A primer on Australia’s proposals to regulate digital asset platforms

The Australian Government has released its Regulating Digital Asset Platforms Proposal Paper (“Paper”) introducing a proposed regulatory framework to regulate digital asset platforms within the existing Australian financial services ("AFS") laws.  

This alert summarises:

• the proposed regulatory model – including what is captured (and what is not);
• the key concepts that are important to know;
• the core compliance obligations that would flow from licensing; and
• some initial observations on the interaction with existing regulation.

The consultation is open until 1 December 2023, with exposure draft legislation expected in 2024.  It will be important for market participants to carefully consider the proposed changes and contribute to the development of the proposed regulatory model to ensure any new framework helps achieve the important policy aims of the proposals.

High-level synopsis

In essence, the proposals seek to expand the application of existing AFS laws (including licensing requirements) to a broader range of participants in the digital asset ecosystem. 

The AFS regulatory framework already applies to many participants in the ecosystem, including those:

1. carrying on a business of providing financial services, including dealing, making a market, providing a custodial or depository service, and providing financial product advice, in relation to digital assets that are financial products; and
2. operating a financial market or clearing and settlement facility in relation to digital assets that are financial products.

If the current proposals in the Paper are implemented, then the following participants would also be included:

1. operating/providing a platform or other arrangement that provides for the holding of digital assets;^[1] and
2. carrying on a business of providing financial services in relation to this type of platform or other arrangement.

This alert focuses on the current proposals only, rather than the existing application of the AFS licensing regime to the digital asset ecosystem.  However, if you would like to explore this with us further, please do let us know.

More specifically, the proposals in the Paper are to:

• create a new financial product being a “digital asset facility” defined as a “facility for holding digital assets and assets backing digital assets” including both “custody only arrangements” and “digital asset platforms”;^[2] and
  
• require platform providers and other persons carrying on a financial services business in Australia in relation to a “digital asset facility” to hold an AFS licence ("AFSL"), subject to certain exemptions, and comply with requirements including:
  
  • the “general obligations” imposed on an AFSL;
  • financial requirements;
  • bespoke disclosure obligations, which includes a ‘facility guide’ in relation to the digital asset facility, and full disclosure on its website;
  • enter into a standard form facility contract that meets minimum standards with any user of the platform; and
  • additional minimum standards when providing trading, staking (validating transactions), tokenisation or fundraising functionalities.
    

The proposals do not amend the application of existing financial services laws, including the requirement to hold an AFSL, which continue to apply when providing financial services in relation to digital assets that are financial products.  Accordingly, a key issue remains whether any particular digital asset is a financial product under the existing AFS licensing regime – this can be a complex question, but it is important for market participants to consider this question for each digital asset in respect of which they provide services to understand how the AFS licensing regime, and associated regulatory requirements, will apply to them.^[3] 

The following paragraphs provide a deeper insight into the proposals. As our summary shows, the proposals would apply a range of AFS regulatory requirements which are well-known in traditional financial markets to digital asset markets.  Accordingly, it is important to understand how those regulatory requirements have been applied before and how they would apply in the context of your business.  We would be delighted to support you with this – so please get in touch with our team if you would like to discuss the Paper, or developments in the regulation of digital assets or financial services more generally.

A deeper dive on the proposals

On 16 October 2023, the Government announced its proposed framework in the Paper.  This framework proposes to regulate digital asset platforms that present similar risks to entities that operate in the traditional financial system within the existing AFS laws, while ensuring all consumers and businesses have the opportunity to safely explore and share in any benefits of the technology. It aims to address the risks and potential harms associated with digital asset platforms, while fostering innovation and safe usage of digital assets and distributed ledger technology.

The proposed framework intends to introduce a new form of financial product, being a “digital asset facility”, and require those providing financial services in relation to this facility, including providers of the facility, to hold an AFSL and comply with various requirements under that regime. 

These reforms aim to:

• protect consumers while ensuring appropriate guardrails are in place within which to safely foster innovation;
• adopt the approach of similar activity, similar risk, same regulatory outcome;
• remain technology neutral; and
• ensure consistency with the international community by bringing specific activities into the regulatory perimeter.

This proposed framework does not displace existing financial services laws.  For those providing services in relation to digital assets, it will still be necessary to distinguish between entitlements and arrangements that are regulated already as financial products and those that are not.  For digital asset facilities holding or dealing in financial products, the proposed framework is focused on being complementary to the existing financial services laws.

Detail regarding the new financial product, relevant financial services and obligations which will apply to financial services providers are set out below. 

New financial product: digital asset facility

The Paper proposes new regulation of platforms through which an entitlement to a token is made available.  This introduces a new financial product of a “digital asset facility”, defined as a:

“facility for holding digital assets and assets backing digital assets”.

This is intended to cover each of the following facilities:

• a custody only arrangement which involves holding digital assets for another person; and
• a digital asset platform which is a multilateral digital asset facility, where multiple customers transact in platform entitlements which are:
  • issued by a platform when a customer transfers tokens or money onto the platform to ‘fund’ their account;
  • exercised by a customer when the platform transfers tokens or money off the platform on the customer’s request (i.e. a withdrawal from the platform); and
  • transferrable instruments (i.e. capable of being exchanged, encumbered, etc).

This would capture, for example, digital asset exchanges that also hold digital assets.

The definition uses ‘holding’ the digital asset as the regulatory anchor point.  To determine who is ‘holding’ the digital asset, the Paper identifies that the framework will leverage broad concepts around ‘control’.  For example, businesses with the ability to exercise, coordinate, or direct ‘factual control’ over the assets in a real and immediate sense would be such an arrangement, whereas the Paper states that “[c]reating or selling software used by others to hold or deal in assets (custody software) would not be an asset holding arrangement”.  However, a business with the necessary level of control of digital assets (whether using custody software or not) would be in scope. 

This approach is intended to provide an avenue for enforcement against some who have labelled themselves as decentralised finance but who retain and exercise the ability to “steal” customer tokens.  We expect that, as a practical matter, careful consideration will be required to determine whether any particular platform, facility or arrangement is an asset holding arrangement, including in relation to the degree of control that the platform provider exerts over the digital assets and platform. Caution should be exercised before relying on arguments that any arrangement is excluded from the licensing regime on the basis that it is a technology or software arrangement or similar arguments. The proposed also allows the regime to focus on the risks associated with the activity of holding the assets, rather than the asset itself which is consistent with the objectives of risk mitigation, consumer protection and innovation, and the policy of ‘similar activity, similar risk, same regulatory outcome’.

Same financial services regulatory framework

The Paper proposes to apply the existing financial services licensing framework to those carrying on a financial services business in Australia in relation to a digital asset facility.  This will apply to:

1. the issuer of a digital asset facility, which would be the person or persons responsible for the obligations owed to customers under the terms of the asset holding arrangement (referred to as the platform provider); and
2. intermediaries including brokers, arrangers, agents, market makers, and advisers, who are providing services including dealing in digital asset facilities.

Importantly, the paper emphasises that the AFS licensing framework would apply in respect of the digital asset facility, and not the digital asset itself (assuming the digital asset is a not a financial product).  For example, financial product advice would be triggered in respect of advice given in relation to the facility, not the underlying digital asset.

Regulatory obligations

The Paper proposes obligations in relation to licensing, financial requirements and disclosure.  Additional obligations are also proposed to be imposed when a person who is providing a financial service in relation to a digital asset facility is undertaking certain specific activities.  Each of these proposals is set out below.

 A. Licensing

A platform provider, who is responsible for the obligations owed to clients under the terms of the digital asset facility, must hold an AFSL to issue and deal in the digital asset facility (unless an exemption applies). 

A person who deals in, or arranges for another person to use, a digital asset facility (whether that facility is in Australia or elsewhere) would need to hold an AFSL authorising them to provide that service.  This would, in effect, capture brokers and arrangers in respect of digital asset facilities.

Exemptions

The Paper includes the following exemptions:

• low value exemption under which the platform provider who is issuing the platform is exempt from licensing where:
  • the total value of platform entitlements held by any one client of the platform provider does not exceed $1,500 at any one time; and
  • the total amount of assets held by the platform provider does not exceed $5 million at any time (“low value exemption”),

This would not exempt a person who is providing another financial service from the requirement to comply with Chapter 7 of the Corporations Act 2001 (Cth) (“Corporations Act”) in respect of such other activity; and

• a person who deals in, or arranges for another person to use, a digital asset facility in the ordinary course of a business that is not primarily a financial services business, does not need to hold an AFSL if:
  • they are dealing in a digital asset facility provided by a licensed platform provider; and
  • the dealing does not involve digital assets that are financial products.

B. General obligations

The Paper states that a platform provider will be required to comply with the ‘general obligations’ which apply to all AFS licensees, including any obligations imposed under their licence. 

This includes obligations to do the following:

While the Paper states that these requirements will apply to platform providers, it does not expressly state the extent to which these would apply to any other entity providing financial services in respect of a digital asset facility.

Other obligations which typically apply to AFSL holders who provide financial services (including obligations which apply where a person is issuing or dealing in a ‘financial product’) would also apply to those persons who hold an AFSL and provide the applicable financial services in relation to digital asset facilities.  This includes obligations in relation to, amongst other things:

• providing information and assistance to ASIC;
• notifying and remediating account holders affected by reportable situations;
• preparing and submitting financial reports;
• prohibitions on conflicted remuneration, unconscionable conduct and hawking financial products;
• design and distribution obligations; and
• requirements for providing financial product advice.

While not expressly discussed in the Paper, we expect that platform providers and other intermediaries involved in digital assets (including tokens which are not financial products) should carefully consider the application of the unfair contract terms regime under the Australian Securities and Investments Commission Act 2001 (Cth) and Australian Consumer Law, particularly the changes to these regimes which will take effect in November this year (e.g. expanding the entities which may be treated as small businesses to which the regime applies and imposing material penalties for non-compliance, as well as other important changes).

C. Financial requirements

A platform provider, being the issuer of the digital asset facility, is required to meet the following financial requirements which are similar to those which apply to other providers of financial services who are required to be licenced in Australia:

• the standard solvency and positive net asset requirements;
• the standard cash needs requirement; and
• a net tangible assets (NTA) requirement for holding cash or cash equivalents and holding liquid assets of at least:
  • 0.5 per cent of the value of the facility (if using a sub-custodian digital asset facility that has $5m NTA); or
  • $5 million (if performing the custody function).

The Paper notes that the NTA requirements are not aimed at preventing licensee failure, but to provide a financial buffer to decrease the risk of a disorderly or non-compliant wind-up.  The Paper also notes that the NTA requirements broadly replicate the NTA requirements for margin lending facilities. 

D. Disclosure obligations

The Paper proposes that platform providers meet bespoke disclosure obligations which relate to a facility guide, to be supplemented by “full disclosure”, and a standard form facility contract.

Facility guide

The Paper proposes that a platform provider provide a facility guide to any retail client before providing services.  The facility guide would be a public document, worded and presented in a clear, concise and effective manner which contains the following information:

• the name and contact details of the platform providers;
• a summary of the significant characteristics or features of the platform;
• a summary of the rights, terms, conditions and obligations arising under the facility contract; and
• references and links to the ‘full disclosure’.

The facility guide mirrors the approach with operators of investor directed portfolio services (known as “IDPS”).  This will allow multiple platform providers to produce one facility guide that satisfies the FSG requirements, without being responsible for disclosures about other operators, so long as it is clear that the other operators are responsible for those disclosures. 

Full disclosure

All information that forms part of the “full disclosure” is to be incorporated into the facility guide by references and links. 

Full disclosure includes all the information a person would reasonably require for the purpose of making a decision, as a retail client, whether to become a client of the platform.  This includes such information a person would reasonably require to:

• understand the nature of the facility being offered 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.

It also includes the facility contract.

Facility contract

The Paper proposes that a platform provider enter into a standard form facility contract with any user of the platform (“facility contract”) which:

• meets minimum standards for holding assets which include that:
  • assets must be held for token holders or account holders through an arrangement that meets ‘minimum standards for asset holders’ that apply to holders of financial products (such as holding financial products on trust);
  • tangible assets may be held on trust or by way of a bailment arrangement; and
  • tokens must be safeguarded according the ‘additional standards for token holders’; and
• when providing multilateral functions (such as intermediating platform entitlements, providing transactional functions, and listing tokens) on top of an asset holding arrangement, includes a set of non-discretionary rules which meet minimum standards regarding intermediating platform entitlements and transactional functions, and a set of transparent and non-discriminatory criteria regarding other aspects including access, fees, and benefits or entitlements of the platform provider.

E. Additional standards for token holders

As custody of bearer assets, such as digital assets, can bring about distinct risks, the Paper proposes additional standards for token holders. 

These proposals would require tokens be held through arrangements that can ensure tokens are:

• safeguarded 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.

F. Additional standards for other services

Although the Paper only relates to digital asset facilities, where the digital asset facility provides certain additional services, the Paper proposes further minimum standards be included in the facility contract.  This includes requirements for:

• intermediating platform entitlements, including that, in respect of issuance, the platform entitlement must be created to represent each asset held by the platform, and that, in respect of exercising of the entitlements, the facility contract must meet the minimum standards including that a person has sole discretion to decide on and provide instructions in relation to exercising their platform entitlement;
• transactional functions, including:
  • that account holders or token holders have sole discretion to decide on and provide instructions on transactions in relation to platform entitlements, including disposal, transfer, exchange, encumbrance and use of any underlying assets;
  • that the platform will have and apply listing criteria being a document outlining the systems, policies and procedures for making tokens available through the platform;
  • acquisitions will only occur if the token disclosure has been made. For each financial product made available for acquisition through the platform, this is the disclosure document for that financial product.  For each non-financial product, this is a document recording the rights and obligations of the issuer and token holder; and
  • certain requirements including notifying ASIC in relation to or suspected market misconduct (or conduct that would be market misconduct had the digital assets been financial products); and
• ‘financialised functions’ (see below).

This framework relates only to the unique risks that arise when holding tokens and issuing entitlements recorded in token-based systems.  In respect of any other financial product, existing laws continue apply. 

“Custody only” framework

The Paper also proposes that in certain circumstances a person may be providing a ‘custody only’ digital asset facility and would be able to comply with a narrower set of obligations.  This includes where an existing financial services business ‘holds digital assets that are not financial products as part of a financial product or financial service’ (e.g. an exchange traded fund that holds bitcoin or an operator of derivatives exchange using digital asset collateral) and would only require that the platform provider enter into a written agreement with any account holder using the facility for business purposes which sets 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 the 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.

‘Financialised’ functions

The Paper also considers circumstances where there is widespread use of digital token-based systems which leads to ‘financialisation’ of non-financial entitlements being: 

• token trading;
• token staking;
• asset tokenisation; and
• funding tokenisation.

The Paper proposes further requirements on the digital asset platforms undertaking these activities.  In relation to staking specifically, the Paper proposes that a digital asset platform must:

• provide account holders with a direct entitlement to ‘unstake’ any staked asset from the facility;
• have and apply objective criteria assessing:
  • network integrity, uptime, data integrity, neutrality, the existence of conflicts of interests among other network operators;
  • the security of the software used to validate transaction (including conducting security audits, implementing real-time monitoring, where appropriate); and
  • the capacity of the staking software to lawfully validate and order transactions and be programmed with sanctions filtering; and
• include clear and prominent statements in the facility guide in relation to:
  • the risks involving in deploying capital to a ‘protocol’;
  • the risks involved in making an ‘investment’ with no counterparty;
  • the potential penalties and rewards distribution mechanisms; and
  • the audits and other assurances that have been conducted in relation to the network, the client software, and any smart contracts holding tokens.

This is intended to provide consumer protection, address the complexities of interacting with public network infrastructure and ensure account holders understand the unique risks of participating in the activity.

What is not covered

The proposals in the Paper do not cover, and are not intended to cover, the spectrum of services which relate to digital assets, or tokens.  In particular, the following are not covered by the regime:

While not expressly mentioned, the proposed framework suggests that solely providing hardware used by others to hold assets or providing a genuine peer-to-peer, over the counter trading platforms will not be captured, if they do not satisfy the requirements of ‘control’ or ‘holding’.  However, the proposal takes a broad technology agnostic approach so any business with the necessary level of control of digital assets would be in scope. Providers of such arrangements would need to careful assess their services.

Overseas influence, but difference

Whilst the overall philosophy of the Paper is consistent with published regulator thinking in the United Kingdom and Europe, it is slightly different in implementation, as it does not seek to characterise different types of tokenised assets (such as security tokens and utility tokens etc).  Instead, it relies on our principles-based financial services regulation to continue to apply to the entitlements provided in a technologically neutral manner, whilst introducing new regulation only for the digital asset exchanges and other platforms as a new type of financial intermediary.  As with other new intermediaries in the past, it proposes a tailored regime to manage the potential risks posed to consumers.

Consistent with the principles-based approach, the proposed regime does not seek to impose granular requirements on issuers of digital asset facilities that are common in other jurisdictions.  For example, there is no proposal to require digital assets be held by a specific third-party custodian, or that digital assets be held in a certain manner, form or location to help safeguard them.  That being said, these proposals are merely a guide as to how the principles might operate. It is not an Exposure Draft or express guidance from a regulator.  

Broader change

The proposals in the Paper form part of a suite of regulatory changes which may impact digital financial service providers, not least of which are the proposed reforms to Australia’s payments system.  Some of the key reforms include:

• proposed changes to the Payment Systems (Regulation) Act 1998 (Cth) set out in the Exposure Draft which is open for consultation until 1 November 2023 (see our alert here);
• further changes to the regulation of payments which includes proposals to replace the regime for non-cash payment facilities with regulation of stored value facilities, which includes a proposal to regulate payment stablecoins (see our alert);
• revisions to the unfair contract terms regime which come into force on 9 November 2023 (see our alerts here and here); and
• changes to the Privacy Act 1988 (see our alert here).

Next steps and timeline

The key points on process are as follows:

• Treasury is seeking feedback from industry stakeholders on the proposed framework, with responses due by 1 December 2023.
  
• Treasury has indicated that there will be further consultation on exposure draft legislation in 2024.
  
• The Paper proposes a 12 month transition period following legislation being made law.

Some preliminary viewpoints

The proposals set out in the Paper present a comprehensive framework for regulating digital asset facilities.  These attempt to balance the existing regulatory framework with the unique nature of digital assets, and the need to protect consumers.

By imposing regulatory requirements on an intermediary, which include a licensing requirement and regulation of the intermediary’s conduct, and require oversight of third parties who provide a variety of services to the intermediary (including staking, custody, tokenisation etc.), many of which are then offered to the intermediary’s customers, the Paper appears to be seeking to impose a comprehensive regime without requiring every participant in the digital asset ecosystem to obtain a licence. 

As a result, some intermediaries and participants who may have previously considered themselves to be outside the scope of the Australian regulatory regime may become subject to regulatory requirements, including the requirement to hold an Australian financial services licence.  These regulatory requirements may arise directly – such as for software providers who have the necessary level of control of digital assets– or indirectly, such as for service providers who will be required to meet minimum standards to provide service to digital asset facilities and platform providers.

Having said all that, compliance with the proposals in the Paper will require a highly sophisticated approach and the ability to navigate the nuance of Australia’s regulatory regime, particularly if there is more than one jurisdiction relevant to the business.

All participants in the digital asset ecosystem, including those who are interested in tokenising traditional financial products, should carefully consider the impact of the reforms proposed in the Paper on their activities. 

With submissions due 1 December, there is time to work through the detail of the proposal and participate in this process.  If you would like to discuss the Paper, or developments in the regulation of digital assets or financial services more generally, please do not hesitate to reach out to our team.  We would be delighted to support.