22 November 2022
Pictures of Bored Apes bought and sold as non-fungible tokens, anonymous purchase and consumption of pornography, drug dealing, and money laundering. These are just a few of the many notable and controversial activities associated with the use of cryptocurrency. However, these days cryptocurrency has become more mainstream with some of the biggest retailers setting up payment systems that enable cryptocurrency transactions1, in addition to payment platforms themselves such as Mastercard2 and PayPal3.
Cryptocurrency exchanges have proliferated to facilitate these transactions, providing services similar to traditional currency exchanges by offering to transfer fiat currency into cryptocurrency and vice-versa. However, this industry is still young and unregulated. Notably, cryptocurrency and cryptocurrency exchanges do not fall within the definitions of ‘financial product’ or ‘financial service provider’ under the Corporations Act 2001 (Cth) (Corporations Act).
Last year some of Australia’s largest cryptocurrency exchanges appealed to the Senate Committee on Australia as a Technology and Financial Centre (SCAT) to urgently introduce legislation to protect investors and customers from the ongoing risk of losing millions of dollars, not only posed by scammers, but by weaker operators in the market4.
But first, how does cryptocurrency work?
To understand why cryptocurrency exchanges require regulation, one must have a base understanding of how cryptocurrency works. Cryptocurrency is essentially comprised of sets of digital tokens, the accounting of which is held on the ‘blockchain’, a collectively maintained digital ledger which uses cryptography to provide secure and public peer to peer transactions. To own currency you require a ‘wallet’, which you can access with a ‘key’ (a random string of numbers and symbols).
Originally, the idea of cryptocurrency was that it would replace the need for third party institutions, such as banks, thereby cutting out the complexity and expense of an intermediary for transactions. However, ironically, due to the complexity of owning a wallet and to get assistance in finding other peers, many use the services provided by cryptocurrency exchanges.
Current state of affairs
In its hearings last year, SCAT heard about the current state of affairs for cryptocurrency regulation in Australia. That is, there was nothing effective to speak of. SCAT heard that there were currently no rules for external audits or IT security standards for cryptocurrency exchanges in Australia5. It is true that these exchanges must demonstrate compliance with Anti-Money Laundering (AML), Counter-Terrorism Financing and Know Your Client (KYC) legislation by providing evidence of such compliance to the Australian Transaction Reports and Analysis Centre (AUSTRAC). However, the application process for AUSTRAC licensing only requires that companies have an AML/KYC policy which can be easily obtained online in a pre-written form. Cryptocurrency exchanges are also not required to perform due diligence on their users or the coins they want to trade in, before allowing them to purchase and sell cryptocurrency.
In October 2021, SCAT published its Final Report into the matter (Final Report), noting that the most appropriate government agency to regulate cryptocurrency exchanges is the Australian Securities and Investments Commission (ASIC)6. This makes sense as ASIC is the body responsible for the regulation of financial products. However, herein lies a major difficulty.
The definition problem
Section 764A of the Corporations Act contains a list of specific things that are financial products, such as securities, interests in managed investment schemes and derivatives, or anything falling under the general definition of a financial product in section 763A.
On the face of it, cryptocurrency is similar to several items that fall within these definitions. As ASIC itself has pointed out in Information Sheet 225: Crypto-assets (INFO 225)7, crypto-assets and initial coin offerings (funding to finance the initial work of a cryptocurrency project) could be financial products, and if they are, that they are likely to be managed investment schemes, derivatives or securities. However, INFO 225 is not definitive on the matter, meaning that it is not certain that cryptocurrency falls within the current legislative regime pursuant to the Corporations Act. The Final Report seems to agree with this position, pointing out that most crypto-assets which are currently available to Australian retail investors fall outside of ASIC’s regulatory ambit8.
Proposed Regulation
The Final Report, having recognised the gaps in Australia’s current regulatory scheme, contains twelve recommendations. The key recommendations that address the major issues outlined above are as follows.
Recommendation 1 – The Australian Government establish a market licensing regime for Digital Currency Exchanges, including capital adequacy, auditing and responsible person tests under the Treasury portfolio9.
As noted above, the existing market licence regime pursuant to the Corporations Act is inadequate to address the crypto-asset market. Accordingly, there needs to be a more thorough regulatory framework with appropriate obligations and requirements around the custody of digital assets. The idea is that these requirements would be scalable with the size of the business, so that newer operators are still able to function as they scale up their operations. Such a regime will ensure that consumers can have increased confidence in their businesses and shoddy operators are weeded out.
Recommendation 2 – The Australian Government establish a custody or depository regime for digital assets with minimum standards under the Treasury portfolio10.
A glaring hole in current legislation is the limited consumer protections available for custody services provided by cryptocurrency exchanges for consumers holding crypto-assets. There needs to be clear arrangements in relation to custodial services to avoid the situations described above where customers lose the cryptocurrency that they thought was theirs. Currently, many exchanges have made use of the anonymity crypto, allowing them to make a swift exit with consumers’ money should anything go awry. Accordingly, there also needs to be a strategy to create greater consumer awareness of the risks associated with utilising cryptocurrency exchanges.
Recommendation 3 – The Australian Government, through Treasury and with input from other relevant regulators and experts, conduct a token mapping exercise to determine the best way to characterise the various types of digital asset tokens in Australia11.
Given the quick and ever evolving landscape of cryptocurrency and other crypto-assets, it is vital to arrive upon an agreed classification of the various types in order to ensure any regulations are fit for purpose and do not need to be constantly updated to close loopholes. This is no mean feat, as it is a task yet to have been done in any other jurisdiction globally. Some have even called the concept that it could be done ‘questionable’12. However, some cryptocurrency exchange heads have welcomed the plan, due to the additional clarity it would provide to the industry13.
Implementation of Recommendations
In December 2021, the Morrison government provided their response to the Final Report, including its recommendations. While there has been a change in government since, key recommendations 1-3 were accepted in principle at the time, and recommendation 5 was noted. A consultation paper was released on 21 March 2022 seeking feedback on a proposal to introduce a licensing regime administered by ASIC that would apply to crypto asset secondary service providers (CASSPrs)14. The regime would be based on, but separate from, the Australian financial services licence and Australian market licence regimes.
The Treasurer, Jim Chalmers, has also confirmed that work is well underway to develop policy advice for the Albanese government. They will be starting with token mapping, in line with Recommendation 3 of the Final Report, with a public consultation paper to be released soon.
Ultimately, the progress to introduce proper legislative reform will still take some time before it is implemented. This can be contrasted with the sheer speed at which the cryptocurrency market continues to change and develop, providing new and complex challenges to businesses and consumers alike. While the currently proposed recommendations for reform appear promising, there remains the very real scenario where they become obsolete upon implementation.
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Footnotes
- https://www.nytimes.com/2021/02/03/style/what-can-you-actually-buy-with-bitcoin.html
- https://investor.mastercard.com/investor-news/investor-news-details/2020/Mastercard-Accelerates-Crypto-Card-Partner-Program-Making-it-Easier-for-Consumers-to-Hold-and-Activate-Cryptocurrencies/default.aspx
- https://newsroom.paypal-corp.com/2022-06-07-PayPal-Users-Can-Now-Transfer-Send-and-Receive-Bitcoin-Ethereum-Bitcoin-Cash-and-Litecoin
- https://www.afr.com/technology/crypto-exchanges-beg-for-regulation-as-low-bar-poses-investor-risk-20210808-p58gvg
- https://www.afr.com/technology/crypto-exchanges-beg-for-regulation-as-low-bar-poses-investor-risk-20210808-p58gvg
- Final Report, Select Committee on Australia as a Technology and Financial Centre, https://parlinfo.aph.gov.au/parlInfo/download/committees/reportsen/024747/toc_pdf/Finalreport.pdf;fileType=application%2Fpdf (Final Report), [2.34].
- ASIC Information Sheet 225 – Crypto-assets, ASIC, https://asic.gov.au/regulatory-resources/digital-transformation/crypto-assets/#managed.
- Final Report, [2.39].
- Final Report, [6.16].
- Final Report, [6.22].
- Final Report, [6.28].
- https://forkast.news/australias-crypto-industry-split-on-treasurys-new-token-mapping-scheme/
- https://www.bloomberg.com/news/articles/2022-08-22/australia-to-map-crypto-tokens-as-part-of-regulatory-ramp-up
- Crypto asset secondary service providers: Licensing and custody requirements (Consultation Paper), The Treasury, https://treasury.gov.au/sites/default/files/2022-03/c2022-259046.pdf.
Disclaimer: The information published in this article is of a general nature and should not be construed as legal advice. Whilst we aim to provide timely, relevant and accurate information, the law may change and circumstances may differ. You should not therefore act in reliance on it without first obtaining specific legal advice.
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