Crypto View - September 2021

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ISDA Working Group

You are no doubt aware that the digital asset derivatives market is rapidly accelerating, with increasing interest from institutional participants. So far, the most popular digital asset derivatives for institutional investors reference either Bitcoin or Ether. There are Bitcoin and Ether futures contracts (e.g. on CME) which are well understood products. However, OTC derivatives referencing these futures contracts present some novel issues when compared to more "traditional" underliers.

There is currently no standardised approach to documenting digital asset derivatives. Some market participants are using ISDA documentation with bespoke amendments, while others are using entirely bespoke documentation.

As trade organisation for OTC derivatives, ISDA has recently launched a ISDA Digital Assets Legal & Documentation Group to identify legal and documentation issues relating to derivatives transactions that reference digital assets. The group will start with an exploratory paper. They will consider how market-standard documentation for digital assets could be structured and developed. The paper will aim to identify key issues that may need to be addressed or resolved before creating market-standard templates and definitions for derivatives referencing digital assets.

Potential issues might include:

• Taxonomy: As ever, agreeing how to classify digital assets, in particular how to distinguish "native digital assets" (i.e. digital assets that have no manifestation other than as a digital record on a distributed ledger, such as Bitcoin and Ether) from "asset-referenced digital assets" (i.e. digital assets which reference some kind of underlying asset or right, such as some stablecoins and security tokens etc. ).
• Transaction fees: How to address transaction fees -- which derivative counterparty should be responsible for them?
• Valuation: Identifying a price reference source. For equities and other securities there is generally a dominant exchange for the security, but for digital assets this is not necessarily the case. There will need to be a way for parties to choose a fair and reliable valuation source.
• Physical settlement: Yes or no? Is there a need for bespoke provisions around delivery?
• Disruption events: Are bespoke disruption events necessary? Presumably forks, airdrops and cyber-attacks should be considered.

If ISDA produces documentation, the plan is to publish them digitally (i.e. for the documentation to be 'digitally native') as they did for the recent 2021 ISDA Interest Rate Derivatives Definitions (which Simmons produced a helpful note on, here). One to follow, as institutions are very comfortable with ISDA documentation.

US Crypto Derivatives

Keeping with the derivatives theme, there are interesting developments in the US.

In a decision which is no doubt food for further thought for the large crypto exchanges, we saw Kraken fined $1.25 million by the Commodity Futures Trading Commission (CFTC) for illegally offering margined retail commodity transactions in digital assets, including Bitcoin, and failing to register as a futures commission merchant (FCM). The transactions that US retail customers were able to enter into on the Kraken platform were unlawful because they should have taken place on a designated contract market (DCM) and did not. Also, by soliciting and accepting orders for and entering into retail commodity transactions with customers, and accepting money or property (or extending credit in relation to them) to margin these transactions, Kraken illegally operated as an unregistered FCM.

However, in a statement from Dawn Stump, Commissioner of the CFTC, she said that it was unclear how Kraken could be regulated as an FCM, noting that it would be "unprecedented" for a company to be registered as a DCM and FCM at once . "Many of the Commission's rules governing its regulation of traditional FCMs do not fit Kraken's role as an exchange", she said.

Chinese Crypto Prohibition

On 24th September the People's Bank of China, alongside nine other Chinese regulators, published a circular detailing a series of stringent measures against crypto businesses. In that circular they made clear that business activities in relation to "virtual currencies" (expressly including all the most common crypto assets) are strictly prohibited. This includes crypto derivatives trading.

Most importantly for those businesses outside of China, the circular clarifies that cross-border provision of these services into China is prohibited (something which could be considered a grey area, at least in part), and advertising of crypto services in China is now also prohibited.

This is clearly a major development for the crypto industry, but perhaps not surprising. The Chinese regulators have long been some of the most negative on crypto in the world and this is an inevitable step given that previous attempts to stamp out crypto trading activity in China have left some room for interpretation. It is clear now that there is no room for interpretation and crypto businesses are now on notice, if they choose to continue to support China-based customers.

FCA Speech

Moving away from derivatives, earlier in September Charles Randell, the Chair of the FCA, gave a speech on the "risks of token regulation". In it he flags three issues that he believes legislators need to consider, namely how to make it harder for digital tokens to be used for financial crime, how to support useful innovation, and the extent to which consumers should be free to buy unregulated, purely speculative tokens. There was little in the speech that was new from the FCA's perspective. The most important takeaways are probably reminders that FCA can currently take action to reduce potential harm in respect of (i) cryptoasset promotions (he could have included crypto derivatives here too), and (2) contagion of the regulated business of authorised firms by unregulated activities in digital tokens.