03 May 2023

ISDA: Navigating Bankruptcy in Digital Asset Markets: Digital Asset Intermediaries and Customer Asset Protection

This whitepaper – the second of two papers covering digital assets – examines how digital assets may be held by customers through intermediaries and considers how those assets can be protected following an insolvency of the intermediary, with a specific focus on English and US law.

The implosion in 2022 of FTX and the cascade of defaults and insolvencies precipitated by its collapse underscores the centrality of enforceable property rights as a fundamental principle of customer asset protection, particularly in bankruptcy scenarios.

This whitepaper – the second of two papers covering digital assets – examines how digital assets may be held by customers through intermediaries and considers how those assets can be protected following an insolvency of the intermediary, with a specific focus on English and US law. While digital assets raise some novel questions, the key finding is that traditional and fundamental protections of clear legal terms and segregation of assets can be adapted to the world of digital assets.

The primary recommendation of this paper is that rules governing the ownership of customer digital assets following insolvency of an intermediary should be made as clear as possible. Achieving greater clarity in the application of these rules – including the contractual and operational frameworks designed to implement them – will ensure that customers are given equivalent rights and protections to what they would expect for traditional assets (such as securities) or financial products (such as derivatives).

While sophisticated market participants – including those in the privately negotiated derivatives market – may decide to accept a lower level of protection, they should always be clear on how their assets will be treated in insolvency.

These protections rely on the existence of unambiguous and enforceable property rights, providing customers with the ability to confidently assert claims over their assets, for those claims to be protected and enforced under applicable law, and for assets to be predictably allocated and distributed following insolvency. These rights are core tenets of the global financial system and central to the risk mitigation techniques and practices promoted by ISDA as part of its mission to foster safe and efficient derivatives markets.

Fortunately, various jurisdictions, including the US and England and Wales, have recognized digital assets as capable of being the subject of property rights.

On the specific issue of customer protection, this paper finds that:

• From both an English and US law perspective, existing private law concepts (such as trusts) can be applied to digital assets to protect customer assets following insolvency;
• Both English and US law requires regulated digital asset intermediaries to adhere to rules governing custodial arrangements and protection of customer assets, including in relation to the segregation and bankruptcy remoteness of customer assets; and
• Existing insolvency regimes in both the UK and US will apply to digital asset intermediaries, although the specific regime will depend on the nature of their legal and regulatory structure.

The analysis demonstrates the importance of ensuring that the precise nature of any custodial relationship is well understood. As such, this whitepaper identifies questions that investors should ask to determine the level of protection they have. It also provides direction for digital asset intermediaries to promote clear standards to give customers the best possible protection in insolvency proceedings.

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