Friday, May 27 2022

Yesterday, Digital Economy Minister Jane Hume addressed the public during Australian Blockchain Week, coinciding with the release of the government’s consultation paper ‘Secondary Crypto Asset Service Providers: Requirements licensing and custody”. Senator Hume introduced the consultation paper by stating that the crypto asset industry, with the right regulation, could grow to “$68.4 billion” by 2030.

The consultation paper outlines the government’s approach to introducing a regulatory and licensing regime for secondary service providers of crypto assets (CASSPrs) that offer custodial, storage, brokerage, exchange, and trading services in crypto assets, or operate a marketplace in crypto assets for retail consumers.

The consultation document considers:

  1. the current state of the crypto asset ecosystem;
  2. proposals for a licensing regime for CASSPrs;
  3. custodial obligations to safeguard private keys; and
  4. first views on the classification of crypto assets.

The expansion of use cases of a virtual economy

From trustless digital currencies, the use of crypto assets has expanded into areas such as games, art, real estate, loans and security. During this period of expansion and innovation, Australians have been at the forefront of adoption, with the Independent Reserve finding that 28% of Australians surveyed owned crypto assets as of December 2021. Private Sectors and public are also exploring the potential of crypto assets and blockchain technology. , with recent examples of efforts from leading organizations including:

  • ASX is replacing its Electronic Clearinghouse Sub-Register System (CHESS) with distributed ledger technology;
  • Rio Tinto uses blockchain to facilitate the trade of iron ore to a foreign country; and
  • the government’s digital economy strategy, designed to position Australia as “one of the top 10 digital economies and societies by 2030 through $1.2 billion in strategic investments”.

The regulatory challenge

The consultation paper rejects the proposal that crypto assets should be regulated as financial products on the grounds that the principles for regulating crypto assets are not identical to those underlying the regulation of financial products. Instead, the consultation paper considers that the regulation of the two should be separate and distinct to provide for the different characteristics and risks of each.

While traditional financial products rely on trust, crypto is trustless. However, the government recognizes that there is a difference between trustless crypto assets and service providers that facilitate access to these assets. The use of secondary service providers and centralized system actors introduces risks and requires trust, leading to the need to regulate these service providers.

Crypto assets are well known to be high risk following several high-profile events where consumers suffered significant losses (e.g. ACX.io failure and MyCryptoWallet). This has led some industry players to call for increased oversight, saying a licensing regime for rCASPs would provide regulatory clarity for operators and protect consumers.

The consultation paper proposes to regulate rCASPs that:

  • provide retail consumers with access to crypto assets of non-financial products, including brokers, traders and market operators;
  • custodial, safekeeping, or storing all Crypto Assets on behalf of a Consumer; and
  • are considered by the Financial Action Task Force definition of a virtual asset service provider for anti-money laundering and anti-terrorist financing purposes.

Proposed CASSPrs Licensing Regime

Consumers are currently exposed to significant financial and operational risks, including custodial risks, when engaging with CASSPrs.

The proposal seeks to implement a CASSPr licensing regime, separate from Australia’s financial services licensing regime and administered by ASIC. In a move that will be welcomed by many, the government has signaled its intention to avoid duplication, meaning providers will likely only be required to hold a CASSPr license or an AFSL or Australian market license (depending on the nature of the crypto asset and services provided).

Proposed obligations for CASSPr licensees include:

  • do all that is necessary to ensure that: the services covered by the license are provided in an efficient, honest and fair manner; and any crypto-asset market is operated in a fair, transparent and orderly manner;
  • maintain adequate technological and financial resources to provide services and manage risk, including complying with the custodial standards proposed in the consultation document;
  • maintain adequate internal and external dispute resolution mechanisms;
  • have adequate dispute resolution mechanisms in place, including internal and external dispute resolution mechanisms;
  • maintain minimum capital requirements; and
  • ensure that directors and key operations managers are suitable and suitable persons and are clearly identified.

Proposed custodial obligations to protect private keys

Consumers accessing crypto assets through CASSPr rely on their service provider to retain custody of their crypto assets (i.e. protect their private keys) and are not well placed to assess the security and resilience of custodial agreements of CASSPr.

The consultation document proposes to put in place mandatory minimum custody obligations for CASSPr holding private keys on behalf of consumers.

Some of the proposed bonds include:

  • hold crypto assets with consumer confidence;
  • ensure that consumer assets are properly segregated;
  • maintain minimum financial requirements, including capital requirements;
  • ensure that the private key custodian has the necessary expertise and infrastructure;
  • processes for redress and compensation in the event of loss of crypto assets held in custody; and
  • appropriate skills to assess compliance when custody is outsourced to a third party.

First Opinions Wanted on Token Mapping

The consultation paper addresses the complexity of crypto assets and the networks they operate on, and notes that the rights and functions associated with crypto assets may change over time.

Taking initial steps to address these concerns, the consultation paper also invites input on the types of crypto assets that will help inform the government’s token mapping exercise. The government aims to complete the token mapping exercise by the end of 2022. It is hoped that this exercise will provide further insight into the current state of crypto-assets in Australia and the risks and technological considerations that may influence how they are classified and regulated.

The consultation document gives examples of crypto assets that include:

  • utility crypto assets, which can only be exchanged for goods or services by the issuer. This includes loyalty programs and digital vouchers represented by crypto assets;
  • collectible crypto assets that include digital representations of real-world collectibles such as artwork, images, music, game items, promotional posters;
  • useless crypto assets that provide no promises, rights, or use cases other than the ability to transfer them over a network; and
  • asset-backed crypto assets used as a store of value, medium of exchange, and unit of account. These would include some stablecoins and central bank digital currencies.

Other areas of feedback sought

While the consultation paper provides a series of regulatory proposals, it also seeks comments on the possibility of self-regulation and integration of crypto assets into the existing framework for financial products, suggesting that these options have not yet been entirely excluded.

The government is also concerned about how the CASSPr will interact with the AML/CFT regime administered by AUSTRAC. The inclusion of “key persons” in CASSPr license proposals suggests that there will likely be some overlap between licensee requirements and existing registration requirements for digital currency exchange providers. In response, the consultation paper seeks answers on how CASPs should comply with AML/CFT obligations and how best to avoid duplication.

Several of the government’s questions to stakeholders relate to the cost of implementing the proposals in the consultation paper, noting that while consumer protection is a priority, there is also a concern to promote industry in Australia and avoid impose unsustainable compliance costs on suppliers.

However, the consultation document also sets out proposed minimum capital requirements for licensees. Although the document does not offer specific numbers, traditional custodians are required to hold between $150,000 and $10 million. While this is any indication of the government’s plans for rCASPs, small providers are unlikely to take much comfort in the document’s concern with implementation costs.

A new regulatory future for crypto?

The consultation paper recognizes the growing importance of the crypto asset ecosystem to the Australian and global economy, as well as the need for regulatory certainty to encourage innovation and competition, and to give consumers greater trust in their dealings with CASSPrs.

Submissions and comments to the consultation are open until May 27, 2022.

This article was written with the help of Eric Lay, a law graduate.

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