Canada: Digital Asset Derivatives: The International Swaps And Derivatives Association, Inc.'s Digital Asset Derivatives Definitions

The increased popularity of cryptocurrencies and other digital assets has sparked an evolution in the market for derivative contracts referencing such digital assets. In this piece, we provide a brief introduction to the concept of digital asset derivatives, their uses and how digital asset derivatives are documented and defined.

What are digital asset derivatives?

A digital asset derivative is a financial product that can be used to manage risk in the underlying digital asset market. The digital assets underlying the derivatives are most commonly cryptocurrencies, specifically Bitcoin (BTC) and Ether (ETH). Cryptocurrency markets offer digital asset-based derivative products such as BTC and ETH-based futures and options. The growth of these financial products has quickly surpassed the growth of the underlying cryptocurrency spot market, with global estimates of just BTC and ETH-based futures exceeding $32 trillion in trading volume in 2021.¹

Just like derivatives in traditional markets, digital asset derivatives are contracts that derive value relative to the performance of the underlying digital asset. Presently, digital asset derivatives are what is known as "bilateral", which means they are bespoke contracts negotiated by two parties. Most commonly, digital asset derivatives are non-deliverable, which means that cash is exchanged based on the changes in the underlying prices of the digital asset.²

How are digital asset derivatives used?

As with traditional markets, digital asset derivatives can facilitate price discovery of the underlying digital asset, increase liquidity, and allow for hedging against price volatility.³ There are different digital asset derivative structures and each can be used to protect against risk at various points of the market cycle.

Perpetual swaps are similar to traditional market swaps, which are contracts where a series of cash flows are exchanged.⁴ Perpetual swaps have become widely used for digital assets. The attractiveness of these contracts is that they do not settle and there is no fixed maturity. Essentially, they "provide the buyer with synthetic long exposure to a digital asset and the seller with short exposure to that same asset".⁵

Non-deliverable forwards (NDF) are forward contracts, which are tied to the price of the underlying digital asset. NDFs can be used to increase one's exposure to a spot market for an asset without directly holding said asset.⁶ Accordingly, NDFs can be used to protect the owner thereof against the volatility of the underlying digital asset.

How are digital asset derivatives documented and defined by ISDA?

Until this year, the digital asset market has been operating without standardization for documenting over the counter (OTC) derivatives. Standardization is welcomed in the digital asset space, however, the International Swaps and Derivatives Association, Inc. (ISDA) itself has expressed concern over creating definitions and setting standards for a uniquely shifting economic environment.⁷ ISDA itself has stated, "given the pace of change, any such definition is likely to quickly become obsolete".⁸ ISDA's hesitation is understandable when looking at the characteristics of the digital asset derivative environment; the underlying assets are subject to shifting regulatory treatment, the underlying assets' technology is constantly changing, the markets trading the underlying assets and derivatives are novel (operating globally, 365 days a year, 24 hours a day) and characteristically lack centralized authority, and finally the assets also lack standard valuation methodologies across markets.⁹

On January 26, 2023, ISDA published the ISDA Digital Asset Derivatives Definitions (the "Definitions"),¹⁰ that set out the definitions and standards for digital asset derivatives. The Definitions initially cover non-deliverable forwards and options on BTC and ETH. In drafting the Definitions, ISDA has provided room for the Definitions to be expanded in the future to cover additional product types, including various tokenized securities and other digital assets executed on distributed ledger technology, or "DLT". In addition, in drafting the Definitions, ISDA have used a controlled language structure to define the processes contained in the Definitions, facilitating integration with ISDA's standardized Common Domain Model¹¹ and automation within smart contracts.

Additional insights

Alongside the release of the Definitions, ISDA simultaneously published Navigating Bankruptcy in Digital Asset Markets: Netting and Collateral Enforceability (the "White Paper") that addressed the issue of digital asset market insolvency. The main inspiration and focus of the White Paper's discussion is, of course, the globally famous collapse of the digital asset market FTX and its negative effect on the world economy. ISDA's decision to simultaneously release the White Paper and the Definitions can be viewed as ISDA providing a backdrop to best understand the necessity of the Definitions. The Definitions provide some greatly needed consistency, transparency, and guidance on the rights and obligations to digital asset derivative participants looking to continue navigating the market after the FTX storm. These standardized Definitions can be used to both increase efficiency in trading digital asset derivatives while simultaneously providing standard terms that can reduce market risk.

Footnotes

1. Ernst and Young LLP, "Crypto derivatives are becoming a major digital asset class" (2022), online: https://assets.ey.com/content/dam/ey-sites/ey-com/en_us/topics/financial-services/ey-crypto-derivatives-pov_final4.pdf?download.

2. Ibid.

3. ISDA, "Contractual Standards for Digital Asset Derivatives", (2021), online: https://www.isda.org/a/QVtgE/Contractual-Standards-for-Digital-Asset-Derivatives.pdf.

4. Supra note 1.

5. Ibid.

6. Ibid.

7. Supra note 4.

8. Ibid.

9. Ibid.

10. https://www.isda.org/2023/01/26/isda-launches-standard-definitions-for-digital-asset-derivatives/

11. https://www.isda.org/2019/10/14/isda-common-domain-model/.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.