Cryptocurrency exchange faces regulatory overhaul – who and what’s included

To improve clarity within the cryptocurrency space, the draft legislation introduces definitions for key terms, including: 

• digital token:
  • ‘a digital object over which one or more persons are capable of exercising control. A person who is capable of exercising control of a digital object is generally taken to have possession of the digital token’
• digital asset platform (DAP):
  • ‘a non-transferable facility under which a person, defined as the operator, possesses one or more digital tokens on trust for or on behalf of another person, defined as the client, or another person nominated by the client’
• tokenised custody platform (TCP):
  • ‘a non-transferable facility under which a person, defined as the operator, identifies one or more assets, defined as the underlying assets; and, for each underlying asset, the operator creates a single digital token, possession of which confers a right to redeem, or direct the delivery of, the underlying asset; and, the operator holds each underlying asset on trust for, or on behalf of, a person who possesses that digital token

Other definitions, including ‘client’, ‘custodian’, ‘operator’, ‘possession’, ‘digital asset’ and ‘underlying asset’ have also been updated to incorporate and facilitate these newly defined terms above. This broadening of defined terms facilitates the interpretation of the more substantive or influential aspects of the draft legislation, described below.  

To directly address the harm faced by the custodial arrangements common within the industry, as described above, the draft legislation utilises these now-defined core concepts to extend the scope Australia’s financial services law. DAP’s and TCP’s are the two custodial arrangements most common in the digital asset space, and operators of these platforms have been key figures in incidents involving consumer harm.

Under the draft legislation, these would now be defined as ‘financial products’ under section 764A of the Corporations Act. This inclusion is perhaps the defining feature of the draft legislation. Under Australian financial services law, where a person deals or issues a financial product, they are considered to provide a ‘financial service’. By providing a financial service, these providers fall under the scrutiny of the Australian Securities and Investments Commission Act 2001, and the Corporations Act. 

While these acts provide general obligations against misleading and deceptive conduct and unfair contract terms, etc, the most significant consequence is the requirement under the Corporations Act, for providers of financial services to hold an Australian financial services licence (AFSL).

The requirement to hold an AFSL is a significant step in legitimising the delivery of services in the cryptocurrency space. 

Before being granted an AFSL, applicants must demonstrate to ASIC that they are competent, honest, fit and proper and can comply with the ongoing obligations that licence holders are subject to. These include managing conflicts of interest, resourcing and compensation mechanisms, dispute resolution processes, design and distribution requirements, and most importantly, are subject to supervision and enforcement by ASIC. 

The draft legislation provides that the full suite of obligations under section 912A of the Corporations Act will apply to crypto platforms. Alongside these general obligations, the government expressed its intent on ensuring the proposed legislation is specific and fit-for-purpose in the digital asset space. 

Due to this, crypto platforms also receive direct attention, with the draft legislation imposing specific obligations regarding:

• tailored disclosure requirements
  • including providing a ‘DAP guide or ‘TCP guide’ when issuing or proposing to issue the financial products. Similar to a product disclosure statement, these guides must include all information that a person reasonably requires to make a decision, as a retail client, whether to become a client of the platform;
• comprehensive rules for dealing with the activities and conduct of persons involved with the platform; and
• minimum standards of conduct for:
  • asset holding; and
  • transactional and settlement functions.

The draft legislation doesn’t provide specifics on what these minimum standards of conduct are. Instead, ASIC is given the power to make any standard, in accordance with guidelines that ultimately intend to ensure the standards provide effective, yet proportionate consumer safeguards across differing business models and technologies. 

Not all crypto platforms are required to hold an AFSL. The draft legislation includes exemptions based on the level of risk that the crypto platform presents in the market. These include:

• low-value exemption:
  • where the total market value of transactions across all an operator’s platforms does not exceed $10 million over a 12-month period; and
  • where the operator holds less than $5,000 per customer
• insignificant part of business exemption:
  • for example, a grocery business that provides a variety of payment methods for customers to purchase goods and services, such as credit card, BPAY, direct debit or even the transfer of underlying assets to a digital asset platform or private wallet controlled by the retailer.

Other exemptions to the requirement to hold an AFSL within the draft legislation include:

• public digital token infrastructure exemption:
  • this exemption aligns with existing policy to exclude physical equipment and infrastructure, ie ATM’s, telecommunication service and internet service providers from regulation as financial products;
  • it will cover operators of certain infrastructure (being hardware and software), where the infrastructure is ‘public and permissionless’ and merely used to transmit, process, or record data relating to digital tokens; and
  • where applicable, these providers will be exempt from constituting a financial product, managed investment scheme, and from being considered a clearing and settlement facility.
• intermediated staking arrangement exemption
  • this exemption relates to the ‘staking’ of digital assets,[2] where through the crypto platform, the operator and the client enter an arrangement to permit the operator to ‘stake’ the digital asset on behalf of, and for the benefit of the client; and
  • where applicable in relation to this specific arrangement, providers will not be considered to have provided a separate financial product, or to have operated a managed investment scheme (though must still hold an AFSL authorising them to operate the platform itself).
• wrapped token exemption
  • this exemption alleviates the uncertainty that arises regarding the redemption rights, where redeeming the related asset of a ‘wrapped token’[3] may constitute a financial product. The draft legislation provides that for situations where the related asset is:
    • another digital token or is rights or interests attached to another digital token; and
    • the facility is a TCP, or would be a TCP if the creation of the wrapped token and the holding of the related asset were not otherwise required to be done by an operator of the facility; then
  • the redemption right is disregarded when working out whether the rights or interests together with the wrapped token constitutes a financial product under the Corporations Act;
  • where the related asset is a financial product, the exemption will extend to this wrapped token only if the possessor of the wrapped token has the same rights as if they held the related asset directly. 

These exemptions are a small element of the otherwise broad regulatory flexibility conferred by the draft legislation, underlining the government’s intent to ensure regulation is fit-for-purpose in the unique, and constantly evolving, digital asset industry. 

In certain circumstances, a DAP (as newly defined) may constitute both a financial product and a financial market, or a clearing and settlement facility, as defined under the current Corporations Act. 

The draft legislation initially remedies this by declaring that a DAP that is a financial market is not also a financial product. The draft legislation gives the minister certain powers to:

• deem a certain digital asset platform to be a financial market or clearing and settlement facility; and
• exempt certain digital asset platform from constituting a financial market or clearing and settlement facility.

Financial markets and clearing and settlement facilities are subject to separate licensing regimes, and these broad powers allow the minister to determine which regime will apply to the particular DAP, with the purpose being to ‘ensure each facility is regulated under the most appropriate licensing regime that effectively addresses the specific risks relating to that facility’.[4] 

The minister is also empowered to make ‘prohibition declarations’ for specific financial products being offered by crypto platforms, preventing them from dealing in the declared financial products. The power to make these declarations provides further flexibility to respond to emerging financial stability risks ie crypto platforms facilitating widespread distribution of ‘highly volatile or opaque financial products’.[5]

The rules will fully commence after 12 months, with this period split into the ‘first transition period’ (first 6 months), and ‘second transition period’ (last 6 months). However, the draft legislation provides the following transitional rules for soon-to-be-regulated crypto platforms, in relation to application of the proposed amendments:

• amendments that are not connected to the provision of a ‘financial service’ will commence:
  • on and from the date the amendments commence (being 12 months after the date the draft legislation receives royal assent);
• amendments that are connected with the provision of a financial service will apply:
  • after the first transition period, where the operator of the crypto platform does not hold an AFSL; unless
  • the operator receives authorisation under an AFSL to provide services under the crypto platform, whereby the amendments will apply to the earlier of either:
    • the date ASIC issues a determination in regard to the AFSL application; or
    • the end of the second transition period. 

Operators must be aware that if no application is made to ASIC for an AFSL within the first transition period (the first 6 months following commencement), then all amendments will apply at the end of the first transition period.