Token mapping: Australian Government seeks feedback on proposed approach to crypto regulation

By John Bassilios and Max Ding

Treasury’s new consultation paper on token mapping provides a proposed approach for how the existing ‘financial product’ regulatory framework may be used to regulate the crypto ecosystem. Treasury now seeks feedback from stakeholders on the challenges and limitations of the proposed approach, and will accept responses until 3 March 2023.

In this update, we outline Treasury’s token mapping approach – a key first step to future regulatory reform for crypto in Australia.

We firstly set out the key concepts Treasury defines in the current crypto ecosystem, then move on to its token mapping framework. Finally, we outline Treasury’s views on the benefits and limitations of the token mapping framework as applied to current crypto systems.

In summary, while Treasury considers that current financial regulation may be mapped onto some kinds of crypto systems (intermediated token systems), a fundamentally different approach may be required for other kinds (public token systems).

You can read the full consultation paper and submit a response on the ‘Token Mapping‘ page of Treasury’s website.

Key concepts in the crypto ecosystem

Treasury’s paper begins by acknowledging the need for an agreed understanding of crypto concepts between stakeholders and policymakers. This will not only help understand how technical terms are used in the consultation paper but will inform future policymaking.

To this end, Treasury provides the following definitions of some key concepts:

• crypto token: a unit of digital information that can be ‘exclusively used or controlled’ by a person – despite that person not controlling the host hardware where that token is recorded.
• crypto networks: a distributed computer system capable of hosting crypto tokens. Crypto networks are the platforms on which crypto tokens and ‘smart contracts’ are recorded. Their primary function is to store information and process user instructions.
• public crypto network: a crypto network that aims to provide certain information security guarantees in a way that does not require a trusted third party to store and process data.
• smart contracts: computer code that has been published to a crypto network’s database. Smart contracts are not ‘contracts’ in a legal or plain English sense. They are a fundamentally unique type of software that can run in a predefined and deterministic manner without risk of intervention.
• smart contract protocol: a collection of smart contracts that can perform more complex and flexible functions than a single smart contract. Smart contracts and smart contract protocols are the building blocks for ‘smart contract applications’.
• smart contract application: a combination of smart contracts with conventional technology to create a user-facing application.
• smart contract token: a crypto token that has been created using a smart contract.

To encourage feedback on these terminologies, Treasury has posed the following consultation questions:

• The concept of ‘exclusive use or control’ of public data is a key distinguishing feature between crypto tokens/crypto networks and other data records.
  • How do you think the concepts could be used in a general definition of crypto token and crypto network for the purposes of future legislation?
  • What are the benefits and disadvantages of adopting this approach to define crypto tokens and crypto networks?

For comparison, the UK Treasury has recently released its own consultation paper on crypto regulation, which provides the following broad definition of ‘crypto assets’: ‘any cryptographically secured digital representation of value or contractual rights that can be transferred, stored or traded electronically, and that uses technology supporting the recording or storage of data (which may include distributed ledger technology).’

Token mapping framework

Treasury’s token mapping framework relies on three key concepts: tokens, token systems, and functions, which are defined as follows:

• tokens: physical or digital units of information that have a role in a token system.
• token system: a collection of steps involved in performing, or anything designed to ensure or facilitate, a function.
• function: any benefit ensured or facilitated by the token system to the token holder.

To understand how these concepts map onto current financial regulation, it is important to understand how a ‘financial product’ is defined in Australian legislation. This is a key concept in determining whether something, such as a crypto product, falls within the ambit of financial services regulation (what Treasury calls the ‘functional perimeter’).

The functional perimeter captures any financial product, being:

• a ‘facility’ – a broad term covering intangible property, a term of a contract, agreement, understanding, scheme, or other arrangement (whether or not wholly: formal, written, implied or required by law, or legally enforceable);
• through which a person:
  • makes a financial investment;
  • manages financial risk; and/or
  • makes non-cash payments.

In addition to the functional perimeter, financial services legislation also lists specific inclusions and exclusions of arrangements which are financial products. In doing so, the legislation provides guidance on the functional perimeter and also includes products that are not captured by the general financial functions.

Token mapping involves asking whether a token system meets the definition of ‘financial product’. This is a two-part question:

• Is the token system a facility?
• Is the facility one through which a person does any of the general financial functions (ie makes a financial investment, manages financial risk, and/or makes non-cash payments)?

If the answer to both questions is ‘yes’, the facility is a financial product, to which current financial services regulations may apply.

Treasury considers that the process of assessing crypto products against the functional perimeter (or a specific definition of financial product) is the same as for any other product. However, it considers that the results of such an assessment will often depend on whether the token system is a:

• intermediated token system, which involves intermediaries or agents performing functions pursuant to promises or similar arrangements, in which case it is relatively straightforward to apply the ‘financial product’ test; or
• public token system, which involves functions being performed by crypto networks in the absence of promises, intermediaries and agents, in which case it is difficult to apply the ‘financial product’ test due to the financial regulatory framework in Australia being founded upon concepts of promises, intermediaries, and agents.

Intermediated token systems and public token systems

Treasury proposes a high-level taxonomy to classify crypto products within two kinds of token systems being ‘intermediated token systems’ and ‘public token systems’. Within these systems, Treasury identifies four product types.

• For intermediated token systems:
  • crypto asset services; and
  • intermediated crypto assets.
• For public token systems:
  • network tokens; and
  • public smart contracts.

Treasury is deterred from creating an exhaustive taxonomy of how these product types translate into functions, for the purpose of determining whether the token system is a ‘financial product’. This is because Treasury considers that their potential functions are so broad that – in the context of regulation – an exhaustive list may have drawbacks, including inconsistent regulatory treatment, co-mingled regulatory supervision responsibilities, and the opportunity for domestic regulatory arbitrage.

We briefly summarise Treasury’s definitions of these token systems and product types below.

Intermediated token systems

Intermediated token systems involve intermediaries or agents performing functions according to legally binding agreement. They facilitate links between crypto systems and the traditional financial system, such as trading between fiat money and crypto tokens and issuing crypto-linked debit/credit cards.

Intermediated token systems can be considered a ‘financial product’ if they fit within the definition of a financial product, either by the functional perimeter approach or specific financial product definitions.

An intermediated token system can be a crypto asset service or an intermediated crypto asset.

• crypto asset service: a token system that accepts crypto tokens as part of performing a function under a legal agreement or other arrangement. The arrangement will typically involve a customer transferring crypto assets or fiat money to a service provider that will then credit the consumer’s ‘wallet’.
• intermediated crypto asset: a crypto asset where the link between the crypto token and the token system is created by legal agreement. Examples of assets connected to crypto tokens include rights or licences in relation to event access or subscriptions, intellectual property, reward programs, consumer goods and services, fiat money, non-financial assets, government bond coupons and units in a member-directed venture capital fund.

To understand the challenges and test how the existing regulatory framework might apply to intermediated token systems, Treasury has posed the following consultation questions:

• Some intermediated crypto assets are ‘backed’ by existing items, goods, or assets. These crypto assets can be broadly described as ‘wrapped’ real world assets.
  • Are reforms necessary to ensure a wrapped real-world asset gets the same regulatory treatment as that of the asset backing it? Why? What reforms are needed?
  • Are reforms necessary to ensure issuers of wrapped real-world assets can meet their obligations to redeem the relevant crypto tokens for the underlying good, product or asset?
• It can be difficult to identify the arrangements that constitute an intermediated token system.
  • Should crypto asset service providers be required to ensure their users are able to access information that allows them to identify arrangements underpinning crypto tokens? How might this be achieved?
  • What are some other initiatives that crypto asset service providers could take to promote good consumer outcomes?
• In addition to the functional perimeter, the Corporations Act lists specific products that are financial products. The inclusion of specific financial products is intended to both: (i) provide guidance on the functional perimeter; (ii) add products that do not fall within the general financial functions.
  • Are there any kinds of intermediated crypto assets that ought to be specifically defined as financial products? Why?
  • Are there any kinds of crypto asset services that ought to be specifically defined as financial products? Why?
• Some regulatory frameworks in other jurisdictions have placed restrictions on the issuance of intermediated crypto assets to specific public crypto networks. What (if any) are appropriate measures for assessing the suitability of a specific public crypto network to host-wrapped real world assets?
• Intermediated crypto assets involve crypto tokens linked to intangible property or other arrangements. Should there be limits, restrictions or frictions on the investment by consumers in relation to any arrangements not covered already by the financial services framework? Why?
• Despite many crypto asset services having clear economic or financial functions, it can be unclear which class of financial product they may fall within. Service providers may use complex or obscure arrangements that further complicate the assessment. Accordingly, should any arrangements be specifically included in the definition of ‘financial product’ to either provide guidance on the functional perimeter or add products that fall outside the general financial functions?

Public token systems

Public token systems operate without a promise that an intermediary will perform a function. These functions are ensured directly by the crypto network. This is made possible by the use of public crypto networks as a neutral, independent infrastructure for creating transactions between parties who do not know or trust one another. Transactions in public token systems are established directly by parties using open-source software simultaneously to create crypto tokens representing the transactional relationship.

Network tokens and public smart contracts are categories of products in public token systems.

• Network tokens: crypto tokens that are created as part of the ‘consensus mechanism’ on public crypto networks, but that are used by holders for various other functions. Network tokens are created by the network itself to reward network participants who contribute to ensuring all participants agree to the same database.
• Public smart contracts: smart contracts (and their associated crypto tokens) that are created for the purpose of enabling unknown parties to enter transactional relationships without the need for intermediaries.

Treasury acknowledges that public token systems cause several legal and regulatory issues in terms of ‘mapping’ onto existing financial regulation. This is because the financial regulatory framework in Australia is grounded upon concepts of promises, intermediaries and agents, and public token systems have functions that allow parties who are unknown to each other to transact in the absence of promises, intermediaries and agents.

An example of this asymmetry is that the risks of a smart contract-based function may be different to the risks of promise or contractual-based function. These include technology risks (eg bugs in the code), model risks (eg an unsound economic mechanism), compliance risks (eg blacklisting by smart contract applications), and unknown risks due to the experimental nature of these systems.

Therefore, a fundamentally different regulatory approach than current financial services regulation may be required for public token systems.

This has led Treasury to pose the following consultation questions:

• Some jurisdictions have implemented regulatory frameworks that address the marketing and promotion of products within the crypto ecosystem (including network tokens and public smart contracts). Would a similar solution be suitable for Australia? If so, how might this be implemented?
• Smart contracts are commonly developed as ‘free open-source software’. They are often published and republished by entities other than their original authors.
  • What are the regulatory and policy levers available to encourage the development of smart contracts that comply with existing regulatory frameworks?
  • What are the regulatory and policy levers available to ensure smart contract applications comply with existing regulatory frameworks?
• Some smart contract applications assist users to connect to smart contracts that implement a pawn-broker style of collateralised lending (ie only recourse in the event of default is the collateral).
  • What are the key risk differences between smart-contract and conventional pawn-broker lending?
  • Is there quantifiable data on the consumer outcomes in conventional pawn-broker lending compared with user outcomes for analogous services provided through smart contract applications?
• Some smart contract applications assist users to connect to automated market makers (AMM).
  • What are the key differences in risk between using an AMM and using the services of a crypto asset exchange?
  • Is there quantifiable data on consumer outcomes in trading on conventional crypto asset exchanges compared with user outcomes in trading on AMMs?

Feedback and future of regulation in Australia and beyond

Treasury’s paper is open for feedback until 3 March 2023.

After token mapping, Treasury intends to release a consultation paper proposing a licensing and custody framework for crypto asset service providers in mid-2023. Australian regulators, like ASIC and the ACCC are also strengthening their focus on crypto asset providers to provide better outcomes for consumers.

Looking abroad, the UK plans to legislate the promotion of crypto assets, the issuance and custody of fiat-back stable coins, as well as payment related activities for fiat-backed stable coins. The UK treasury has recently published a consultation paper on their future plans to regulate crypto.

Have your say

You can submit responses to the Treasury on the ‘Token Mapping‘ page of its website. If you would like further information on token mapping, or assistance with making a submission in response to the Treasury’s consultation paper, please contact us.

We encourage you to read the Australian chapter of the Lexology Getting The Deal Through Fintech 2023 publication, which is also written by Partner John Bassilios, our Fintech and Blockchain Lead (and Blockchain Australia Director).