What are Australia’s digital asset custody requirements?

Please note that this article was first published on Zodia Custody.

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As discussed in the first blog in this series, “Will you be custodying digital assets?“, anyone who has factual control of digital assets will, under changes proposed by the Australian Treasury in the Regulating Digital Asset Platforms Consultation Paper, be providing a financial service and will be subject to requirements for a digital asset facility (DAF).

The current proposal is that DAFs will need to meet the minimum standards for asset holding.  There’s not much detail about the minimum standards but it appears they will include:

• A requirement to hold digital assets on trust

• A net tangible assets (NTA) requirement

• Other financial requirements including a solvency and positive net assets requirement and cash needs requirement

• Requirements relating to adequate organisation structure, staffing capabilities, and capacity and resources to perform core administrative activities.

What does it mean to hold digital assets on trust?

In a digital asset context, holding assets on trust essentially means that the DAF provider will hold the private key for the digital assets. By holding the private key, the DAF provider essentially holds legal title to the digital assets on behalf of its customers. Customers are beneficially entitled to those digital assets and this entitlement is reflected in the DAF provider’s records. These records are normally kept in ledgers which identify what digital assets are credited to a customer’s account.

What is the NTA requirement?

Treasury’s Consultation Paper proposes that DAF providers will be required to hold NTA of at least:

• 0.5% of the value of the DAF (if using a sub custodian digital asset facility that has $5 million NTA); or

• $5 million (if performing the custody function itself).

This requirement is broadly based on the NTA requirements for margin lending facilities. It is unclear why this approach was adopted, especially given that DAFs are more akin to platforms and schemes given the trust requirements that will apply.

Net tangible assets is not defined in the Consultation Paper, but it is likely to have the same meaning as in ASIC RG 166, which sets out the financial requirements for AFS licensees. Net tangible assets are essentially all your unencumbered assets, less your liabilities, and there is a formula for determining this in ASIC RG 166.

We expect that at least some of the NTA must be held in cash or cash equivalents, with the remainder to be liquid assets. There isn’t much detail on this in the Consultation Paper, and presently RG c166 prescribes no cash equivalents or liquid assets rules for NTA for margin lending facilities, so we’ve had reference to these requirements in ASIC RG 166 for funds, IDPS operators, and custodians, who all have a cash equivalents and liquid assets rule. This means it is likely that the DAF NTA must be:

• held as:
  • at least 50% as cash or cash equivalents, such as:
    • cash on hand, demand deposits and money deposited with an Australian ADI that is available for immediate withdrawal;
    •  short-term, highly liquid investments that are readily convertible to known amounts of cash that are subject to an insignificant risk of changes in value;
    • certain specific financial undertakings or commitments made by third parties and which are permitted by ASIC; and
  • the balance of the NTA in assets where the market value can reasonably be expected to be realised within 6 months.

However, as no detail has been provided in the Consultation Paper, it is possible that Treasury or ASIC could propose different cash equivalent and liquid asset rules for DAFs. It will be interesting to see if stablecoins will be permitted and, if so, what requirements will apply.

The rationale for the NTA obligation is to:

• address the costs of an orderly wind-up in the event the DAF provider fails (i.e. to provide a financial buffer to decrease the risk of a disorderly or non-compliant wind-up);

• balance the need to avoid concentration of digital assets among a small number of custodians with the need to ensure robust NTA; and
• ensure that as a facility expands, and the operational risk exposure of the platform provider grows, the provider will maintain a corresponding level of financial resources.

Look out for part 3 in this series “Should you custody digital assets?”.