Crypto update: ASIC seeks consultation on exchange traded products investing in crypto-assets

By John Bassilios and Kai Liu

With crypto-asset exchange traded products (ETPs) attracting significant attention globally, ASIC has now released Consultation Paper 343 Crypto-assets as underlying assets for ETPs and other investment products (CP 343).

ASIC is aware of interest in, and demand for, domestic crypto-asset ETPs. However, ASIC notes that there is real risk of harm to consumers and markets if these products are not developed and operated properly.

ASIC considers that crypto-asset ETPs have novel and unique features that require consideration of whether such products can support fair, orderly and transparent markets and comply with our regulatory framework. Similar issues have been, or are being, actively considered by other jurisdictions in the context of their regulatory frameworks.

ASIC has announced a series of proposed amendments to regulations which govern ETPs, including market operators, responsible entities, listed investment entities and AFS licensing matters. In CP 343, ASIC is seeking feedback on its proposed amendments and has set out proposed guidance and specific questions that it is seeking responses to.

ASIC is requesting responses to CP 343 by Tuesday 27 July 2021.

We set out below both the ASIC proposals and the feedback that ASIC is seeking, and our views in respect of these proposals.

INFO 230 amendments

Outline

ASIC Information Sheet INFO 230 sets out the guidelines for licensed Australian exchanges that admit exchange traded products (ETP) a class of products which include certain managed investment schemes, exchanged traded funds and structured products.

Under CP 343, ASIC has set out a proposed good practice guideline for product issuers and Australian market licensees about how ETPs which invest in crypto-assets can meet the expectations of ETPs as set out in INFO 230.

These proposals can be broadly placed into two categories, being:

1. the suitability of crypto-assets and identifying features; and
2. robust and transparent pricing mechanisms.

Suitability of crypto-assets

We set out below the proposal and the feedback sought by ASIC.

No.	Proposal	Feedback sought
1.	Proposal B1: The proposal is to establish the following factors as the basis to identify whether a crypto-asset is appropriate to be an underlying asset for an ETP. A high level of institutional support and acceptance of the crypto asset being used for investment purposes The availability and willingness of service providers to support ETPs that invest in, or provide exposure to, the crypto-asset A mature spot market for the crypto-asset A regulated futures market for trading derivatives linked to the crypto asset The availability of robust and transparent pricing mechanisms for the crypto-asset, both throughout the trading day and to strike a daily net asset valuation (NAV) price	Should crypto-asset ETPs be available to retail investors through licensed Australian markets? Should ETPs be cleared and settled through licensed Australian clearing and settlement facilities? If you are a clearing participant, would you be willing to clear crypto-asset ETPs? If you are a trading participant, would you be willing to trade crypto-asset ETPs? Do you agree with ASIC’s approach to determine whether certain crypto assets are appropriate underlying assets for ETPs on Australian markets? Do you have any suggestions for additions or modifications to the factors in proposal B1? Do you have any suggestions for alternative mechanisms or principles that could achieve a similar outcome to the approach set out in proposal B1?
2.	Proposal B2: The proposal is for ASIC to work with Australian market licensees to establish a new category of permissible underlying asset for crypto-assets that, at a minimum, is consistent with the factors set out in proposal B1.	Do you agree that a new category of permissible underlying asset ought to be established by market operators for crypto-assets?

 

In short, ASIC’s position is that not all crypto-assets are appropriate underlying assets for an ETP, and is of the view that a principles based approach should be used to determine whether a crypto-asset is appropriate to be an underlying asset of an ETP. In particular, ASIC considers that an assessment should be made as to whether the asset is able to support the fair, orderly, and transparent operation of the relevant financial market.

ASIC considers that market licensees are primarily responsible for making this assessment, as they are the primary gatekeepers for product admission.

ASIC has additionally highlighted the following matters as requiring further consideration in respect of this proposal.

Mature spot market

ASIC is of the view that a holistic assessment of the state of the relevant spot market for the crypto asset should be conducted, with a focus on a variety of factors, including:

1. the value and frequency of trading activity across platforms;
2. the level of trading fees and bid-offer spreads;
3. the diversity of buyers and sellers;
4. the extent to which trading activity takes place on platforms that have policies and procedures to promote fair, orderly, and transparent trading activity; and
5. the effectiveness of arbitrage activity and consistency of pricing across major platforms.

Regulated futures market

ASIC considers that the relevant standard of regulation should be that of a licensed derivatives market, which is:

1. required to maintain a fair, orderly and transparent market; and
2. subject to oversight by a financial markets regulator.

Under the approach suggested by ASIC, market operators could determine that a particular crypto-asset is an appropriate underlying asset for ETPs on their market. ASIC has indicated that it would not object to that determination, provided that the market operator has demonstrated that the crypto-asset satisfies the factors in proposal B1.

Importantly, ASIC has stated that the only crypto-assets that are likely to satisfy these factors are bitcoin (BTC) and ether (ETH).

ASIC considers that it would be good practice for a market operator to assess whether the ETP’s custody solution is consistent with proposal C1 and that its risk management system is consistent with proposal C2.

Permissible underlying assets

ASIC notes in CP 343 that it considers that the establishment of a new category of permissible underlying crypto-assets is the appropriate way to facilitate ETPs that invest in these assets.

Currently, ASIC is agnostic as to whether the relevant category should be an ‘approved assets’ list or is defined in reference to the factors in B1.

ASIC is aware that this would require market operators to amend their operating rules. It proposes to work with Australian market licensees to establish the precise parameters of the category.

Hall & Wilcox’s view

It is clear from ASIC’s proposals and the rationale for these proposals that ASIC is of the view that transparent pricing and perceived volatility in the crypto-asset market renders the majority of crypto-assets as inappropriate underlying assets for ETPs that are offered to retail investors.

In particular, ASIC’s statement that the only crypto-assets which are likely to satisfy the factors identified in B1 are BTC and ETH suggests that ASIC has taken the position that broad adoption and trading of the relevant asset will be necessary to enter a crypto-asset on the permissible underlying asset list for a market operator.

We welcome any proposal which would increase clarity with respect of what is and is not permitted in respect of crypto-assets. However, we query the need for a regulated futures market for trading derivatives linked to the crypto asset and that adopting a set of regulations which overly restricts access by retail consumers to structured crypto-asset investment products could potentially increase overall risk to retail consumers by driving them towards investing in higher-risk crypto-assets directly.

Robust and transparent pricing mechanisms

We set out below the proposal and the feedback sought by ASIC.

No.	Proposal	Feedback sought
3.	Proposal B3: The proposal is to establish the following good practices in relation to demonstrating a robust and transparent pricing mechanism: The basis of the pricing mechanism for crypto-assets held by an ETP should be an index published by a widely regarded provider that: reflects a substantial proportion of trading activity in the relevant pair(s) in a representative and unbiased manner; is designed to be resistant to manipulation; complies with recognized index selection principles such as the International Organization of Securities Commission (IOSCO) Principles for financial benchmarks, the EU Benchmarks Regulation, or other internationally recognized index selection principles; and pricing mechanisms which rely on a single crypto-asset spot market would be unable to achieve robust and transparent pricing.	Do you agree with the good practices in proposal B3 in respect of the pricing mechanisms of underlying crypto assets? Are there any practical problems associated with this approach? Do you think crypto-assets can be priced to a robust and transparent standard? Do you consider that a more robust and transparent pricing standard is achievable in relation to crypto assets, such as, for example, by using quoted derivatives on a regulated market?

 

ASIC’s view is that the underlying assets of an ETP should have robust and transparent pricing mechanisms, as this provides retail investors confidence that they can transact in the ETP units at a price at or around the NAV of the underlying investment portfolio.

ASIC has identified three unique challenges to pricing crypto-assets:

1. the number and variety of trading platforms on which crypto-assets trade on, and the different trading pairs with other crypto-assets or fiat currency creates price divergence across markets and trading pairs;
2. most crypto-asset trading platforms are generally not required to have rules and practices to maintain fair, orderly, and transparent markets, and are generally not subject to oversight by financial markets regulators; and
3. the difficulty of valuing crypto-assets based on fundamentals that are commonly applied to other types of investment assets renders crypto-asset trading platforms more susceptible to price manipulation risk than most other markets.

ASIC references a number of studies which found that price discovery of crypto-assets is led by unregulated futures, perpetual swap, and spot markets for crypto-assets, rather than regulated future markets, and platforms with higher trading activity have larger contributions to price discovery. However, ASIC identified two issues in respect of the literature which was reviewed:

1. there was no established consensus between studies, though most studies came to the conclusion identified above; and
2. most of the research in the area is based on data available prior to the large increase to BTC futures trading on the CME market in late 2020. Given the statement above that platforms with higher trading activity have larger contributions to price discovery, it would be expected that a large enough increase on a particular market would have the potential to obsolete previous studies.

ASIC further notes that research examining statistical anomalies in trading activity has identified evidence of potential market manipulation and other integrity concerns in crypto-asset trading platforms.

In sum, ASIC considers that a pricing mechanism for crypto-assets that could meet the requirements in INFO 230 could be demonstrated by using an index to strike a daily NAV price, and provide an intraday indicative net asset value if a product issuer decides to make this available.

ASIC’s view is that the product issuer should not rely on a single crypto-asset spot market in order to determine a pricing mechanism, as such a mechanism is subject to a greater level of operational risk, is less resistant to manipulation and the pricing generated by the mechanism would be reflective of trading in that crypto-asset on that relevant spot market, rather than the crypto-asset generally.

ASIC considers that such a position is distinguishable from pricing mechanisms used by existing ETPs which rely on a single spot market, as those markets are regulated financial markets that are subject to significant regulatory oversight and monitoring.

Hall & Wilcox’s view

While ASIC’s rationale for their proposed pricing mechanism reform is well reasoned and justified, the shortcoming of the studies which have been identified by ASIC warrants a review and return to this policy once more data on the impact of the CME market on the pricing of BTC is available. In particular, this is one area which should be constantly reviewed as crypto-asset trading platforms mature, and as more regulators begin to exercise oversight over the industry.

No other INFO 230 related guidance

No.	Proposal	Feedback sought
4.	Proposal B4: The proposal is that ASIC does not include any further expectations in INFO 230 in relation to crypto-asset ETPs	Are there any other good practice expectations in INFO 230 that need to be clarified or modified to accommodate crypto-asset ETPs?

 

Responsible entity obligations

Custody

ASIC considers that crypto-assets are sufficiently unique such that specialized infrastructure and expertise is required by custodians to hold crypto-assets safely and securely.

No.	Proposal	Feedback sought
5.	Proposal C1: The proposal is for ASIC to establish a range of good practices for Responsible entities (RE) in relation to the custody of crypto-assets, as set out below. The chosen custodian has specialist expertise and infrastructure relating to crypto-asset custody. The crypto-assets are segregated on the blockchain. The private keys used to access the scheme’s crypto-assets are generated and stored in a way that minimizes the risk of unauthorised access. Multi-signature or sharding-based signing approaches are used, rather than ‘single private key’ approaches. Custodians have robust systems and practices for the receipt, validation, review, reporting and execution of instructions from the RE. REs and custodians have robust cyber and physical security practices with respect to their operations, including appropriate internal governance and controls, risk management, and business continuity practices. The systems and organizational controls of the custodian are independently verified to an appropriate standard – for example, through a SOC2 Type II or equivalent report. REs and custodians have an appropriate compensation system in place if a crypto-asset held in custody for REs is lost. If an external or sub-custodian is used, REs should have the appropriate competencies to assess the custodian’s compliance with RG 133.	Do you agree with our proposed good practices in relation to the custody of crypto-assets? Are there any practical problems associated with this approach? Do you consider there should be any modifications to the set of good practices? Do you consider that crypto-assets can be held in custody, safely and securely? Do you have any suggestions for alternative mechanisms or principles that could replace some or all of the good practices set out in proposal C1? Should similar requirements to proposal C1 also be implemented through a market operator’s regulatory framework for ETPs?

 

ASIC considers that a number of additional responsibilities are required when providing custodial and depository services in respect of crypto-assets. In particular, ASIC identifies the security of private keys, and ensure that the private keys are protected from unauthorized access, both online and offline.

ASIC also considers that multi-signature signing approaches should be used, rather than single private key approaches, with a quorum of keys required to sign a given transaction.

Additionally, ASIC’s position is that processes which govern the receipt, validation, review, and execution of customer instructions should include permissioning such that no one party has control over the entire process. Where a product is structured such that it only needs to deal with a certain number of pre-defined addresses, a whitelisting approach should be taken.

Hall & Wilcox’s view

We agree in principle with ASIC’s general approach in respect of multi-signature signing approaches and ensuring that custody over crypto-assets is secure. However, we note that the proposal for the chosen custodian to have specialist expertise and infrastructure relating to crypto-asset custody should be clarified. Clarification is required so that there is not an unintended effect of freezing out competent custodians who would be able to put in place robust arrangements with respect to custody over crypto-assets by bringing in the relevant expertise, where a custodian is implementing its arrangements in respect of crypto-assets for the first time.

Additionally, where a particular ETP has a trading strategy which may rely on executing trades in a timely fashion, the stringent custodial requirements as set out above may not provide sufficient flexibility to allow such a strategy to be implemented, and as such we are of the view that single private key approaches should be allowable in specific circumstances, provided that the RE and the custodian are aware of, and have made arrangements to manage, the risks involved with such a structure.

In our experience, AFSL holders and responsible entities in particular are having difficulty in sourcing appropriate insurance with many insurer having specific crypto asset exclusions in their policies for investment management professional indemnity insurance.

Risk management

We set out below the proposal from ASIC

No.	Proposal	Feedback sought
6.	Proposal C2: The proposal is for ASIC to establish a range of good practices for REs in relation to the risk management systems in respect of crypto assets. If the RE undertakes trading activity in crypto assets, it should do so on legally compliant and regulated crypto-asset trading platforms. For this proposal, ASIC considers that an appropriate baseline level of regulation to be know your customer (KYC) and anti-money laundering and counter-terrorism financing (AML/CTF) obligations. The RE should ensure that authorised participants, market makers and other service providers that trade crypto-assets in connection with the product do so on crypto-asset trading platforms that meet the same standard as in the proposal above. The RE is responsible for ensuring its risk management systems appropriately manage all other risks posed by crypto-assets.	Do you agree with our proposed good practices in relation to risk management systems for REs that hold crypto assets? Are there any other regulations (other than KYC and AML/CTF) that should form part of an appropriate baseline level of regulation for crypto-asset trading platforms used by REs and connected service providers? Are there any practical problems associated with this approach? Are there any other matters relating to holding crypto-assets that ought to be recognised in the risk management systems of REs and highlighted through ASIC good practice information? Should similar requirements to proposal C2 also be imposed through a market operator’s regulatory framework for ETPs?

 

ASIC’s proposals focus primarily on the KYC and AML/CTF obligations and regulations which crypto-asset trading platforms are subject to. ASIC’s primary concern appears to be to ensure that REs have systems in place to ensure that crypto-asset trading activity they engage in takes place on legally compliant and regulated crypto-asset trading platforms.

ASIC’s proposed minimum requirements are to ensure that trading platforms which are utilised are based in jurisdictions with KYC and AML/CTF laws, and that they comply with those obligations.

Hall & Wilcox’s view

In our view, ASIC’s identified minimum requirements is an appropriate place to set the bar. Ensuring that crypto-assets are traded on platforms which are subject to KYC and AML/CTF laws will also assist with REs obligations to review and monitor their own AML/CTF obligations and risks.

We do not consider that any regulations other than KYC and AML/CTF should form part of the baseline level of regulation for crypto-asset trading platforms utilised by REs.

Disclosure

We set out below the proposal from ASIC

No.	Proposal	Feedback sought
7.	Proposal C3: The proposal is for ASIC to establish a range of good practices for REs in relation to the product disclosure statement (PDS) for a registered MIS that holds crypto-assets. The RE should consider disclosing information about the unique characteristics of crypto assets.  This may include:  the technologies that underpin crypto-assets, such as blockchains, distributed ledger technology, cryptography and others;  how crypto-assets are created, transferred and destroyed;  how crypto-assets are valued and traded; and how crypto-assets are held in custody. The RE should consider providing appropriate disclosure of the following and other risks: market risk – highlighting the historic volatility of crypto-assets;  pricing risks – highlighting the difficulty in valuing crypto-assets accurately; immutability – highlighting the immutable nature of blockchains and the difficulty in reversing unauthorised transfer; increased regulation risks – highlighting the potential for increased regulation in the future; custody risk; cyber risk; and environmental risk – highlighting the risk that crypto-assets may require significant amounts of energy to operate.	Do you agree with ASIC’s proposed expectations regarding disclosure obligations for registered MIS that hold crypto-assets? Are there any practical problems associated with this approach? Are there any additional categories of risks that ought to be specified by ASIC as good practice for disclosure in relation to registered MIS that hold crypto-assets?

 

ASIC considers that a PDS for a crypto-asset fund should have sufficient risk disclosure specific to crypto-assets to enable a retail client to make an informed decision about whether to purchase a financial product. Importantly, ASIC does not propose to mandate certain disclosures or provide examples of ‘correct’ disclosure with respect to crypto assets.

Hall & Wilcox’s view

In our experience, all disclosure documentation for products which invest into crypto-assets should already contain risk disclosure which covers off the matters identified in proposal C3, and as such we support ASIC’s proposal.

Design and distribution obligations (DDO)

No.	Proposal	Feedback sought
8.	Proposal C4: The proposal is that ASIC does not include any further expectations about how the DDO can be met for investment products that invest in, or provide exposure to, crypto-assets	Are there any aspects of the DDO regime that need to be clarified for investment products that invest in, or provide exposure to, crypto-assets?

 

ASIC considers that the existing guidance in RG 274, the Corporations Regulations, and ASIC Corporations (Design and Distribution Obligations – Exchange Traded Products) Instrument 2020/1090 already provides sufficient guidance with respect to DDO as they relate to ETPs that invest into crypto-assets.

Hall & Wilcox’s view

We agree with ASIC that no further guidance is required in respect of DDO as they relate to ETPs that invest into crypto-assets.

Listed investment entities

We set out below the proposal from ASIC

No.	Proposal	Feedback sought
9.	Proposal D1: The proposal is for ASIC to work with market operators to establish that: the approach used to determine and classify appropriate crypto-assets for investment entities is the same as that set out in Section B for ETPs; in respect of the admission process, to be considered to have a structure and operations that are appropriate for a listed entity, a listed investment company (LIC) that invests a material amount in crypto-assets is expected to: have a custody solution for its crypto-assets that is consistent with the expectations for custody set out in proposal C1; ensure that it only trades crypto-assets on crypto-asset markets that are regulated in a manner consistent with proposal C2; and value crypto-asset held by the LIC using an approach that is consistent with expectations for pricing set out in proposal B3; in respect of the admission process, to be considered to have a structure and operations that are appropriate for a listed entity, a listed investment trust (LIT) that invests a material amount in crypto-assets should values crypto-assets held by the LIT using an approach that is consistent with expectations for pricing set out in proposal B3; and the expectations for the admission of LICs and LITs set out in points 2 and 3 above should also be ongoing requirements for listing.	Do you agree that crypto-assets are capable of being appropriate assets for listed investment entities on Australian markets? Do you agree with ASIC’s proposed expectations for LICs and LITs that invest in crypto-assets to ensure equivalent standards are applied by market operators? Are there any practical problems associated with this approach? Are there any additional standards which ought to apply via market operators to LICs or LITs that invest in crypto-assets? Should LICs and LITs only be able to invest significant funds in crypto-assets if this is either set out in their investment mandate or with member approval? For the purposes of this proposal, we consider a material investment is where an entity invests or plans to invest more than 5% of its funds in crypto-assets.  Should another materiality threshold apply?

 

ASIC’s proposals represent a change to the way in which LICs and LITs have been regulated to date as they relate to investments into crypto-assets. Until now, LITs and LICs have not been able to invest significant funds directly into crypto-assets. ASIC has now recognised LITs and LICs as another way to provide investors with exposure to crypto-assets.

ASIC’s proposal is to subject LICs and LITs to the same crypto-assets that meet the factors set out in proposal B1. Additionally, responsible entities for LITs should be required to comply with the expectations as set out in section 3 above.  Proposal C3 as they relate to PDS disclosure would also be relevant to prospectus disclosure under section 710 of the Corporations Act.

Directors of LICs would also need to ensure they act in shareholders’ best interests with important issues, such as the safekeeping of assets. Reliable pricing and valuation of crypto-assets are also important for investment entities’ NTA and statutory financial reporting obligations.

ASIC also considers that investment entities which are seeking to invest into crypto-assets should seek member approval to amend their investment mandate to allow an investment into the relevant crypto-asset, if the investment plan does not already clearly extend to crypto-assets.

Additionally, ASIC takes the view that market licensees should consider that the entity should re-comply with admission requirements on the basis that crypto-asset investment constitutes a significant change to the entity’s activities.

Hall & Wilcox’s view

In general, we welcome the change to LIT and LIC regulations to allow the amendment of investment mandates to allow investment into crypto-assets. Additionally, we agree with ASIC’s approach to apply the same standards and requirements (as relevant) to LICs and LITs in respect of crypto-asset investment.

ASIC has recommended a 5% of total investment materiality threshold with respect to the investments of a LIC or a LIT. We consider that this amount is reasonable, but it should be clarified that where an investment was made when it was less than 5% but increased in value so that it became more than 5% then investor approval would not be required.

In terms of questions relating to investment mandates, whilst we agree that an investment into a crypto-asset is a different proposition to more traditional investments, we do not necessarily agree that an amendment to an investment mandate is necessary in all instances if it does not ‘clearly extend’ to crypto-assets as crypto assets may still be captured by the terms of the mandate.

AFS licensing

We set out below the proposal from ASIC

No.	Proposal	Feedback sought
10.	Proposal E1: The proposal is for ASIC to establish a new asset kind that can be selected when applying for a new AFS licence, or a variation to an existing AFS licence, to operate a registered managed investment scheme which holds a particular kind of asset. This asset kind will cover crypto-assets.	Do you agree with ASIC’s proposal to establish a new asset kind that will cover crypto-assets? Do you consider that crypto-assets may be captured by the existing asset kinds?
11.	Proposal E2: The proposal is for ASIC to restrict the granting of an AFS licensee’s authorisation to operate a registered MIS which holds crypto-assets by reference to the factors set out in proposal B1. Accordingly, at this point in time, ASIC considers that such authorisations could only be given to operate registered MIS schemes that hold BTC or ETH.	Do you agree with our approach to restrict the crypto-assets a registered managed investment scheme is authorised to hold (ie to BTC or ETH)? Do you consider there are any other aspects of the AFS licensing regime that need to be clarified or modified to accommodate investment products that invest in, or provide exposure to, crypto-assets?

 

When applying for an AFS licence to operate a registered managed investment scheme and when applying to register a scheme, AFS licensees must nominate the type of asset which the registered managed investment scheme will hold. ASIC is proposing to introduce a new asset type because, in ASIC’s view, none of the existing options are appropriate for crypto-assets.

Additionally, ASIC is of the view that, while it will provide a broad definition of ‘crypto-asset‘, it will restrict any such authorisation to specific crypto-assets which comply with those factors set out in proposal B1, functionally limiting such to BTC and ETH.

Hall & Wilcox’s view

On a practical level, we note that ASIC’s organisational competency requirements with respect to AFS licences typically requires three out of the last five years’ experience with the relevant financial product, generally under licence. To the extent that new authorisations and categories are to be added, we consider that ASIC must include a grace period by which organisations can include experience gained with crypto-assets under previous regulatory guidance as experience for this new authorisation.

Conclusion

Overall, we consider these proposals to be a positive step forwards, and another sign of the growing maturity of the crypto-asset market.

Hall & Wilcox is able to assist organisations wishing to submit a response to CP 343.