Developments in Crypto Derivatives

The Mayer Brown derivatives team recently attended (virtually, as is increasingly market standard) ISDA’s conference on “Developments in Crypto Derivatives”. This is a “hot” area of the legal market, as we have recently reported on this blog, and so the conference was well attended.

In this post we summarise the main themes of the conference and issues market participants should consider regarding crypto derivatives.

1. Benefits and drawbacks of crypto derivatives

• Crypto derivatives allow market participants not to hold the physical asset, which avoids the need to navigate wallets and other complicated market infrastructure.
• Facing regulated counterparties is a safer way for new buy side participants to get access to the asset class.
• Many of the potential drawbacks relate to the nature of the underlying reference crypto assets, rather than the nature of derivative contracts. These drawbacks include: price volatility/market risk, 24 hour trading and the resulting need for risk controls and unexpected technology/protocol changes.
• An investor’s perspective and background will determine which factors are most important: crypto-native firms are more interested in the products and financial institutions are more interested in risk for clients.

2. Crypto market features and impact on crypto derivatives

• Whilst crypto markets lack aspects of traditional markets infrastructure which help price discovery, such as centralised exchanges and shared protocols for valuations (end-of-day valuations, etc.), it also has infrastructure which provides new means for managing credit risk, such as technology which provides 24 hour and a real-time view of portfolio valuations.
• After some initial uncertainty, cryptocurrencies are now widely considered a form of property in many legal systems, albeit a novel form of property. See e.g. AA v Persons Unknown, Re Bitcoin [2019] EQHC 3556 (Comm), ai Ltd and another v Persons Unknown Category A and others [2021] EWHC 2254 (Comm) and the UK Jurisdictional Task Force’s November 2019 Legal Statement on Crypto-Assets and Smart Contracts. One important area where the legal status of crypto currencies has not yet been finally resolved is whether crypto currencies are property for the purposes of financial collateral arrangements (which would simplify and strengthen collateral arrangements).
• The Index Disruption / Index Adjustment Event provisions (an index sponsor fails to calculate and announce a relevant reference index) do not cater for the increasing role of decentralised exchanges (which rely on distributed ledgers rather than a central index administrator).
• Buy side participants increasingly report that they are unhappy with the valuation mechanics in Section 6(e) of the ISDA Master Agreement as they apply to crypto derivatives. For instance, the accuracy (or usefulness) of quotations from third party may be less in crypto markets, especially where there is fragmented liquidity in the relevant underlying (split across several exchanges). It is practice in some crypto derivatives to specify certain trusted dealers or sources of information.
• The current Credit Support Annex does not readily account for novel issues relating to crypto assets which may be held in custody, such as airdrops, forks, and most secure method of custody for different assets.

3. Documentation for crypto derivatives

• The current ISDA suite of documentation does not easily accommodate cryptocurrencies as reference assets (the bitcoin white paper was published in 2008, 6 years after the release of the 2002 ISDA Master Agreement). The prevailing approach to documenting crypto derivatives is to use an amalgam of the commodity definitions and the equity definitions and bespoke terms.
• There are two possible approaches to adapting the standards so they are applicable to cryptocurrencies: amend existing terms and events or introduce completely new bespoke events. Regardless of the direction taken, moving towards a more standardised set of legal documentation allows for a more standardised trading infrastructure, which is key for the crypto market maturing.
• The task of standardising cryptocurrency trading documentation also comes at a time where there is a movement towards digitalisation of documentation, a movement which fits with the digital nature of crypto assets. Digitalisation of documents has a number of potential benefits: reduction of human error; standard language makes interpretation easier; and natively digital contracts are easier to automate.
• In the longer term, there is likely to be a move from natural language (English) contracts to code, where the code itself determines parties rights and obligations (instead of, at the moment, automating contracts which are drafted in natural language).

Please get in touch with your Mayer Brown contact if you require assistance with entering this developing area.