Not by the same token - Treasury releases its Token Mapping consultation

In February, the Australian Treasury released the Token Mapping consultation paper (“Paper”). The Paper is a “foundational step” for establishing a framework for reform for the crypto sector.  It is important to understand what the Paper purports to do, what it does not purport to do, the context in which it was published, and the potential next steps.  If implemented, these next steps are likely to be transformative to the regulation of crypto assets in Australia. 

The token mapping exercise set out in the Paper does not set out which crypto assets are or are not financial products.  Nor does it propose a model for regulation.  Instead, it seeks to identify the key activities and functions of products in the crypto ecosystem and map them against the existing “functional” definition of financial product.  This exercise also aims to identify any practical issues which complicate compliance with the existing Australian regulatory regime. 

The results of this consultation are expected to inform future consultations, including a consultation paper proposing a licensing and custody framework for crypto asset service providers (which is due to be released in mid-2023). 

This consultation is part of the broader agenda to modernise Australia's financial system, including updating Australia’s payments system.  By consulting on token mapping, Treasury seeks to ascertain a common understanding of the fundamental legal and technological elements as a foundation on which future potential regulatory reform could be built.

TL;DR

• Token mapping focuses on the functional definition of financial product and its application to the crypto asset ecosystem.
• Some, but not all, crypto assets are financial products. Treasury has not advised which crypto assets are financial products.  Instead, it is important to carefully assess any crypto asset against the “functional perimeter”, as Treasury describes it, of Australia’s financial services licensing regime, and the specific definition of “financial product”, in order to determine its regulatory status. 
• Just because it is hard to ascertain arrangements regarding the nature of a crypto asset does not mean the product is not a financial product.
• Australia’s existing financial regulation targets intermediaries, agents and financial markets through providing boundaries, obligations, protections and supervisory powers. Applying this to public crypto networks, which can operate without promises, intermediaries or agents, complicates compliance. 
• Responses are due to Treasury by 3 March 2023. These will inform Treasury’s future consultations, including a proposed framework for licensing and custody to be released for consultation in mid 2023. 

Background to reform

The Australian Government, in releasing the Paper, announced that regulation of crypto assets has a dual role of protecting consumers and positioning our economy to take advantage of new digital products and services.  

The need for reform was first identified in the Final Report of the Senate Select Committee on Australia as a Financial and Technology Centre (October 2021), and the Government’s response (December 2021), which found that the complexity of crypto-assets poses challenges for consumers, investors, policymakers and regulators.[1]  Following this, Treasury consulted on a proposed framework for regulating crypto assets, Crypto asset secondary service providers: Licensing and custody requirements in March 2022.

Following the commencement of the new Australian Government, the Treasury Ministers announced in December 2022 an agenda to modernise Australia’s financial system to ensure we have a financial system that works for consumers, businesses and investors.[2]  This agenda includes:

1. updating and strengthening Australia’s payments system;
2. strengthening our financial market infrastructure;
3. establishing a regulatory framework for Buy Now Pay Later; and
4. establishing a framework for the licensing and regulation of crypto service providers.

A key step was the Strategic Plan for Australia’s Payments System, published for consultation in December 2022.  Further details of this consultation and broader financial system reform are available here.  Consultation on changes to buy now pay later commenced in November 2022.

The current consultation in the Paper explores in detail which elements of the crypto ecosystem are sufficiently regulated and which require additional attention.[3]  The Paper does not focus on stable coins.  However, these may be considered as part of reforms of the payments system.[4] [5]

What is token mapping?

Token mapping is the process of identifying the key activities and functions of products in the crypto ecosystem and mapping them against existing regulatory frameworks.  This is the first step towards identifying:

• the elements of the crypto ecosystem that fall inside and outside the existing regulatory perimeters;
• the key risks that are added or removed by products using crypto networks;
• the sensible regulatory targets for a future regulatory framework; and
• the legitimate technical criticism and anticipated opportunities of the technology.

Token mapping is designed to ensure that future regulation:

• remains consistent (including remaining technology neutral);
• facilitates existing policy goals (including not being inconsistent with existing policy); and
• allows responsible actors to innovate with appropriate regulatory oversight.

When is a crypto asset a financial product?

The Paper examines how Australia’s existing financial services laws already apply to crypto assets, and where difficulties and complexities in the application of these laws to crypto assets may arise.  The regulatory perimeter for Australia’s financial services laws includes a broad functional definition of ‘financial product’ (“functional perimeter”).  This is supplemented by specific definitions of financial products, which both provide guidance on the functional perimeter and add additional products that do not fall within the general financial functions.  This functional perimeter differs from the regulatory regimes of many other jurisdictions, which list regulated products and may be guided by risk based or activities-based approaches in updating those lists. 

As a result, it is possible to determine the regulatory status of a crypto asset under existing Australian financial regulation, in the normal course of legal advice.  Treasury’s token mapping exercise provides guidance as to how to undertake that assessment. 

Key concepts in the crypto ecosystem

This Paper seeks to clarify some key concepts in the crypto ecosystem in order to inform future policy choices:

(a) Crypto network

A crypto network is a distributed computer system capable of hosting crypto tokens.  Crypto networks are the platforms on which crypto tokens and ‘smart contracts’ are recorded.  Their primary function is to store information and process user instructions. 

Crypto networks are either public or private.  Public crypto networks aim to secure and process information in a way which does not rely on a third party.  Instead, they rely on public communication and data standards.  The network is established when a group of individual computers begin communicating and processing information by following the agreed standards.

(b) Crypto token

A crypto token is a unit of digital information that can be ‘exclusively used or controlled’ by a person – despite that person not controlling the host hardware where that token is recorded.  This exclusive use or control differs from other record keeping systems which rely on records maintained by a third party.  The authenticity of the token is established using cryptography. 

(c) Smart contract

A smart contract is computer code that has been published to a crypto network’s database.  It is computer code that can be guaranteed to run in a predefined and deterministic manner without risk of intervention.  This includes 3 related terms:

• smart control protocol: a collection of smart contracts that can perform more complex and flexible functions than a single smart contract (e.g. an escrow arrangement on the Bitcoin blockchain);
• smart contract application: a combination of smart contracts and conventional technology to create a user facing application (e.g. an automated market maker); and
• smart contract token: a crypto token created using the smart contract (e.g. a non-fungible token or NFT).

Treasury’s token map

(a) Token taxonomy

To determine whether a crypto asset fits within the regulatory perimeter, Treasury proposes a framework that relies on the following 3 concepts:

1. the token (i.e. the unit of information);
2. the token system (i.e. a business, social or physical protocols, or mechanism which is designed to ensure or facilitate a function); and
3. the function (i.e. any benefit ensured or facilitated by the token system).

Each crypto asset can be divided into these categories.  For example, on Ethereum, Ether (token) is used to pay the network fee (token system) in exchange for using the Ethereum network (function). 

The Paper proposes that the application of the functional perimeter is not a question of whether the token or the function meets the financial product definition, as the token itself is merely information and the function is its economic function.  Instead, noting that a crypto asset is a token system that is intrinsically linked to a specific crypto token, the question is whether the token system meets this definition.  The crypto asset is comprised of both the digital unit of information (token) and the benefits provided by its token system (including the applicable smart contracts and business rules).  As a result, it is necessary to analyse whether the token system, which gives effect to this function, may be a financial product.

Whether a token system is a financial product and its nature is to be determined separately, in the normal course of legal advice in respect of:

• whether:
  • the token system is a “facility”;[6] and
  • whether the facility is one through which a person does any of the functions contemplated in the general definition of a financial product; or
• whether the token system falls within a specific definition of financial product.

(b) Token systems

Once the smart contracts and business rules which form the token system are determined, the Paper proposes that the token system can be classified according to the following taxonomy:

• for intermediated token systems:
  • crypto asset services; and
  • intermediated crypto assets; and
• for public token systems:
  • network tokens (a type of crypto asset); and
  • public smart contracts (including some crypto assets created using smart contract tokens).

(c) Intermediated token systems

Intermediated token systems involve intermediaries or agents performing functions pursuant to promises or other arrangements.  These link crypto and the real world as they facilitate functions that cannot be performed by crypto networks and smart contracts alone.  Instead they rely on a combination of crypto networks, tokens or smart contracts as part of the product.

An intermediated token system is either:

• a crypto asset service, which is a token system that accepts crypto tokens as part of performing a function under a legal agreement or other arrangement. Many consumers will not interact with or use crypto assets or a crypto network directly so this is the most common way that consumers get access to crypto assets; or
• an intermediated crypto asset, which is a crypto asset where the link between the crypto token and the token system is created by legal agreement or other arrangement. This is frequently called “tokenising” or making an asset “programmable”.  Examples include rights, licences, and traditional financial products. 

Intermediated crypto assets typically fall into the following categories:

• wrapped assets (also known as tokenisation), which give a person a right to redeem the crypto asset for another asset (such as fiat currency) from a third party. The bundle of rights are usually set out in the terms and conditions between the issuer and its customers (e.g. a wrapped form of fiat currency available on a blockchain); and
• other real world assets, which are promises or arrangements made in respect of crypto tokens that do not relate to any underlying asset (e.g. arrangements between an event ticket issuer and purchaser of the crypto token ticket to access an event).

Legal issues associated with intermediated token systems

The Paper provides that it is possible to determine whether an intermediated token system may be a financial product by considering:

• for crypto asset services: the terms and functions of the arrangement that constitute the service. Note that if the crypto asset service is provided in respect of a crypto asset that is a financial product then service providers are likely to be providing a financial service;
• for wrapped assets: the rights set out in the terms and conditions (including all real-world internal business protocols) and the underlying ‘asset’; and
• for other real world assets: the bundle of rights or expected functions linked to the specific crypto token under an agreement or arrangement. In these cases, the crypto tokens are used as a record keeping device.

In relation to crypto asset services, despite having a clear economic or financial functions, the class of financial product they may fall within can be unclear.  For example, a system which provides rewards such as a ‘staking’ system may be a managed investment scheme, or a derivative.  Alternatively, complex or obscure arrangements are sometimes used which has resulted in very similar products being offered by compliant and non-compliant providers simultaneously. 

Further, although crypto networks and smart contracts may be used to automate or remove the need for certain business protocols, these technology choices may mean other legal and regulatory frameworks are also relevant.  In relation to intermediated crypto assets specifically, this may include:

• rights not accruing to the holder of an asset, where, for example, the only person who can claim against the issuer is the initial acquirer of the asset and not any subsequent purchaser;
• difficulties identifying the issuer of the product. For example, a crypto asset may have one initial issuer of the token but another party may accept the token for another purpose (function).  The second person may be the issuer of a separate token system (which could be a separate financial product) notwithstanding that there is no separate token;
• difficulties identifying the terms of the arrangement, as written terms and conditions which link the crypto token and the underlying asset may not always be available. This can raise issues regarding how individual holders exercise rights, the likelihood that the crypto token will maintain its peg if “wrapped”, and issues in insolvency, as well as issues regarding what the asset actually “is”.

(d) Public token systems

The Paper suggests that public token systems involve functions being ensured by a crypto network directly.  Public crypto networks involve neutral independent infrastructure for creating transactional relationships and provide their holders with a factual ability to perform functions in the future.  Smart contracts on the public crypto network can create ‘economic mechanisms’ without intermediaries. 

Public token systems typically involve networks tokens and public smart contracts.

Network tokens

Network tokens are created by the network itself to reward specific network participants who contribute to ensuring all participants agree to the same database. 

The features of networks and their respective tokens are:

• cryptocurrency network: designed for the purpose of maintaining a secure ledger of network tokens;
• cryptocurrency token: a form of peer-to-peer ‘currency’ available on a peer-to-peer payment infrastructure, the primary function of which is transferability (e.g. bitcoin);
• general network: designed for the primary purpose of being a secure platform for developing software; and
• general token: a form of peer-to-peer ‘currency’ and is intrinsically connected to the factual ability to publish or interact with smart contracts. This is typically relevant to the network’s ‘fee market mechanism’ being the economic mechanism used to price and allocate resources in the network, usually to process transactions (e.g. ether).

Public smart contracts

Smart contracts are either used by intermediaries in providing a service (intermediated smart contracts) or used to remove the need for an intermediary in providing a service (public smart contracts).  For further insights on smart contracts, see KWM’s 10 points alert.

Public smart contracts can only exist on public networks and are created for the purpose of enabling unknown parties to enter transactional relationships.  They are used to remove the need for an intermediary and perform any computable function, including:

• interoperability mechanisms: a simple, immutable public token system published for a technical purpose, such as to facilitate making a crypto asset on one blockchain available on another blockchain;
• economic mechanisms: a mathematical structure that models institutions, such as an auction, an exchange, a marketplace, a set of standards, organisations, etc.  Many of these functions are known as decentralised finance (or DeFi); and
• coordination mechanisms: a system used by people who do not know each other to make collective decisions and take actions, such as to control pooled funds for a decentralised autonomous organisation (“DAO”).

Legal issues associated with public token systems

In addition to determining whether public token systems involve financial products, the Paper identifies other issues to consider, including:

• control: although public token systems are intended to operate on a peer to peer basis with unbreakable rules encoded in smart contracts, coordination mechanisms mean that an individual or group of individuals may have control over the protocol. In these circumstances it may no longer be “intermediary-less”;
• practical compliance: existing regulatory frameworks assume a context involving promises, intermediaries, and agents which may not exist for public token systems;
• risk alleviation: the protections provided by the current regime may not map to the relevant risks of interacting with public token systems. For example, the risk that an economic function will not be ensured by a smart contract-based mechanism may be different to the risk that the same function will not be facilitated when supported by a contractual-based promise;
• smart contract risk: smart contracts are said to remove counterparty risk however this is replaced by or increases a user’s exposure to the following risks:
  • technology risks (e.g. a ‘bug’ in smart contract code);
  • model risks (e.g. an unsound economic mechanism);
  • compliance risks (e.g. blacklisting by smart contract applications); and
  • unknown risks (due to the experimental nature of these systems).

Key takeaways

The Paper does not advise which crypto assets are financial products.  Instead, the Paper clarifies the application of Australia’s existing financial services regulation to crypto assets.  It provides that it is important to carefully assess any particular crypto product against the “functional perimeter”, as Treasury describes it, of Australia’s financial services licensing regime, and the specific definition of “financial product”, in order to determine the regulatory status of a token system.  This process is no different than the process for any other product.   The results will often depend on all aspects of the token system.  

Some key takeaways from the Paper are:

• Crypto assets are not excluded from Australia’s current financial services regulatory framework. Any product which fits the functional perimeter or the specific definition of a financial product falls within Australia’s financial services regulation.  Even where arrangements are hard to ascertain, the token system may be a financial product.
• A large portion of the crypto ecosystem is ‘intermediated token systems’, which involve intermediaries issuing crypto assets and providing crypto asset services. Some of these token systems are clearly facilitating general financial functions.  Others are clearly not.
• Not all crypto assets are financial products. This includes those which are not facilities.  In addition, generating a return or being used as a means of exchange of value alone may not be sufficient for a crypto asset to be a financial product.
• Crypto assets are not homogenous. Even those which may appear to have the same financial function may take different forms and have different regulatory outcomes.  
• A key innovation of public crypto networks is that they can be used as neutral, independent, and immutable infrastructure for high value activities between unknown parties.
• Australia’s financial regulation targets intermediaries, agents and financial markets through providing boundaries, obligations, protections and supervisory powers. Applying this to public crypto networks, which can operate without promises, intermediaries or agents, complicates compliance. 

Questions

Treasury is seeking feedback on 14 questions regarding its proposed token mapping exercise.  This exercise will assist Treasury to consider what is currently covered under legislation, what is not, whether those aspects which are not should be and if so, what that may look like.  It also aims to determine any practical gaps which make compliance difficult given the nature of distributed ledger technology.  Some of the areas Treasury is consulting on include:

• the role of government in regulation of the crypto ecosystem;
• Treasury’s approach to token mapping, including not suggesting a bespoke taxonomy;
• whether any arrangements should be specifically included in the definition of ‘financial product’ to either provide guidance on the functional perimeter or add products that fall outside the general financial functions;
• how compliance may be possible in the absence of intermediaries, agents and financial markets;
• consumer and investor protection and mechanisms to ensure financial stability, including protection against scams, regulatory reforms (in addition to licensing and custody reforms), or limits, restrictions or frictions on investment, and marketing;
• intermediated token systems, including issues identifying the arrangements that constitute an intermediated token;
• regulatory treatment of wrapped real world assets and obligations to redeem for the underlying asset;
• the concept of ‘exclusive use or control’ of public data and its use, benefits or disadvantages in a general definition of a crypto token and crypto network;
• regulatory and policy levers available to encourage the development of smart contracts that comply with existing regulatory frameworks; and
• innovative arrangements including ‘lending style arrangements’ which involve collateral, somewhat like a pawn broker style arrangement, and automated market making activities, including the nature of these features.

Other information

The Paper also sets out an analysis of the legal framework and relevant technological concepts which underpin the crypto industry.  In relation to the legal framework, this includes information regarding the nature of property rights, contractual rights, and financial services regulation.  Whilst this is not intended to be comprehensive or legal advice, it is useful background.  In relation to technological concepts, it considers digital signatures, data processing, consensus and incentives, and fee markets.  The Paper also provides an overview of smart contract protocols and applications.  This includes smart contract protocols relating to interoperability, economic and revenue generating (e.g. automatic market makers, lending and borrowing, and collateralised debt positions), and coordination (e.g. DAOs).

Next steps

Token mapping is an important step towards developing an effective regime for distributed ledger technology and crypto assets.  For the crypto industry, it is an opportunity to meaningfully engage with Government, to build a regulatory framework that:

• reflects the technology and its use;
• fits within existing regulatory policy and laws; and
• provides proper protections for consumers and investors and supports innovation.

For traditional players, particularly in financial services and markets, this is a chance to reflect on the desire to engage with distributed ledger technology and set out any regulatory and practical barriers to taking advantage of its unique features. 

While the Paper’s primary focus is on Australia’s financial services regulatory framework, the concepts and insights are likely to also be relevant to the Review of the Tax Treatment of Digital Assets and Transactions in Australia currently being undertaken by the Board of Taxation, which is expected to report back this year. Responses are due to Treasury by 3 March 2023.  These, along with all other previous submissions, will inform Treasury’s future consultations, including a proposed framework for licensing and custody to be released for consultation in mid 2023. 

Please do reach out to us anytime to discuss any of the issues considered in the Paper, particularly if you have any questions about how the current requirements apply to you, the interaction with other consultations, or want to explore the opportunities that these developments could present for you and your business.

For more insights into the world of fintech, payments and digital assets, including in relation to Treasury’s previous consultations, please see KWM’s crypto hub.

Reference

[1] Transforming Australia’s Payments System – Government Response, December

[2] Developing a Strategic Plan for Australia’s Payments System, December 2022

[3] For completeness, we note this is unrelated to the private member’s bill regarding a bespoke regulatory regime for crypto asset service providers proposed by Senator Andrew Bragg in September 2022. 

[4] Treasury released a strategic plan for regulation of payments systems for consultation in December 2022.

[5] Other relevant consultations include:

• Senate Select Committee on Australia as a Financial and Technology Centre - Final Report (October 2021);
• Transforming Australia’s Payments System – The Government’s response to the Final Report of the Senate Select Committee, the Payments System Report, and Mobile Payment and Digital Wallet Report (December 2021);
• Treasury’s consultation paper - Crypto asset secondary service providers: Licensing and custody requirements (March 2022);
• Updated roadmaps and guidance from APRA^[1] and AUSTRAC^[1] in respect of crypto assets (April 2022);
• The Board of Taxation’s Consultation Guide for the review of the tax treatment of digital assets and transactions (August 2022);
• ASIC’s 2022-2026 Corporate Plan (August 2022) and ASIC’s enforcement priorities for 2023, (November 2022);
• Treasury’s consultation paper on the Strategic Plan for the Payments System (December 2022).

[6] Note that a facility is defined under the Corporations Act as including intangible property, an arrangement or a term of an arrangement (including a term that is implied by law or that is required by law to be included) and a combination of intangible property and an arrangement or term of an arrangement.  It is also worth noting that 2 or more arrangements may be taken to constitute a single arrangement--see sections 762C and 761B of the Corporations Act.