupt­cy cas­es that “prompt­ed a cas­cade of liq­uid­i­ty and sol­ven­cy con­cerns across the cryp­to ecosys­tem.” Along with oth­er things, the papers will offer guid­ance for mar­ket par­tic­i­pants regard­ing cryp­to own­er­ship and the role of inter­me­di­ates in the event of bankruptcy.

“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,” notes the announcement. 

In addi­tion, the asso­ci­a­tion said that the oft-repeat­ed prin­ci­ple “not your keys, not your cryp­to” seems to imply that fun­da­men­tal ques­tions set­tled in the tra­di­tion­al mar­kets may still be evolv­ing or may not exist in the cryp­to indus­try, such as “what defines the own­er of an asset?” or for “a par­ty that is not the direct own­er, but holds an asset indi­rect­ly via an inter­me­di­ary, what is the impact of an intermediary’s bank­rupt­cy?” Specif­i­cal­ly, the state­ment says:

“The FTX col­lapse indi­cates that such norms are still evolv­ing (or may not yet exist) in the cryp­tocur­ren­cy mar­kets. When these issues are not well under­stood by mar­ket par­tic­i­pants or the risks are not prop­er­ly man­aged, unan­tic­i­pat­ed and sig­nif­i­cant loss of cap­i­tal can emerge.”

The pub­li­ca­tions will deliv­er stan­dards on close-out net­ting and col­lat­er­al and address issues relat­ing to cus­tomers’ dig­i­tal assets held with inter­me­di­aries and how they may be held and treat­ed in an insol­ven­cy sce­nario. The papers will also inform legal and doc­u­men­ta­tion need­ed to estab­lish own­er­ship of dig­i­tal assets and their use as collateral. 

The ISDA is a pri­vate trade asso­ci­a­tion com­pris­ing pri­mar­i­ly banks that trans­act in the over-the-counter deriv­a­tives mar­ket. As part of its work, the asso­ci­a­tion seeks to iden­ti­fy and reduce risks in the markets. 

The USDA’s last annu­al meet­ing, held in May 2022, had the pres­ence of Sam Bankman-Fried, for­mer CEO of FTX, rep­re­sent­ing the cryp­to indus­try. Fea­tured keynotes at the event includ­ed Gary Gensler, chair of the Unit­ed States Secu­ri­ties and Exchange Com­mis­sion, and Ros­tin Behnam, chair of the Com­mod­i­ty Futures Trad­ing Commission. 

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