Analysis of Australia's Digital Asset Regulatory Proposal: What Trends Does It Reflect?

Authors: Michele Levine & Jaime Lumsden

Following the release of the "Regulatory Framework for Digital Asset Platforms Consultation Paper" (hereinafter referred to as the "Consultation Paper") in October 2023, the Australian government is consulting on a new regulatory framework for digital asset service providers and proposes to regulate digital assets within the existing Australian Financial Services License (AFSL) framework. The Consultation Paper is the next step in Australia’s effort to establish a robust regulatory framework for digital assets. The proposed regulatory framework will be Australia's first of its kind; however, several issues need to be addressed. This article highlights the questions that should be raised during the consultation process. It is crucial for the industry to seize this opportunity to identify issues and provide guidance to the Treasury on alternative solutions to support the Australian cryptocurrency industry, as further consultation before the legislative draft cannot be guaranteed.

What activities will be regulated?
Asset holding will be a key regulatory activity. Any entity that holds digital assets (in cases where real-world assets are tokenized to support digital assets) will become a "digital asset platform," which will be a new type of financial product as defined by the Corporations Act 2001. Anyone operating a digital asset platform will need to hold an AFSL with specific authorizations and comply with a range of tailored regulatory requirements. In addition to holding assets, certain "financialization functions" related to digital assets (non-financial products) will also be regulated. These financialization functions include digital asset trading, token staking, asset tokenization, and crowdfunding. These financialization functions will also be subject to customized regulatory requirements. Currently, there are no proposals to regulate non-financial digital assets, and any digital assets that fall under financial products will continue to be governed by the existing financial services regime.

What is asset holding?
The Consultation Paper introduces the concept of "factual control" as a threshold for determining whether a person holds assets and thus qualifies as a Digital Asset Facility (DAF). We have no objection to the use of "factual control" itself, and we believe it is generally a good standard for asset holding. However, the concept of "asset holding" needs further clarification and definition, especially considering the different business models in the market. For example, in a brokerage model, brokers may not provide wallets or hold assets for clients, but during brokerage transactions, they may temporarily hold tokens between the exchange and the client. This seems likely to trigger DAF regulation. We believe this is inappropriate, and there are other models that can address the risks. One option might be to implement client asset rules (similar to client money rules) to provide protection around temporary custody. For instance, all assets must be held in designated trust wallets, assets can only be held for a limited time (e.g., 5 days), and clients must provide wallet addresses when placing trade instructions to facilitate timely token transfers. If a Decentralized Autonomous Organization (DAO) is not sufficiently decentralized and can be factually controlled through transaction verification or governance proposals, it may also be subject to regulatory constraints. This needs further exploration, as it could stifle innovation efforts in Australia and raise potential enforcement issues. For example, Australian innovators may be less likely to launch DAOs onshore because it may take time for DAOs to become fully decentralized (i.e., having a large number of unique nodes/validators across different regions). If there is a risk of being discovered in Australian activities that could lead to some form of personal liability, this may also deter Australians from participating in DAOs. We recommend that the industry (particularly DeFi and web3 enterprises) consider these proposals and highlight any concerns and potential solutions.

Is a low-value exemption appropriate?
The Consultation Paper proposes that DAFs holding assets below a certain threshold may be exempt from complying with AFSL requirements under the following circumstances:

• The total value of DAF rights held by any one client of the platform provider does not exceed AUD 1,500 at any time;
• The total amount of assets held by the DAF provider does not exceed AUD 5 million at any time.

This exemption is based on the exemption for non-cash payment facilities; however, while we support the concept of an exemption, we question whether the proposed thresholds are appropriate for DAFs. This is because the exemption for non-cash payment facilities is based on ongoing transactions—meaning each transaction has a limit, and all currently processing transactions have a total limit. When a transaction is being processed, it counts toward the limit. Once the transaction is completed, that portion of the limit can be reused. This approach may not be suitable for asset holding arrangements, as this function is not transactional but static. Therefore, we believe there should be no individual account limits, and we also inquire about what the appropriate total limit for DAFs should be. A good starting point might be the current and proposed limits for stored value facilities, as a means of indefinitely holding fiat currency until instructions are received, which seems more akin to token asset holding arrangements. Another important issue is how to value the total assets of a DAF, considering that the assets held by the DAF may lack liquidity or volatility. Providers of non-cash payment facilities and stored value facilities can easily operate within limits because the value of the assets (fiat currency) typically does not change, whereas DAFs may exceed limits due to favorable market conditions. A more appropriate approach might be to allow for a rolling period (e.g., 30, 60, or 90-day rolling average) and/or to provide a grace period before a breach occurs to buffer against exceeding thresholds.

What licensing authorizations are needed?
At this stage, the Consultation Paper has not proposed specific authorizations, as this will be the responsibility of the Australian Securities and Investments Commission (ASIC), but we understand that DAF providers will need an AFSL, and anyone providing financial services related to DAFs will also need an AFSL. This is conceptually reasonable; however, we believe certain amendments to the Corporations Act are needed to better meet the requirements of DAFs. For digital asset facility providers, it is suggested that authorization to "operate" the facility be required (similar to the authorization for registered managed investment schemes). Additionally, we recommend including specific transaction definitions to cover the proposed regulated financialization functions. That is to say, the current concept of financial product transactions is unlikely to encompass transactions executed through DAFs, so changes are needed to include them in the definition. Furthermore, the Consultation Paper covers intermediaries that facilitate transactions or provide advice regarding DAFs. Our understanding is that the proposed regulation will apply at the DAF level (rather than the digital asset level), so intermediaries have obligations when advising the use of a specific DAF for asset holding or one of its financialization functions, but have no obligations when advising tokens as any transaction subject. Since token trading is one of the regulated financialization functions (provided the transaction definition is modified as discussed earlier in this document), any intermediate digital asset trading on a DAF will also be considered financial services. We believe it is appropriate to adopt the approach taken by insurance intermediaries, where intermediaries can act as agents for either the product issuer or the client.

Is the tangible asset net worth (NTA) calculation valid?
The proposal states that DAFs must hold a tangible asset net worth of AUD 5 million unless the entity outsources custody. If custody is outsourced, a tangible asset net worth of 0.5% must still be held. This amount is considered suitable to cover the orderly winding-up management costs, and is unlikely to change unless it can be demonstrated that the costs of an orderly winding-up for cryptocurrency businesses are higher or lower, thereby justifying an increase or decrease in the tangible asset net worth requirement. It is currently unclear how the "value" of a DAF will be calculated. Presumably, the value of all tokens in the asset holding arrangement will need to be included, even if custody has been outsourced. Therefore, valuing DAF assets for the purpose of calculating tangible asset net worth will face the same issues as we highlighted earlier regarding the low-value exemption. That is to say, if the assets lack liquidity or stability, how should their value be determined?

Is the proposed approach effective?
According to the current proposal, if a DAF provider outsources custody to an entity not licensed in Australia, it must still hold a tangible asset net worth of AUD 5 million. We believe this will pose problems for global businesses and local enterprises that need to obtain global custody solutions, especially considering that there is currently no local digital asset custody market in Australia. We suggest considering an approach similar to APRA's outsourcing framework, allowing businesses to choose overseas custody, provided certain minimum protective measures are in place. Additionally, it is proposed that clients need to contract directly with the custodian. This is very unusual and does not reflect the current outsourcing model in the financial services industry. This requirement is a major barrier to outsourced custody, as it eliminates any control DAFs have over their custody providers. We suspect the intent behind this is to protect client assets in the event of bankruptcy. We believe there are better ways to address this issue, which may include robust client asset rules (similar to client money rules) to protect assets in liquidation, asset segregation and fencing rules, and in some cases, providing clients with intervention rights.
Providing multiple digital asset facilities
According to the proposal, each DAF can only provide one service, such as custody, and each financialization function must be provided through a separate DAF. We believe this practice is clumsy and does not recognize the fact that DAFs hold digital assets while providing financialization functions. This is because many financialization functions stem from asset holding. We suggest that DAFs should be able to hold digital assets and provide token trading and token staking functions. However, we do agree that each asset tokenization and crowdfunding project should be a separate DAF and comply with the proposed requirements separately. The consultation document also mentions that multi-facility platforms may have DAFs provided by different facility providers. Aside from situations where different entities within a corporate group provide specific functions, we are not aware of any platforms currently operating this way. If this is the case, we would like to know whether this is merely an outsourcing arrangement or involves separate facilities provided by different entities. This is something the industry may wish to clarify or comment on.

Trading
Different market rules have been proposed for non-financial digital assets. The industry may wish to raise any concerns they have regarding these market rules and whether they are appropriate given how the crypto market operates. That is to say, what are the specific risks associated with cryptocurrency trading and markets? Do the proposed requirements adequately address those risks? Additionally, there is a question of what market rules apply when non-financial digital assets are exchanged for financial products' digital assets that are subject to the usual market rules. This is a question that requires further thought, especially in light of the merging of TradFi (traditional finance) with DeFi.

Asset Tokenization
Businesses wishing to tokenize assets will need to comply with AFSL as DAFs, as they will be custodians of the assets supporting the tokens and executing the financialization functions of asset tokenization. We believe it is appropriate for token issuers to operate their own DAFs for their asset tokenization projects. Once asset-backed tokens are completed, any platform facilitating transactions or token staking for those asset-backed tokens will also become a DAF and will need to hold an AFSL and comply with the proposed regulatory requirements. We believe that all DAFs involved in the digital asset value chain should be subject to the proposed regulatory regime.

Crowdfunding
Any project wishing to raise funds through token issuance will be intermediated through a DAF and must comply with multiple requirements. This approach is similar to the fundraising regime in Chapter 7 of the Corporations Act. However, the financialization functions of fundraising do not facilitate direct financing similar to what is allowed under Chapter 6 of the Corporations Act, which involves the issuance or sale of securities, and these securities will still be regulated as financial products. The proposal may affect the current ways the industry funds crypto projects and could lead to crypto projects moving offshore. We recommend that the industry consider this and raise any issues they foresee related to this approach and propose alternative solutions to mitigate client risks. One alternative might be to allow projects to raise funds directly through an Initial Coin Offering (ICO) without a DAF license, provided the project does not hold any tokens issued as part of the ICO (i.e., providing a custodial wallet), which is based on a self-trading exemption for financing. If a project holds tokens issued as part of the ICO, it would make sense to regulate that project as a DAF and comply with the proposed licensing and regulatory requirements. If the proposed self-trading exemption for ICOs is allowed, a question arises as to whether any limits should be imposed on the total number or value of tokens issued or sold through the ICO. This is because the current self-trading exemption for securities is predicated on financing not being a "public offering." Since ICOs are typically public, replicating public offering requirements may be challenging. Therefore, limits or caps may be more appropriate. The industry may wish to comment on the feasibility of this option and what limits or caps they consider appropriate. In cases where ICOs may be launched outside of DAFs, it is important to consider whether disclosure should be mandatory and what should be disclosed. For securities financing, a prospectus is required unless an exemption applies. For ICOs, it is appropriate to require a simplified disclosure document and basic disclosure, but it must comply with exemption provisions. For example, if a project raises funds below a specific threshold or from certain specific investors (i.e., wholesale, sophisticated, or professional clients), disclosure documents may not be required. Similar exemptions currently exist for securities, which may be a beneficial point. We also believe it is worth considering whether any disclosures required for ICOs (whether direct disclosures or disclosures through platform intermediaries) should adhere to the same disclosure requirements. This would ensure consistency in project financing and reduce any potential regulatory arbitrage.

What happens next?
The Consultation Paper is a critical step on the path to regulating the cryptocurrency industry. The industry must take this opportunity to consider, pause, and reflect on these proposals and raise any questions or concerns. There may not be another opportunity for input before the legislative draft is released, at which point raising significant structural issues may be too late.