CASSPrs in from the cold: A regulatory framework for crypto asset secondary service providers in Australia?

The Treasury has sought feedback on proposals to regulate crypto asset secondary service providers (‘CASSPrs’) in a consultation paper (‘Consultation Paper) released on 21 March 2022.  The proposals follow recommendations as to reform options for the regulation of digital assets made by the Senate Select Committee on Australia as a Financial and Technology Centre in its October 2021 report.

Treasury’s proposals follow rapid expansion in the crypto asset ecosystem. The Australian Tax Office submission to the Senate Select Committee showed a dramatic increase in trading since the beginning of 2020, with an estimated 600,000 taxpayers or more that have invested in digital assets in recent years.  Other research suggests that as many as 17% of Australians own crypto currency and capital expenditure by new businesses building digital asset infrastructure is in the billions of dollars.

This expansion has led to calls for additional regulation to provide certainty in crypto investment and consumer trust in its platforms (particularly in the wake of recent crypto exchange failures such as ACX and MyCryptoWallet).

While ASIC, AUSTRAC and the ATO all have some oversight and regulatory jurisdiction over aspects of digital assets, there are gaps and uncertainties and the regulatory issues the industry raises for the financial system and consumers remain to be coherently and comprehensively addressed.

Internationally, the need for regulation has been recently highlighted with growing concerns that cryptoassets could be used to circumvent financial sanctions against Russia following its invasion of Ukraine. An effort to address the gaps which cryptoassets create in financial services regulation has already commenced globally – in the US, CASSPrs are subject to anti-money laundering laws and must register with FinCEN, implement an AML/CFT program, maintain appropriate records and submit reports to the authorities. The UK government is expected to announce a new regulatory regime for crypto at any time, while in the European Union the European Commission’s legislative proposals (Markets in Crypto-assets (‘MiCA’)) continue to inch forward.

Crypto context

Crypto assets (also known as ‘virtual currency’ in other regions) can extend to a range of different instruments.  ASIC defines them as a ‘digital representation of value or contractual rights that can be transferred, stored or traded electronically, and whose ownership is either determined or otherwise substantially affected by a cryptographic proof’.  Crypto assets can be used as an investment, as a means of exchange, and to access goods and services.

CASSPrs provide the infrastructure for the crypto asset ecosystem, including custody and storage, exchange, brokerage and dealing services, and operating a market. There are a number of potential risks associated with CASSPrs including insolvency and disorderly wind down (as evidenced by recent failures of exchanges which saw investors lose access to their crypto assets and cash the exchanges held on their behalf.

1. Who will the proposals apply to?

Terminology

While the Senate Select Committee used the term ‘digital currency exchange’, Treasury seeks to encompass secondary service providers including brokerage services, dealers and custody services and proposes the new term ‘crypto asset secondary service providers’.  Treasury defines CASSPrs as:

Any natural or legal person who, as a business, conducts one or more of the following activities or operations for or on behalf of another natural or legal person:

1. 1. exchange between crypto assets and fiat currencies;
   2. exchange between one or more forms of crypto assets;
   3. transfer of crypto assets;
   4. safekeeping and/or administration of virtual assets or instruments enabling control over crypto assets; and
   5. participation in and provision of financial services related to an issuer’s offer and/or sale of a crypto asset.

The current crypto ecosystem and challenges to its regulation

Treasury (rightly) describes the existing regulatory framework in Australia is a ‘patchwork of principles-based obligations’. Depending on its features a crypto asset may be regulated either by ASIC as a financial product or the ACCC as a consumer product.  Indeed Treasury notes the regulatory gap raised by doubts about whether crypto assets are a financial product under the Australian Financial Services Licencing regime at all (doubts which ASIC shares).  Regulatory intervention is largely limited to the subset of CASSPrs that exchange fiat currency to crypto assets (digital currency exchanges).  These are subject to the anti-money laundering and counter-terrorism financing (‘AML/CTF’) regime following relatively recent amendments.

The gaps remaining to be addressed, in addition to the challenge in classifying crypto assets, include

• counterparty risks associated with using crypto assets as a store of value or for investment,
• the perception that similar services are regulated in a similar way, and
• protecting the community from the use of crypto assets to facilitate criminal enterprise and fraud.

2. What are the proposals?

A new regime for a new kind of asset

Treasury proposes a new and separate licensing regime under which CASSPrs would hold the same type of licence but with obligations that adapt flexibly to the services offered. The regime would require CASSPrs to comply broadly with a suite of requirements similar to the general obligations of financial services licensees under the Corporations Act, in addition to obligations to:

1. take reasonable steps to ensure that their crypto assets are “true to label”, meaning that a product is not falsely described as a crypto asset, and that crypto assets are not misrepresented or described in a way that is intended to mislead;
2. ensure scams are not facilitated through their platforms;
3. observe anti-hawking rules;
4. comply with audit requirements;
5. comply with AML/CTF laws (with a breach of these provisions being grounds for a licence cancellation); and
6. maintain adequate custody arrangements.

One notable question raised for consultation is whether CASSPRs should be prohibited from providing what would be considered personal advice in relation to financial products under the AFSL regime (i.e. that takes into account the person’s circumstances, needs and objectives).

Proposed prohibition on hawking or pressure selling crypto assets

Treasury proposes a hawking prohibition similar to the requirements for financial products proposes to the effect that a CASSPr must not offer or invite a consumer to ask for crypto assets in the course of an unsolicited contact with a retail consumer:

Proposed custody standards

As custody of client assets is central to the business model of most CASSPrs, the Treasury proposes custody standards aiming to ‘protect both crypto and non-crypto client assets from the insolvency of a service provider, and thereby support consumer confidence when dealing with industry’.

Treasury proposes principle-based obligations (see the Appendix) which are similar to traditional financial markets, and suggests industry self-regulation for the enforcement of these standards.

3.  How will the proposals be implemented?

Alternative options to regulation

Treasury’s proposal is for a separate licensing regime.  There would be one type of licence for CASSPrs that facilitate the buying and selling of crypto assets (exchanges, dealers and brokers) and custodians, though the obligations of the licencee would be graduated to reflect the number and type of services the CASSPr offered.

Treasury is also seeking feedback on this and the following alternate options:

Early views sought on token mapping

The Senate Committee Report recommended a token mapping exercise is undertaken to classify the various types of crypto-asset tokens and other digital assets being developed in the market, to ensure that the regulatory classifications for these assets are fit-for-purpose.

Treasury seeks to begin this process as to the various types of crypto assets through a token mapping exercise to be completed by the end of 2022. The Consultation Paper provides a non-exhaustive list of descriptions (see the Appendix below).

Conclusion

The closing date for submissions on Treasury’s proposals is 27 May 2022. If you would like further guidance as to the impact of these proposals, or assistance in making a submission, please contact our Banking & Finance Team.

Appendix

Proposed custody standards

These proposed obligations are:

1. holding assets on trust for the consumer;
2. ensuring that consumers’ assets are appropriately segregated;
3. maintain minimum financial requirements including capital requirements;
4. ensuring that the custodian of private keys has the requisite expertise and infrastructure;
5. private keys used to access the consumer’s crypto assets must generated and stored in a way that minimises the risk of loss and unauthorised access;
6. adopt signing approaches that minimise ‘single point of failure’ risk;
7. robust cyber and physical security practices;
8. independent verification of cybersecurity practices;
9. processes for redress and compensation in the event that crypto assets held in custody are lost;
10. when a third-party custodian is used, that CASSPrs have the appropriate competencies to assess the custodian’s compliance necessary requirements; and
11. any third-party custodians have robust systems and practices for the receipt, validation, review, reporting and execution of instructions from the CASSPr.

Token mapping descriptions

A non-exhaustive list of descriptions include:

• utility crypto assets which can only be redeemed for goods or services by the issuer. This includes loyalty schemes and digital vouchers represented with crypto assets. For example, crypto assets that are developed for storage and digital content and data;
• collectable crypto assets that include digital representations of real-world collectible items like art, image, music, in-game items, promotional posters;
• zero utility crypto assets that provide no promises, rights or other use case than the ability to transfer them via a network;
• membership crypto assets that allow access to communities or loyalty schemes. This can include ‘social crypto assets’;
• asset-backed crypto assets used as a store of value, means of exchange and unit of account. These would include certain stablecoins and Central Bank Digital Currencies (CBDCs);
• algorithmic stable crypto assets whether under-collateralised or over-collateralised;
• crypto assets used for fundraising similar to not-for-profits;
• crypto assets used for fundraising by performing artists, journalists, or similar publications as a form of income to offer their services;
• governance crypto assets that have no value accrual;
• governance crypto assets that have value accrual (e.g. buy back and burn model);
• crypto assets that replicate the functions of a financial product (whether they strictly meet the definition or not, for example, derivatives where technology is the intermediary instead of the issuer); and
• hybrid crypto assets that may perform multiple functions across a number of categories.

~ with Pippa Thorne, Graduate-at-Law