The Australia Securities & Investments Commission (ASIC) has today put the call out for industry comment on new proposals regarding regulatory expectations in the context of investment products providing exposure to underlying crypto assets. ASIC released Consultation Paper 343: Crypto-assets as underlying assets for ETPs and other investment products (CP 343) which sets out its proposals on good practice for market operators and exchange traded product (ETP) issuers, as well as other investment products that provide retail investors with exposure to crypto assets.
Proposals for consultation
CP 343 sets the scene by outlining the fundamental challenges associated with understanding crypto assets as an appropriate underlying asset class, including how product issuers can maintain compliance with existing regulatory frameworks with respect to custody, risk management and disclosure. The consultation paper addresses four broad proposal categories on which ASIC seeks comment.
1. Eligible crypto assets
INFO 230 sets out ASIC’s good practices to assist market operators with admission and monitoring standards for ETPs to support fair, orderly and transparent markets.
ASIC proposes to work with Australian market licensees to establish factors that ought to be considered in determining whether crypto assets may be appropriate underlying assets for an ETP, including:
- a high level of institutional support and acceptance of the crypto asset being used for investment purposes;
- the availability and willingness of service providers (eg, custodians, fund administrators, market makers and index providers) to support ETPs that 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; and
- 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 price,
(collectively, Crypto Criteria).
ASIC proposes to establish a new category of permissible underlying crypto assets that, at a minimum, is consistent with the factors set out in the Crypto Criteria.
2. Robust and transparent pricing mechanisms
ASIC proposes the following good practices in relation to demonstrating a robust and transparent pricing mechanism, in an attempt to support market liquidity and to provide retail investors confidence that they can transact in the ETP units at a price at, or closely resembling, the net asset value:
- 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 portion of trading activity in the relevant pair(s), in a representative and unbiased manner;
- is designed to be resistant to manipulation;
- complies with recognised index selection principles such as the International Organisation of Securities Commission Principles for financial benchmarks, the EU Benchmarks Regulation, or other internationally recognised index selection principles; and
- pricing mechanisms which rely on a single crypto asset spot market would be unable to achieve robust and transparent pricing, predominately because:
- the pricing mechanism would be subject to a greater level of operational risk and would not be able to function if the relevant crypto asset spot market were to cease operating;
- the pricing mechanism would be less resistant to manipulation; and
- the pricing generated by the mechanism would be reflective of trading in the crypto asset on that single crypto asset spot market, rather than of the crypto asset generally.
There are a range of obligations that apply to responsible entities (REs) in relation to custody of crypto assets in managed investment schemes (MISs) and ETPs (eg, RG 133 Funds management and custodial services: Holding assets (RG 133), Class Order 13/1409, RG 166 Licensing: Financial requirements).
ASIC proposes the following good practices for REs in relation to the custody of crypto assets (which apply in addition the REs existing obligations):
- custodians have specialist expertise and infrastructure relating to crypto asset custody;
- crypto assets are segregated on the blockchain, meaning that unique public and private keys are maintained on behalf of the RE so that the scheme assets are not intermingled with other crypto asset holdings;
- the private keys used to access the scheme’s crypto assets are generated and stored in a way that minimises the risk of unauthorised access. For example, holding private keys in hardware devices with no internet connection (ie, cold storage) is preferred; private keys should not be held in inter-connected systems or networked hardware (ie, hot storage) beyond what is required for operation; and the hardware devices used to hold private keys should be subject to robust physical security practices;
- multi-signature or sharding-based signing approaches are preferred, 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 organisational controls of the custodian are independently verified to an appropriate standard (eg, SOC 2 Type II or equivalent);
- REs and custodians have an appropriate compensation system in place in the event of lost crypto assets; and
- if an external or sub-custodian is used, REs should have appropriate competencies to assess the custodian’s compliance with RG 133.
2. Risk management
All Australian financial services (AFS) licensees (including REs) are required to have adequate risk management systems in place. ASIC has previously published RG 259 Risk management systems of REs which sets out how REs may comply with this obligation. Given the unique risks associated with crypto assets, ASIC is proposing the following good practices in relation to risk management systems for REs that hold crypto assets:
- if the RE undertakes trading in crypto assets, it should do so on legally compliant and regulated crypto asset trading platforms. ASIC considers an appropriate baseline level of regulation to be know your customer and anti-money laundering and counter-terrorism financing 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 above standards; and
- the RE is responsible for ensuring its risk management systems appropriately manage all other risks posed by crypto assets.
Financial product issuers (including REs, and ETP issuers) are required to comply with disclosure obligations, including issuing a product disclosure statement (PDS) that discloses any risks associated with holding the product. Given the unique risks associated with crypto assets, ASIC proposes the following good practices regarding PDS obligations for registered MISs and ETPs that holds crypto assets:
- the RE should consider disclosing information about the unique characteristics of crypto assets, which may include the technologies that underpin crypto assets, as well as how crypto assets are created, transferred, destroyed, valued, traded and custodied; and
- the RE should consider providing appropriate disclosure of other risks, which may include market risk, pricing risk, immutability, increased regulatory risk, custody risk, cyber risk, and environmental risk.
The list is not exhaustive and REs must determine what is appropriate disclosure in the context of the characteristics and operations of their product
4. Design and distribution obligations
From 5 October 2021, REs will be subject to design and distribution obligations. However, ASIC does not propose to issue any additional expectations regarding how these obligations can be met for investment products that invest in, or provide exposure to, crypto assets
Listed investment entities (including listed investment trusts (LITs) and listed investment companies (LICs)) capture closed ended investment vehicles which are listed on licensed financial markets and are available to retail investors.
To prevent regulatory arbitrage and encourage competition between different investment vehicles (eg ETPs and LICs), ASIC proposes to work with market operators to establish that:
- the approach used to determine and classify appropriate crypto assets for LITs and LICs is the same as for ETPs (refer to the Crypto Criteria above);
- a LIC that invests in crypto assets will be expected to have custody solutions, trading processes and valuation mechanisms that are consistent with those proposed for ETPs, for the LIC to be considered to have a structure and operations that are appropriate for a listed entity;
- a LIT that invests in crypto assets will need valuation mechanisms that are consistent with those proposed for ETPs to be considered to have a structure and operations that are appropriate for a listed entity; and
- the above criteria should be ongoing requirements of listing (eg, they should be imposed as a condition of listing).
Crypto assets do not currently fall within any existing asset kind that can be selected by an AFS licence applicant when applying to operate a registered MIS that holds these types of assets (noting that scheme assets do not have to be financial products).
To ensure that an AFS licensee has the appropriate AFS licence authorisations, ASIC is proposing to establish a new asset kind, specifically addressing MISs that hold crypto assets. While this asset kind will be defined broadly, ASIC proposes to restrict the AFS licence authorisations to operate a ‘crypto-asset scheme’ to specified crypto assets that a registered MIS can hold by reference to the Crypto Criteria above. On this basis, ASIC considers that at this point in time, such AFS licence authorisations will only be given to operate registered MISs that hold bitcoin or ether.
Although ASIC noted that it is open to allowing other crypto assets in the future, this last requirement will likely have a significant impact on entities seeking to operate registered MISs that hold other crypto asset types.
Context for consultation
ASIC’s proposals in CP 343 come amidst a more general push by the Australian Government to consider key opportunities and risks in the digital asset and crypto sector. Most notably, the Senate Select Committee on Australia as a Technology and Financial Centre (Committee) is currently undertaking a detailed review into the development of a comprehensive regulatory framework for crypto assets.
While ASIC notes the Committee’s review, ASIC acknowledges that it does not seek to pre-empt the outcome of any such review and does not comment on the regulatory status of any crypto assets. Rather, CP 343 is limited to proposing good practices for ETPs and other investment products providing exposure to crypto assets under the current regulatory framework. That is, ASIC is consulting on best practice for ETPs and other investment products, which are regulated by ASIC under the Corporations Act 2001 (Cth), where such ETPs and other investment products provide exposure to crypto assets. Regardless, CP 343 is a welcome insight into ASIC’s key focuses for market operators and issuers of ETPs and other investment products and is a clear indication that ASIC is considering the intersection of crypto and regulated products.
The deadline for comments on CP 343 is slated for 27 July 2021.
Please be in touch with our Fintech + Financial Services Team should you wish to discuss.