A new regulatory framework for digital asset service providers is currently under consultation, following the release of the Regulating Digital Asset Platforms Proposal Paper October 2023 (Consultation Paper). It is proposed that digital assets be regulated within the existing Australian financial services licence (AFSL) framework.
The Consultation Paper is the next step in developing and embedding a robust regulatory framework for digital assets in Australia. The proposed regulatory framework would be the first of its kind in Australia; however, several issues need to be addressed. This article highlights the issues that should be raised as part of the consultation process. It is critical that industry takes this opportunity to identify concerns and provide guidance to Treasury on alternate solutions that will support the crypto industry in Australia, as there are no guarantees of further rounds of consultation prior to draft legislation.
What activities will be regulated?
Asset holding will be the key regulated activity. Any entity that holds digital assets (or assets backing digital assets, in cases where real-world assets are tokenised) will be a “digital asset facility”, which will be a new type of financial product under the Corporations Act 2001 (Cth). Anyone operating a digital asset facility (DAF) will need to hold an AFSL with certain authorisations and comply with a number of bespoke regulatory requirements.
In addition to the holding of assets, certain ’financialised functions’ in relation to digital assets (which are not financial products) will be regulated. These financialised functions are digital asset trading, token staking, asset tokenisation, and crowd funding. These financialised functions will also be subject to bespoke regulatory requirements.
There is no current proposal to regulate digital assets that are not financial products, and any digital assets that are financial products will continue to be subject to the current financial services regime.
What is asset holding?
The concept of ‘factual control’ is proposed as the threshold to determine if a person is holding assets and is therefore a DAF. We don’t have any issues with the use of ‘factual control’ as such, and we believe in general this a good yardstick for asset holding.
However, the concept of ‘asset holding’ needs to be further clarified and defined, particularly in light of the different business models in the market. For example, under the broking model, a broker may not provide a wallet and doesn’t hold assets for customers, but when broking a transaction, they may have temporary custody of tokens between the exchange and the customer. At the moment, it appears this will trigger regulation as a DAF. We are not convinced this is appropriate and consider there are alternate models to address the risks. One option may be to impose client asset rules (similar to client money rules) to provide guardrails around temporary custody. For example, all assets must be held in a designated trust wallet, the assets can only be held for a limited time (i.e. 5 days) and customers must provide a wallet address at the time a transaction is instructed to enable the timely transfer of tokens.
It is also possible that Decentralised Autonomous Organisations (DAO) may be caught by the regulatory regime if they are not sufficiently decentralised and can exercise factual control via transaction validation or governance proposals. This needs to be explored further as it may dampen Australian innovation efforts and give rise to potential enforcement issues. For example, Australian innovators may be less likely to launch DAOs onshore as it can take some time for a DAO to sufficiently decentralise (i.e. have a large number of unique nodes/validators across a range of geographies). It may also disincentivise Australians from participating in DAOs if there is a risk that their activities will be caught and may give rise to some form of personal liability. We recommend that industry (particularly, DeFI and web3 businesses) consider the proposals and highlight any concerns and potential solutions.
Is the low value exemption appropriate?
DAFs that hold assets below certain limits are proposed to be exempt from the requirement to hold an AFSL if:
- the total value of DAF entitlements held by any one client of the platform provider does not exceed $1,500 at any one time; and
- the total amount of assets held by the DAF provider does not exceed $5 million at any time.
This exemption is based on the exemption for non-cash payment facilities; however, while we support the notion of an exemption, we query whether the limits proposed are appropriate for DAFs. This is because the exemption for non-cash payment facilities is based on transactions in process – that is, there is a dollar limit per transaction and a total dollar limit for all transactions currently being processed. While a transaction is in processing, it counts towards the limit. Once the transaction completes processing, that part of the limit becomes available again to be re-used. This approach doesn’t necessarily suit an asset holding arrangement as the function is not transactional, but rather static.
For this reason, in our view, there should not be any individual account limits, and additionally we query what is an appropriate total limit for DAFs. A good starting point may be the current and proposed dollar limits for store value facilities which, as an arrangement that holds fiat indefinitely until an instruction is received, seems more analogous to a token asset holding arrangement.
Another important issue is how to value the total assets of a DAF given a DAF will hold assets which may be illiquid or volatile. Providers of non-cash payment facilities and stored value facilities can easily operate within limits as the value of the assets (being fiat currency) does not generally change, whereas a DAF could exceed the limit for no other reason that because the market has a good day.
A more appropriate method might be to allow for a buffer by which the assets can exceed the threshold, by performing the calculation over a rolling period (for example, a 30, 60 or 90-day rolling average) and/or a grace period to rectify exceeding the threshold before a breach occurs.
What licence authorisations are required?
Specific authorisations have not been proposed at this stage (as this will be a matter for ASIC), but we do know that a DAF provider will require an AFSL and any person who provides financial services in respect of a DAF will also need an AFSL. This conceptually make sense, however, our view is that certain amendments will need to be made to the Corporations Act to better cater for DAFs.
For digital asset facility providers, we recommend that they be required to have an authorisation to “operate” a facility (similar to the authorisation for registered managed investment schemes). In addition, we recommend that a specific dealing definition be included to capture the proposed regulated financialised functions. That is, at present, the concept of dealing in a financial product is unlikely to capture transactions performed through a DAF, so changes will need to be made to bring this inside the definition.
Further, the Consultation Paper captures intermediaries who facilitate trades or advise in respect of DAFs. Our understanding is that the regulation of advice will apply at the DAF level (not at the digital asset level) such that intermediaries have obligations when recommending the use of a given DAF for asset holding or one of the financialised functions, but not when recommending the tokens the subject of any trade. Any intermediated digital asset transaction on a DAF will also be caught as a financial service because token trading is one of the regulated financialised functions (provided the dealing definition is amended as discussed earlier in this article).
We consider that it is appropriate to replicate the approach taken for insurance intermediaries, where the intermediary can act as agent for the product issuer or customer.
Does the NTA calculation work?
A DAF is proposed to need to hold $5 million net tangible assets (NTA) unless the facility outsources custody. If the facility outsources custody, the facility will still need to hold 0.5% of the value of the DAF. This amount is considered appropriate to cover the administrative costs of an orderly wind-up, so it is unlikely to change unless it can be shown that the costs of an orderly wind up of a crypto business are higher or lower so as to justify a higher or lower NTA requirement.
It is unclear how the ‘value’ of the DAF will be calculated. Presumably, the value of all tokens in an asset holding arrangement need to be counted, even if custody has been outsourced. Accordingly, there will be the same issue with valuing the assets of the DAF for the purposes of the NTA calculation as we highlighted for the low value exemption above. That is, if assets are illiquid or volatile, what value is to be attributed to them.
Does the proposed approach to custody work?
Based on the current proposal, DAF providers will still be required to hold $5 million NTA if they outsource custody to someone who is not licensed in Australia. We suspect that this will raise issues for global businesses and local businesses who need to access global custody solutions, especially given there currently is no local market for digital asset custody in Australia. We propose that an approach similar to APRA’s CPS 231 Outsourcing should be considered, so that businesses have the option to custody overseas provided they ensure certain minimum protections are in place.
In addition, it is suggested that customers will need to contract directly with the custodian. This is highly unusual and does not reflect current outsourcing models in the financial services industry. This requirement is a major disincentive to outsourcing custody and it removes any control the DAF has over its custody provider. We suspect the intent behind this is to protect customer assets in the event of insolvency. In our view, there are better ways to address this, and this could include robust client asset rules (similar to client money rules) that protect assets in liquidation, asset segregation and ring-fencing rules and providing customer step-in rights in certain circumstances.
Platforms that offer multiple digital asset facilities
Under the proposal, each DAF can only offer one service, for example, custody and each financialised function needs to be offered through a separate DAF.
In our view, this is clunky and doesn’t recognise the fact that the financialised functions are offered due to the very fact the DAF holds the digital assets. This is because many of the financialised functions flow from asset holding.
We propose that a DAF should be able to hold digital assets and also provide token trading and token staking functionality. However, we do agree that each asset tokenisation and crowd funding project should be separate DAFs and separately comply with the proposed requirements.
The Consultation Paper also refers to the fact that a multi-facility platform may have DAFs that are provided by different facility providers. We are not aware of any platform that currently operates like this, outside of the case where different entities within a corporate group provide specific functions. If this is the case, we wonder whether this is simply an outsourcing arrangement or involves the provision of separate facilities provided by different entities. This is something that industry may wish to clarify or comment on.
Different market rules are proposed for digital assets that are not financial products. Industry may wish to raise any concerns they have with these market rules and whether they are appropriate given the way in which crypto markets operate. That is, what are the specific risks associated with crypto trading and markets and do the proposed requirements appropriately address that risk?
In addition, there is the question as to what market rules apply where a digital asset that is not a financial product is exchanged for a digital asset that is a financial product that is subject to usual market rules. This is a matter that requires further thought especially as TradFI merges with DeFI.
Businesses that wish to tokenise assets will need to hold an AFSL as a DAF because they will hold in custody the assets that back the tokens and will perform the financialised function of asset tokenisation. In our view, it is appropriate for token issuers to be able to operate their own DAF for their asset tokenisation project.
Once an asset backed token has been minted, any platform that facilitates trading or token staking in respect of that asset-backed token will also be a DAF and will need to hold an AFSL and comply with the proposed regulatory requirements.
In our view, it is appropriate for all DAFs involved in the digital asset value chain to be subject to the proposed regulatory regime.
Any projects that wish to raise funds via a token issue will be intermediated via a DAF and subject to several requirements. This approach is similar to the crowd funding regime in Chapter 7 of the Corporations Act. However, the financialised function of crowdfunding does not facilitate direct capital raises similar to those permitted under Chapter 6C of the Corporations Act, which involve the issue or sale of securities (which are financial products) as these will remain regulated as financial products.
This proposal may impact how industry currently funds crypto projects and may result in the outflow of crypto projects offshore. We suggest that industry consider this and raise any issues they foresee with this approach and pose alternate solutions that seek to redress customer risk (i.e. pump and dump schemes).
An alternative approach may be to enable projects to directly raise capital via an initial coin offering (ICO) without a DAF licence, provided the project will not hold any of the tokens issued as part of the ICO (i.e. provide a custodial wallet), on a basis that is similar to the self-dealing exemption for capital raises. If a project will hold tokens issued as part of an ICO, then it would make sense for the project to be regulated as a DAF and comply with the proposed licensing and regulatory requirements.
If a self-dealing exemption is permitted for ICOs as suggested, the question arises whether any limits on the total number or value of tokens issued or sold via an ICO should be imposed. This is because the current self-dealing exemption for securities is predicted on the basis that the capital raise is not a ‘public offer’. As ICOs are usually public, replicating a public offer requirement may be challenging. Accordingly, limits or caps may be more suitable. Industry may wish to comment on the viability of this option and what industry considers to be appropriate caps or limits.
In circumstances where an ICO may be launched outside of a DAF, it will be important to consider whether and what disclosures should be mandated. For security capital raises, a prospectus is required unless an exemption applies. For ICOs, it may be appropriate to require a shortform and basic disclosure document subject to exemptions. For example, a disclosure document may not be required if the project raises funds under a dollar threshold or from certain investors (i.e. wholesale, sophisticated or professional clients). Similar exemptions currently exist for securities and may be a helpful starting point.
We also believe it is worthwhile considering whether any required disclosure for an ICO (whether direct or intermediated via a platform), should be subject to the same disclosure requirements. This will provide consistency with project fundraising and mitigate any potential regulatory arbitrage.
Where to next?
This Consultation Paper is a critical step in the pathway to regulation for the crypto industry. Industry must take the opportunity to consider, pause and reflect on the proposals, and raise any questions or concerns. There may not be another opportunity to be heard until draft legislation is released, at which point it may be too late to raise major structural concerns.
Hamilton Locke will be preparing a submission to the Consultation Paper and will also be supporting industry submissions.
Please reach out if you have any questions about this blog, the Consultation Paper or would like to discuss how the proposals may impact your business. We would be happy to make a time to chat with you.
For more information, please contact Michele Levine and Jaime Lumsden.