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.

Parties should consider the following key issues when entering these arrangements:

• Based on the customer’s intended trading or investment activity, what level of customer asset protection is necessary or commercially desirable?
• Which jurisdiction’s law would govern the insolvency of the intermediary and how does it recognize rights in digital assets and customer assets?
• What are the rights granted under the prospective contractual arrangement between the customer and intermediary?
• Does the intermediary have a specific contractual or regulatory obligation to segregate customer assets from its own assets?
• What is the operational approach taken by the intermediary to record and segregate assets, and what security mechanisms does it have in place to protect their operation?

Although traditional financial market principles will generally apply to digital asset intermediaries, this paper acknowledges that distributed ledger technology (DLT) or similar technology may present some novel legal and practical questions compared to traditional financial assets.

For example, control of an intermediary’s private keys for customer assets held on chain will likely have special relevance in an insolvency scenario, resulting in an operational issue that does not have a ready analogy in traditional finance. This is relevant both for ensuring that an insolvency administrator can gain swift access to assets held for customers and to reduce the risk of losses due to hacking. Intermediaries and customers should ensure at the outset of the relationship that these operational issues are identified and managed.

While not directly an intermediary issue, a customer choosing to gain exposure to a digital asset through an intermediary may also be subject to legal uncertainties relating to the asset itself. In the cross-border world of DLT, there are two key questions: which governing law applies to the digital asset; and how can a proprietary claim to the asset be enforced in the relevant jurisdiction.

These questions have been analyzed in previous whitepapers published by ISDA, which found that issues could arise when using decentralized, permissionless blockchains that do not have any identifiable legal entity that could be the subject of a claim relating to a disputed on-chain asset. In these scenarios, it may not be clear which governing law applies to the platform or which court(s) may have jurisdiction to resolve disputes or enforce these claims.

Resolving these questions may require new conventions for resolving conflict-of-laws issues. ISDA encourages national authorities to ensure clear legal frameworks are in place for defining the property status of digital assets and supports the ongoing work and consultations administered by national authorities like the UK Law Commission and international organizations, such as the International Institute for the Unification of Private Law (UNIDROIT).

Regardless of how these important legal questions are ultimately resolved, the asset holding structures and practical steps described in this paper are likely to continue to be necessary to protect customers from the consequences of a digital asset intermediary insolvency. ISDA encourages digital asset intermediaries, customers and regulators to review current practices and address any identified gaps to reduce the likelihood of a future collapse causing significant harm to market participants.