On 16 October 2023, Treasury released a consultation paper for industry comment on proposals to regulate digital asset intermediaries under the existing financial services licensing framework. This consultation paper follows Treasury’s token mapping exercise earlier this year and its crypto asset secondary service provider consultation in 2022. The overarching theme is to require digital asset intermediaries to hold an Australian financial services licence (AFSL) and comply with enhanced requirements regarding conduct and standard contracts.
This article sets out:
- key concepts used in the consultation paper;
- the proposed scope of regulation;
- applicable licensing obligations;
- minimum standards for facility contracts;
- minimum standards for ‘financialised functions’;
- engaging ‘custody only’ providers;
- future considerations; and
- what crypto businesses can do to prepare.
The consultation paper adopts defined concepts that are key to interpreting the regulatory framework.
- Digital asset platform: intermediaries in the digital asset ecosystem that operate multi-function platforms and hold assets for clients. These platforms allow multiple customers to transact in platform entitlements.
- Entitlement: any kind of right, benefit or claim flowing from any kind of contract, understanding, scheme or convention.
- System of record: any authoritative store of information used to record entitlements. This includes ‘account-based systems’ where entitlements flow to a specific person identified in a record (ie, account) and ‘token-based systems’ where entitlements flow directly to any person holding a specific record (ie, token).
- Token: a record in a token-based system. These can be held by a person and are hard to counterfeit. The consultation paper explicitly excludes ‘token-like’ systems such as event tickets or gift cards that can be delivered by email (ie, this is just information).
- Digital asset: refers to a token and its associated entitlements (ie, digital bearer asset).
Digital asset facility
The proposed regulatory framework uses asset holding as an anchor and seeks to introduce a new financial product into the AFSL regime, called a ‘digital asset facility’. This will be a non-transferable facility (ie, an arrangement like a non-cash payment facility) rather than a transferable instrument (eg, shares). The digital asset facility definition will capture asset holding arrangements, including ‘custody only’ arrangements as well as digital asset platforms that allow customers to transact in platform entitlements. These entitlements relate to rights that a customer has to transfer or withdraw tokens once they are deposited into a platform account. The consultation paper calls out token marketplaces (account-based) and asset-backed tokens (token-based) as falling into this definition. Broad concepts of ‘control’ are adopted to capture businesses with an ability to exercise, coordinate or direct factual control over assets in a real and immediate sense. The regulation is not proposed to apply to custody software.
Entities providing financial services in relation to a digital asset facility will be required to hold an AFSL. This includes:
- Platform providers that issue digital asset facilities (including providing financialised functions) and are responsible for the obligations owed to customers under the terms of the asset holding arrangement;
- Brokers and dealers that arrange for a person to use a digital asset facility (whether that facility is in Australia or offshore). However, an AFSL exemption will apply where (a) the dealing is in the ordinary course of a business that is not primarily a financial services business, (b) the digital asset facility is provided by a licensed platform provider, and (c) the digital assets are not financial products; and
- Advisers that provide advice in respect of digital asset facilities.
Minimum standards for facility contracts
All arrangements involving digital asset facilities will be required to be structured as non-discretionary arrangements (ie, operate on pre-agreed rules) and will need to be disclosed and agreed in a written agreement (facility contract) between the platform provider and customers. A facility contract must meet minimum standards for holding assets, intermediating platform entitlements and managing transactional functions (see below).
The consultation paper proposes imposing additional requirements on ‘financialised functions’ that are carried out in relation to non-financial product digital assets as part of a digital asset facility. This includes:
- Token trading: intermediating the exchange of platform entitlements between account holders;
- Token staking: intermediating the 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 platform entitlements to fund the development of non-financial products and services.
The consultation paper attempts to ensure the proposed regulation does not impede other areas of law. Examples of where this applies includes:
- Primary and secondary sales non-financial product entitlements: these are subject to existing state and federal laws that apply to businesses generally;
- Providing financial services in relation to financial product entitlements: these are captured under existing financial services laws;
- Providing a payment stablecoin: this is intended to be covered under a separate ‘stored value facility’ framework;
- Accepting tokens as payment for goods and services: existing contract law principles will apply; and
- Publishing data to a public database: existing laws relating to intellectual property, privacy, media and defamation will apply.
Requirement to hold an AFSL
All entities that provide services in relation to digital asset facilities, including financialised functions for non-financial product digital assets, will be required to hold an AFSL. The relevant authorisations will turn on the financial services the entity intends to provide. For example, providing advice, arranging, dealing as principal (ie, issuing) or on behalf of customers.
The consultation paper proposes an AFSL exemption for digital asset facilities where:
- the total value of platform entitlements held by any one client does not exceed A$1,500 at any one time; and
- the total amount of assets held by the platform provider does not exceed A$5 million at any one time.
The existing general obligations that apply to all AFSL holders will continue to apply, including:
- providing financial services efficiently, honestly and fairly;
- managing conflict of interests;
- complying with AFSL conditions;
- complying (and ensuring representatives comply) with financial services laws;
- maintaining (and ensuring representatives maintain) adequate competence to provide the financial service covered by the AFSL;
- having the financial, technological and human resources to carry out and supervise financial services;
- having dispute resolution systems and compensation arrangements in place for retail clients; and
- maintaining a risk management system.
Other financial services law obligations will apply, including requirements to:
- provide information and assistance to ASIC (including under the reportable situations regime);
- notify and remediate account holders affected by reportable situations;
- prepare and submit financial records, statements and audits;
- not accept or provide conflicted remuneration;
- comply with design and distribution obligations for retail clients;
- not engage in unconscionable conduct;
- not hawk financial products; and
- additional requirements relating to financial product advice.
The consultation paper proposes imposing the standard AFSL financial requirements on platform providers (ie, solvency, positive net asset and cash needs requirements), as well as imposing a net tangible asset (NTA) requirement. NTA is unencumbered cash or cash equivalents and will be set at least:
- 0.5% of the value of the facility (if a licensed sub-custodian is used that meets the A$5 million NTA requirement); or
- otherwise, A$5 million.
This NTA requirement will be a significant barrier for new entrants.
Platform providers must provide a ‘facility guide’ to any retail clients before providing services to them. The facility guide is a blend of the current product disclosure statement and financial services guide requirements. This includes providing the following information in a clear, concise and effective manner:
- the name and contact details of the platform provider(s);
- a summary of the significant characteristics or features of the platform;
- a summary of the rights, terms, conditions and obligations under the facility contract; and
- references and links to the full disclosure, including both the facility contract and any information that a person would reasonably require to:
- understand the nature of the facility and the risks associated with participation in the platform;
- identify the platform providers and custodians and the nature of their responsibilities and relationships;
- understand any differences between a platform entitlement and holding an asset directly;
- understand the dispute resolution process; and
- understand rights to disclosure in relation to assets and tokens the subject of platform entitlements.
All facility contracts will be required to meet minimum standards in relation to holding assets, intermediating platform entitlements and transactional functions.
These standards largely reflect the existing minimum standards for holding financial products, including that:
- assets must be held for token holders or account holders through an arrangement that meets the minimum standards for holders of financial products (eg, see ASIC Regulatory Guide 133);
- tangible assets may be held on trust or through a bailment arrangement;
- tokens must be safeguarded on the following basis:
- using the highest level of safety that reasonably balances security and the timely processing of requests to exercise platform entitlements;
- only held using custody software that is continuously monitored and routinely audited;
- only held with the assistance of a custody software service provider, if the services agreement requires that service provider to establish and maintain business continuity arrangements that are reasonable for the nature, scale and complexity of its business; and
- only held by a third party sub-custodian if that third party is a platform provider that meets the minimum standards for asset holders.
Intermediating platform entitlements
In relation to the issuance of platform entitlements, the facility contract must meet the minimum standards, including that platform entitlements:
- must be created to represent each asset held by the platform, or each unit of an asset if it is fungible; and
- may be recorded using an account-based system or a token-based system.
In relation to the exercise of platform entitlements, the facility contract must meet the minimum standards, including that:
- a person with a platform entitlement has sole discretion to decide and provide instructions;
- instructions to exercise platform entitlements must be processed by the platform provider in a timely manner; and
- a platform entitlement can only be exercised once.
The minimum standards would also not permit the platform to issue complex platform entitlements (ie, only the delivery or transfer of assets).
The facility contract must meet the minimum standards for transactional functions, including that:
- subject to existing financial services laws and any of the relevant financialised functions, holders have sole discretion to decide and provide instructions on transactions in relation to platform entitlements (eg, disposal, transfer, exchange, encumbrance, use);
- the platform will have and apply a ‘listing criteria’ for any product made available for transactional functions on its platform. The listing criteria will be a public document setting out the systems, policies and procedures for making tokens available through the platform;
- acquisitions of digital assets via a transactional function will only occur if the ‘token disclosure’ has been made. Token disclosure requirements will include:
- for financial product tokens, that the platform provider only facilitates the acquisition on behalf of an account holder if they believe the holder has been given a disclosure document;
- for non-financial product tokens, making available a copy of the document recording the rights and obligations of the issuer and token holder and making clear statements regarding non-financial purposes;
- for each token attaching no entitlements except factual control, the platform provider obtains express confirmation from the account holder that they have read the summary of public information, make available technical information regarding the token and make clear statements regarding non-financial purposes; and
- the facility contract must not exclude the platform provider’s liability for misstatements in information made available in relation to tokens attaching no entitlements;
- the provider will notify ASIC in writing if it has reasonable grounds to suspect that a person has engaged in market misconduct; and
- the platform provider will make reasonable efforts to identify, prevent and disrupt market misconduct on its platform.
In addition to general AFSL obligations, the consultation paper proposes imposing additional minimum standards on the performance of financialised functions.
A digital asset platform with a token trading function must:
- have and apply policies and procedures that implement objective criteria for assessing supported networks, measures for dealing with network congestion and fee spikes relating to timely redemption, measures for evaluating bridge security and technical factors relating to timely exercise, measures for mitigating the impact of critical network events, and measures for recovering tokens;
- have and apply protocols, procedures and criteria for the efficient execution of instructions, delisting of assets, engaging market makers and liquidity providers, suspension conditions, instruction filtering and fee structures;
- make public the bid and offer prices (including depth);
- make public the prices, volumes and time of executed transactions; and
- make available public data meeting the needs of Australian regulators.
A digital asset platform with a token staking function must:
- provide account holders with a direct entitlement to ‘unstake’ any staked asset from the facility;
- have and apply objective criteria assessing supported networks, security of validation software and capacity of staking software to lawfully validate and order transactions; and
- include clear and prominent statements in the facility guide in relation to the risks involved in deploying capital to a protocol and making an investment wit no counterparty, potential penalties and rewards and audits and other assurances conducts in relation to the network.
A digital asset platform with an asset tokenisation function must:
- include in the facility guide the terms and conditions for token holders and terms and conditions of order;
- have the technical capacity to evaluate supported networks and operate nodes to mitigate the impact of critical network events;
- use token standards that can be programmed to comply with access restrictions, enable the platform provider to respond to theft and lawful demands; and
- enter into an agreement with market makers to ensure secondary market liquidity.
A digital asset platform with a funding tokenisation function must:
- provide basic fundraising disclosure documents, commensurate to the nature of the fundraising being ‘non-financial’;
- ensure an efficient, honest and fair distribution of facility tokens to backers, either with non-fungible tokens with a 1:1 entitlement for the product or service, or fungible tokens indicating an entitlement to acquire a portion of the product or service;
- program tokens to remain non-tradeable during the product or service’s developmental phase;
- meet financial service provider expectations when implementing KYC protocols, coordinating a milestone driven fund release for projects, publishing disclosure documents, ensuring transparent communication, having sole responsibility for token creation and distribution and oversee audits;
- lodge facility guides, terms and conditions and marketing material with ASIC before onboarding clients;
- not limiting liability for misstatements in the terms and conditions; and
- only relate to one ‘project’ and wound down after the arrangement loses its financial-like nature.
The consultation paper notes that in some cases entities will need to engage ‘custody only’ digital asset facility providers for business purposes. For example, an exchange traded fund that holds non-financial product digital assets as part of the broader financial product or service. The provider must enter into a written agreement with the account holder, setting out:
- the reasonable rights that each party will have in relation to record keeping, ongoing review and monitoring, and auditing that would be necessary to ensure compliance with financial services laws;
- the responsibilities of each party to cover losses incurred by the account holder’s customers due to the acts and omissions of the platform provider under the facility contract; and
- that the business will not hold out that the transactional functions it performs for customers are regulated (unless they are).
The consultation paper addresses activities that are not currently in scope for the proposals, however may require regulatory changes in the future, including:
- Debenture-like arrangements: the regulatory regime will require platform entitlements to be fully backed by in-kind assets and therefore the provider cannot lend out assets held on behalf of account holders. However, consumers extending credit to businesses lacks regulatory clarity. This may require amendments to relevant legislation to capture stablecoins and other assets within the ‘money’ definition or create an activity for lending and borrowing digital assets under the proposed financial functions regime; and
- Margin lending-like arrangements: as digital assets are broadly not marketable securities, secured lending arrangements do not fall under the existing margin lending regime. This may be addressed by changing the definition of ‘marketable security’ to include non-financial product digital assets or creating an activity for lending and borrowing digital assets under the proposed financial functions regime.
What crypto businesses can do to prepare
Treasury’s current consultation process is open until 1 December 2023. The consultation paper anticipates exposure draft legislation will be released in 2024 followed by a 12 month transition period.
While these regulatory proposals are in a consultation phase and will be subject to further review, there is a clear intention by Treasury to bring digital asset facility providers within the existing AFSL regime. The AFSL regime is well understood and Gilbert + Tobin advises a broad range of licensees within the market, including guiding clients through the AFSL application process. Crypto businesses should review the proposed scope of regulation and consider if they will be caught by the regime. Businesses can start taking steps to make themselves ‘AFSL ready’ by ensuring they have appropriate business and compliance processes and resourcing in place ahead of time.
Please reach out to our Fintech + Web3 team to discuss whether the regime may apply to your business and applicable licensing options.