Regulating digital asset platforms – new regulatory framework proposed

By John Bassilios

Overview

On 16 October 2023, the Treasury announced that the Government intends to introduce a regulatory framework for entities providing access to or holding digital assets on behalf of Australians and Australian businesses. The proposed framework outlines the creation of a new financial product, proposed minimum standards and places digital asset platforms within the ambit of Australia’s financial services framework and licensing regime.

Some key takeaways from the response paper include:

• Crypto exchanges holding more than $5 million in total or more than $1,500 for any individual will be required to hold an Australian Financial Services Licence (AFSL).
• Platform providers will be required to have net tangible assets at the greater of $5 million or 0.5% of the value of the assets held by the facility.
• Certain non-financial products (referred to as ‘financialised functions’), which are normally outside the scope of financial services laws, will be subject to minimum standards and regulation.
• Digital asset facilities will be required to meet minimum standards that largely replicate the minimum standards that apply to financial products and services that hold assets. This includes the requirement to hold financial products on trust.

Who do the reforms apply to?

The proposed framework would apply to digital asset service providers that present similar risks to entities that operate in the traditional financial system.

The Treasury is proposing that operators of digital asset service providers be regulated under the AFSL framework and will aim to ensure consistent oversight and safeguards for consumers. This includes:

• Regulating digital asset intermediaries: including a proposed regulatory framework for digital asset facilities.
• Licensing digital asset intermediaries: a mix of standard and tailored licensing obligations that would apply to service providers in relation to digital asset facilities.
• Minimum standards for facility contract: including requirements for structuring a digital asset facility, including custodial and reporting rules.
• Minimum standards for ‘financialised functions’: for specific non-financial activities that would require compliance with additional rules.

The paper seeks feedback on the proposals and their underlying assumptions by 1 December 2023.

Policy aim

The proposal is inspired by Australia’s increasing interest in digital and crypto assets, with around 1 in 4 Australians owning some crypto. Digital asset platforms most commonly provide access to such tokens and, in response, the Government is seeking to regulate these platforms to protect customers. The regulation aims to achieve three key goals, including:

• the introduction of a framework for industry innovation and growth;
• to provide certainty and clarity for the industry; and
• to protect customers and their assets.

Regulating digital asset intermediaries

Introduction of a ‘digital asset facility’ financial product

Rather than creating a new framework, the Government intends to incorporate digital asset platforms and other intermediaries within the existing financial services framework via the creation of a new type of financial product called a ‘digital asset facility‘.

A ‘digital asset facility’ would be inserted into the Corporations Act 2001 (Cth) as a new financial product. The financial product would not be a transferable instrument (such as a share or bond). Instead, it would be a non-transferable facility (such as a non-cash payment facility or a margin lending facility).

Scope of the proposed framework

While there are a vast number of asset holding arrangements in the digital asset space, typically an asset holding arrangement involves a customer transferring an asset to a service provider in return for a ‘right’ to receive their asset back in the future.

A ‘digital asset facility’ will be an asset holding arrangement. In addition to arrangements simply for holding digital assets for another person (such as custody only arrangements), the proposed framework would apply minimum standards to digital asset platforms. A digital asset platform would be a multilateral asset holding arrangement, where multiple customers transact in platform entitlements.

The proposed framework will specifically cover arrangements where:

• the platform administers the exercise of platform entitlements for account holders (such as holding tokens, issuing platform entitlements in relation to those tokens, and recording platform entitlements in an account-based system); or
• the platform administers the exercise of platform entitlements for token holders, including asset-backed tokens and other ‘wrapped’ assets (such as holding any asset, issuing platform entitlements in relation to those assets, and recording platform entitlements using a token-based system).

In some instances, it may be difficult to determine whether a person is ‘holding’ a digital asset for the purposes of a ‘digital asset facility’. However, the proposed laws aim to distinguish those who create or sell software used by others to hold or deal in assets (known as ‘custody software’) which would not be an asset holding arrangement, and a business with the necessary level of control of digital assets (whether the business uses custody software or not) which would be an asset holding arrangement and therefore within scope of a ‘digital asset facility’. This broad approach is intended to be technology agnostic and provides an avenue for enforcement action and protects consumers who rely on a third party to hold assets on their behalf.

Licensing digital asset intermediaries

Overview of proposed framework

The proposed framework seeks to recognise certain asset holding arrangements as a financial product (known as a ‘digital asset facility’) and apply Australia’s existing AFSL regime to any person ‘carrying on a financial services business in Australia’ in relation to a digital asset facility.

What digital asset intermediary will need to obtain an AFSL?

The proposal seeks to require all digital asset platforms that hold over a certain threshold of Australian assets ($1,500 for an individual; $5 million in aggregate) to obtain an AFSL. This would include the requirement to meet all general licence obligations and financial requirements consistent with other AFSL holders.

The issuer of a digital asset facility would be the person or persons responsible for the obligations owed to customers under the terms of the asset holding arrangement (known as the platform provider). Platform providers and other intermediaries performing financial services in relation to digital asset facilities (such as brokers, agents, arrangers, market makers, and advisers) would therefore be required to hold an AFSL.

Further, while the application of Australia’s AFSL regime is jurisdictionally limited to Australia, an intermediary business (such as an arranger or broker) would need to be licensed to provide services that involve dealing in digital asset facilities generally. These include intermediary businesses who are not licensed or located in Australia.

Financial requirements

AFSL holders have obligations to meet certain financial requirements which are typically tailored for different financial products. This includes a net tangible asset requirement (NTA). Critically, the response paper sets the NTA requirement for a platform provider as:

• at least 0.5 per cent of the value of the facility (if using a sub-custodian digital asset facility that has $5 million NTA); or
• $5 million (if performing the custody function).

This is a burdensome requirement and aims to ensure digital asset platforms have adequate financial resources to conduct their business and address the costs of orderly wind-up in the event the platform fails.

Specific obligations unique to digital asset platforms under the proposed framework

The proposal also outlines multiple specific obligations unique to the digital assets industry which will apply to digital asset platforms. These include:

• Standard form platform contracts: platform providers must enter into a standard form facility contract with any user of the platform (known as a ‘facility contract’).
• Minimum standards for holding tokens: tokens must be held through arrangements that ensure that tokens are adequately safeguarded.
• Standards for custody software: whereby tokens are only held using custody software that is continuously monitored and routinely audited.
• Standards when transacting in tokens known as ‘financialised functions’: including token trading (intermediating the exchange of platform entitlements between account holders), token staking (intermediating an account holder’s participation in validating transactions on a public network), asset tokenisation (intermediating the creation and exchange of platform entitlements backed by tangible and intangible non-financial product assets) and funding tokenisation (intermediating the sale of entitlements to fund the development of ‘non-financial’ products and services).

These obligations are inspired by corresponding frameworks used to regulate digital asset platforms in jurisdictions such as the EU, UK, Canada and Singapore.

Proposed exemptions

While many digital asset platforms will now fall within the ambit of Australia’s financial services regime, the proposal recognises that the risks associated with digital asset facilities correlate to the size and scale of the asset holding role of the platform provider.

As such, a ‘low-value facility’ exemption will be introduced (similar to the ‘low value facility’ exemption for non-cash payment facilities) and applies to digital asset facilities who hold less than $1,500 per customer and less than $5 million in total.

Disclosure obligations

Similar to the requirement to provide a Product Disclosure Statement when offering a financial product, platform providers will be required to provide a ‘facility guide’ to any retail client before providing any services to them directly. The facility guide approach will be for platform providers to provide effective and concise disclosure to clients in the facility guide, which would include full disclosure through links to online resources.

The facility guide would need to include a summary of the key information a retail client needs to know to decide whether to on board to the platform (and how to exercise a platform entitlement, if they are holding a platform token).

Minimum standards for facility contract

Platform providers will also be required to enter into standard form facility contracts with any user of their platform. These are known as a ‘facility contract’ and they must meet minimum standards for:

• Holding assets: including the requirement to have adequate organisation structure, staffing capabilities, and capacity and resources to perform core administrative activities. These standards would apply to holders of financial products and non‑financial assets (including digital assets that are financial products and those that are not) and includes a requirement to hold financial products on trust.
• Intermediating platform entitlements: in relation to the issuance of platform entitlements (including requirements for a platform entitlement to represent each asset (or unit) held by the platform) and the exercise of platform entitlements (including requirements that a person with platform entitlements has sole discretion to provide instructions relating to their entitlement and such instructions are to be processed by the platform provider in a timely manner).
• Transactional functions: including requirements that account-holders or token-holders have sole discretion to decide on transactions relating to platform entitlements (including the disposal, transfer, exchange of their platform entitlement or any encumbrance of their platform entitlements or use of any assets underlying their platform entitlements), provide adequate disclosure to account holders, ASIC notification and combat market misconduct.

Minimum standards for ‘financialised functions’

Finally, the proposal seeks to set minimum standards for ‘financialised functions’.

While transactions involving assets that are not financial products are not ordinarily subject to financial services laws, an important feature of the proposed framework is the addition of obligations to four specific activities involving non-financial products offered by digital asset platforms. These include:

• Trading: the exchange of digital asset platform entitlements between account holders and set requirements for token trading systems such as rules that currently apply to ‘crossing systems’ in Australia or to non-discretionary trading venues in other jurisdictions.
• Staking: the participation in validating transactions on a public network. This includes requiring digital asset platforms with a token staking function to provide account holders with an entitlement to ‘unstake’ any staked asset from the facility, ensure network integrity and security software used to validate transactions and include certain risks and statements within the facility guide.
• Tokenisation: the creation and exchange of entitlements backed by tangible and intangible assets. This includes requirements to provide certain information in the facility guide, have the technical capacity to evaluate and mitigate security and integrity risks, adopt token standards that can be programmed to sanction or constrain access or enable the platform provider to respond to token theft or court orders, and enter into written agreements with market makers to ensure liquidity.
• Fundraising: the sale of entitlements to fund the development of products and services. Some requirements for a digital asset platform with a funding tokenisation function will be to provide adequate disclosure, ensure fair and honest distribution, meet expectations of a financial services provider, lodge requisite documents with ASIC, and not limit liability for misstatements within any ‘terms and conditions’ document.

Next steps

This long-awaited consultation paper for the regulation of digital asset platforms is a milestone for Australia’s cryptocurrency and digital assets sector.

Consultation on the proposal closes 1 December 2023. Make a submission.

This article was written with the assistance of Isabella Emanuel, Law Graduate.