As the leading trade association in the OTC derivatives space, ISDA has been active in supporting the expansion of the use of derivatives to new asset classes, including digital assets. For example, in January 2023, ISDA published version 1.01 of their Digital Asset Derivatives Definitions, which provide a standardised set of definitions and provisions for non-deliverable digital asset forwards and options relating to BTC or ETH.
More recently, ISDA has turned its attention to the use of digital assets, specifically assets that utilise distributed ledger technology (DLT) as collateral, and has published two documents on the subject:
- Tokenized collateral model provisions in ISDA 2016 Credit Support Annexes for Variation Margin (VM) (the VM CSAs), published December 2023 (the Model Provisions); and
- Guidance note on tokenized collateral, published 21 May 2024 (the Guidance Note).
The Model Provisions set out model provisions to enable “DLT Cash” or “DLT Securities” to be used as Eligible Credit Support under a VM CSA. The Guidance Note offers useful guidance to counsel being asked to opine on the enforceability of collateral arrangements where the eligible collateral includes tokenized collateral.
It is left to the parties to agree whether a particular digital asset is treated as “DLT Cash” or “DLT Securities”, which, in each case, is defined as collateral transferable by entry in a distributed ledger. The decision as to whether a particular digital asset is treated as “DLT Cash” or “DLT Securities” seems unnecessarily important. We explain why below.
Cash or securities?
Traditionally, ISDA credit support documents, such as the VM CSAs, provide for the use of two types of asset as eligible credit support: cash and securities. The VM CSAs distinguish between cash and securities in several provisions, including those governing valuations of collateral and transfers of collateral.
The Model Provisions maintain this approach. They include additional language which provides that references in the VM CSAs to:
- “currency” or “cash” in the VM CSA shall include “DLT Cash”; and
- “securities” shall include “DLT Securities”.
Based on the Guidance Note, the expectation appears to be that stablecoins will be specified as “DLT Cash” and tokenized securities as “DLT Securities”.
The Model Provisions specify that in the case of “DLT Cash” or “DLT Securities”, transfers are made by causing such changes to the entries in the distributed ledger sufficient to result in a legally effective transfer of the relevant right or interest to the recipient or its agent.
In relation to all other provisions, “DLT Cash” is treated as cash or currency, and “DLT Securities” as securities.
This raises an odd issue relating to valuations.
In the case of a digital asset that is specified as Eligible Credit Support and “DLT Cash”, the value of an amount of that digital asset will be the “Base Currency Equivalent” of such amount subject to a haircut based on an agreed valuation percentage and FX haircut percentage.
In the case of an “amount denominated in the Base Currency”, the “Base Currency Equivalent” is such “Base Currency” amount, whereas in the case of an amount denominated in a currency other than the Base Currency, there is a currency conversion process. In the case of an amount of a stablecoin that is intended to track the Base Currency, it raises an interesting question: Is the amount of the stablecoin “denominated in the Base Currency” or “in a currency other than the Base Currency”?
If it is denominated in another currency, everything is fine – there is a currency conversion process. If it is regarded as denominated in the Base Currency, there is no currency conversion process, so 5,000 USDT is identical to US$5,000.
One would have thought the intention would be that 5,000 USDT is denominated in a different currency to US$5,000, otherwise, any tracking error or difference in value between the stablecoin and the Base Currency would not be accounted for in the value of the Credit Support Balance. However, the point is not specifically addressed in the Model Provisions and it is not as clear as it should be. This could lead to unintended consequences if the treatment of a stablecoin as “DLT Cash” versus “DLT Securities” is not considered and addressed by the relevant parties.
To address this issue, parties could specify that the relevant stablecoin should not be regarded as being denominated in the Base Currency. Alternatively, parties could instead provide that the stablecoin is Eligible Credit Support that should be characterised as “DLT Securities”, since in that case, its value will be its bid price subject to a haircut based on an agreed valuation percentage and FX haircut percentage.
Other issues
Parties using the Model Provisions will need to undertake due diligence as to whether the inclusion of the digital assets in question disturbs their analysis of the collateral provisions’ effectiveness. The Guidance Note helpfully discusses several general issues that would need to be considered across jurisdictions.
Here we highlight two slightly more specific issues:
- In EEA jurisdictions, tokenized collateral may fall outside the scope of local implementation of the Financial Collateral Directive, thereby causing the VM CSA in question to fall outside the protections afforded to title transfer collateral arrangements.
- The VM CSAs were created to support the margining in accordance with regulatory VM standards. Parties using the Model Provisions together with VM CSAs intended to comply with regulatory requirements should also confirm whether the relevant digital asset is one that can be treated as eligible variation margin under the relevant regulatory regime(s).
Client Alert 2024-115
