The recent volatility in the cryptocurrency markets has not tempered the momentum towards developing contractual standards and norms for digital asset derivatives.
What are the key issues for crypto/digital assets derivatives, which are different from other asset classes, such as equities or credit? Here are four of the key issues that parties to a cryptocurrency derivative need to consider:
- Valuation mechanics: parties need to agree on both the price source for a digital asset and a methodology for applying that price source.
Establishing a price source for heavily traded listed stocks is straightforward, but is no easy feat for cryptocurrencies considering the decentralised nature of most markets in digital assets. For the most liquid digital assets, bitcoin and ether, intra-day and end-of-day future prices are available from the CME, which include relevant methodologies – either an observed price as at a specified date and time (i.e. the real time CME CF Bitcoin Real-Time Index) or an average price based on observed prices at multiple price sources over a specified valuation period (i.e. the CME CF Bitcoin Reference Rate – which aggregates the trade flow of Bitcoin on major exchanges and publishes a daily rate at 4pm London time). For other digital assets, the parties can agree on a suitable price source, such as a large, recognised exchange like Coinbase and apply an observed price / average price methodology, as desired.
- Valuation-related Disruption Events: existing definitions booklets contain many disruption events which may be applied or amended to apply to digital asset derivatives. It turns out that the incredible infrastructure created for equity, fx and commodity derivatives by ISDA can, with some tweaking, be made to work with crypto-derivatives.
Here are some examples: (i) price source disruption (risks related to a lack of available rates from external sources (which may occur as a result of temporary disruptions or permanent cessations)) is available in the 2011 Equity Definitions, FX Definitions and 2005 Commodity Definitions and (ii) change in law (it becomes illegal to hold the underlying physical asset or a change in law or regulation means it becomes materially more expensive to continue performing under the transaction) is available in the 2011 Equity Definitions (but not for instance the FX or Commodity Definitions). These kinds of events would usually cover more general technology and market infrastructure disruptions.
The issue is how suitable the relevant definitions are for the new digital assets asset class, and ISDA is considering bespoke definitions for their templates. One issue being considered is whether, for a pricing disruption, an announcement of future discontinuation of publication of a relevant price should trigger the disruption event. It seems likely this will follow the approach taken in the IBOR transition provisions and be included in the definition. Parties should also consider the consequences of the occurrence of a Disruption Event, which may turn for instance on how fundamental the disruption is to the relevant transaction. The consequences could range from a postponement of the relevant valuation, use of a fall-back price source, a fall-back to calculation agent determination or the occurrence of a termination event.
- Fork Disruption Events: Crypto currencies do have some bespoke and unusual features which have not been covered in any other asset class.
One of these particular risks is “forks”, and in particular those which result in several assets/securities being created. Forks are a technological change to a blockchain which may result in amendments to a digital asset or completely new assets. Such a fork may cause valuation issues where the price source tracks the wrong or both fork assets. One of the trickier issues is identifying which forks produce assets that are capable of producing valuation uncertainty.
Some technical forks will be unproblematic, and any consequences can be dealt with by existing disruption events. But what happens where they are problematic? If a Fork Disruption Event occurs, parties should agree the consequences for affected transactions: transaction adjustment, price source fall-back, termination, etc..
- Airdrops: airdrops are another idiosyncratic feature of digital asset markets. They are best described as a bonus issue type of token distribution. In relation to non-deliverable forwards and options, which are the most common types of OTC digital asset transaction, the market view is that there is no need to cover for the consequences of an airdrop, as NDFs and NDOs are not generally expected to give the contract buyer all the economic benefits / consequences of ownership (in contract to total return swaps). Parties are free of course to negotiate a different position and should consider who should benefit from the proceeds of an airdrop.
Help is at hand at an industry level, The ISDA Digital Asset Working Group, a group of ISDA members comprising interested law firms and market counterparties has been reflecting upon the key terms to be included in transaction templates being developed for Bitcoin and Ether derivative transactions (limited for the time being to non-deliverable forwards and non-deliverable options). This work in progress, once finalised, will bring much needed standards.
Mayer Brown is currently drafting digital asset transaction documentation for several crypto firms and considering these issues with clients in detail. Please speak to your Mayer Brown contact if you would like assistance on any of these issues. * $1.3tn of BTC futures were traded in June 2022: