Institutional adoption of cryptocurrencies has thus far been slower than retail, but as the market infrastructure is sorted, the flow of sophisticated money continues to quicken.1 Recently released considerations by ISDA regarding digital assets derivatives under the Master Agreement begin to provide needed clarity around contractual standards and lay the groundwork for business-as-usual consistency across the industry.2 With the standardization of terms and remediations, firms that may have been hugging the sideline can break the yoke of inaction and get into the game.
A prominent concern for institutions engaging in these types of transactions is the valuation of the underlying assets. Any valuation will be the key to determining counterparties’ obligations for payment and delivery, close-out values, and collateralization. With crypto assets, valuation heartburns can become pronounced.
When it comes to their valuations, the decentralized nature of cryptocurrencies becomes problematic. CoinMarketCap currently tracks over 300 separate exchanges.3 While arbitrageurs could, theoretically, trade away any differences in value, sizable discrepancies can and do appear on a semi-regular basis.4 Firms should be considerate of valuation limitations and methodology, whether aggregated from providers, or from a centralized service like CFIX.
Traditional illiquid assets often employ a third-party for valuation services. This may provide a solution for certain digital assets, however the trading activity of these assets means that the breadth of discretion given to calculation agents should be weighed against and used in conjunction with more systematic pricing apparatuses.
The term “business day” appears several times in the Master Agreement, and regarding when assets valuations are marked. This definition, however, loses its meaning in the world of digital assets where there is no settlement window and trading happens in real time on a continuous, 24/7 basis. Beyond determining the valuation venue for underlying assets, parties to derivative contracts will also have to determine a timeframe for this valuation to take place. Even published prices may be misleading as different venues may use different timing snapshots, moving averages, or smoothing mechanisms.
These variations in valuation can also affect collateralization. There are likely no changes to be required when collateralizing a digital asset derivative contract with traditional assets, however using digital assets themselves as collateral will likely require the same valuation considerations already mentioned. Additionally, firms will have to determine, in the event of default where digital assets are being used as collateral, if margin interest is to be charged in traditional currency, or the underlying digital asset.
Events for traditional assets are well-defined within the Master Agreement, and while there are some overlaps with events for digital assets — both for default and termination events — many potentially disrupting digital assets events are completely novel.5 An example of a common occurrence in digital assets for which there are neither parallels with traditional assets nor appropriate language in the Master Agreement is a fork.
In contrast to forks, for which there is typically adequate notice, there are market infrastructure issues specific to digital assets that could cause disruption to a derivatives contract with little to no forewarning. Issues around settlement, venue, and index relation all differ between digital assets and their traditional counterparts, and language needs to be drafted in anticipation of such events.
Due to the immature regulatory landscape in which digital assets operate, most jurisdictions (including the USA), do not have guiderails around market manipulative activity. Until more clarity is provided by regulators, derivative contracts based on these assets could be vulnerable to bad actors.
Finally, participant firms should also consider language around exploitation of smart contract code. Recent high-profile thefts have shown the eye-popping values associated with potential vulnerabilities.6 The computing power still does not exist to compromise the underlying blockchains, but it is worth noting the affect that these hacks could have on underlying tokens. This risk is made more severe if the derivative contract itself is structured as a smart contract.7
Firms also need to examine their obligations around settlement. Many organizations are structurally prohibited from directly owning cryptocurrencies, adding a wrinkle to any physical settlement. While ISDA currently has guidance for such contracts road mapped for 2023, firms who deal in this space should begin to carve out language for dealing with these restricted counterparties.
Furthermore, there needs to be agreement between parties, and clarifying language in the contract, as to whether a digital asset is classified as a “payment,” “currency,” or “fund.” In addition to the already mentioned concerns, ISDA identifies implications including whether delivery of a relevant digital asset would discharge payment obligations, the impact on payment netting, and definition of the term “account.”
For forward-looking institutions, the time has arrived to consider operational controls and contract language for digital assets derivatives. Firms taking thoughtful steps now will find themselves on solid footing for their final approach, and well positioned in a maturing, accelerating marketplace.