Regulating crypto – token mapping consultation paper hints at future licensing regime

By David Rountree, Simun Soljo, Gabor Papdi, Isaac Nankavill
Financial Services Technology & Outsourcing

Token mapping will help shape crypto asset service providers' obligations 12 min read

Last week the Federal Government published its consultation paper Token Mapping, setting out Treasury's proposed taxonomy of the crypto asset ecosystem. This is the first step in the current Government's process to regulate that space, and will inform the design of future licensing and conduct obligations. In this Insight, we provide an overview of the Government's proposed approach and how it will impact regulatory reform in the crypto-asset sector. Public submissions on the consultation close on 3 March 2023.

Key takeaways

  • The consultation paper contains no actionable proposals for regulation. It seeks to explain key concepts relating to crypto assets, outlines the challenges the Government sees in crypto asset regulation, and provides hints on what a future licensing regime may look like.
  • The paper highlights some of the key areas where existing regulatory schemes are inadequate to deal with certain classes of 'crypto assets' – particularly where the relevant assets are able to operate and perform their functions in the absence of traditional 'promises, intermediaries or agents', which are traditionally the classes of persons or conduct that are regulated. However, the paper does not purport to solve these regulatory lacuna.
  • Consistently with other similar regulatory schemes, the Government appears to be in favour of a functional and technology-neutral approach to regulating crypto assets. It also warns against any exhaustive approach to crypto-asset regulation.
  • The outcomes will inform the design of the future licensing and custody framework for crypto asset service providers, which Treasury has indicated will be released in mid-2023, as well as subsequent regulatory reform. We think this represents a significant delay in the implementation of an appropriate regulatory regime for crypto, given the multiple reports and consultations, and the progress that has been made in other comparable jurisdictions (Singapore, the UK and Europe) on implementing crypto-specific regulation that responds to the risks this technology raises.
  • Any organisation providing or considering providing crypto asset services within Australia should consider making a submission. The consultation period is brief – closing on 3 March 2023.

The Government's proposed approach

The Government's stated objective in taking a 'token mapping-based' approach to regulation is to:

  1. ensure consistency in regulating activities (ie be technology neutral);
  2. facilitate existing policy goals; and
  3. allow responsible actors to innovate with appropriate regulatory oversight.

In the consultation paper, Treasury takes a functional approach to categorising crypto assets and related services. In doing so, it maps crypto assets by reference to how they achieve their functions. This approach is broadly similar to aspects of the existing financial services regulatory framework in the way it defines financial products and financial services (which the consultation paper refers to as the functional perimeter).

In the Treasurer's press release announcing the consultation paper, it is clear that the Government intends to approach its regulatory framework focusing on consumer protection. The press release states that the Government will perform additional work to 'understand the risks and opportunities crypto poses for the future', and will 'focus on regulatory gaps and ensure that emerging risks are identified and controlled'. This is unsurprising, given recent developments in the crypto ecosystem.

What does this mean for crypto ecosystem regulation?

While the consultation paper contains no actionable proposals for regulation, it sets out the challenges that the Federal Government will face in designing a system of regulation for the crypto ecosystem, and provides more questions than clear positions. However, it gives hints on what a future licensing regime will look like, suggesting that:

  • regulation will be applied by reference to the high-level function that a token or token system seeks to serve;
  • the regulatory regime ultimately settled on may apply more broadly than the 'secondary service providers' that were the subject of the previous Government's proposed licensing regime (see our Insight).

The paper does not provide definitive guidance on any specific tokens, and acknowledges that seeking to do so may ultimately be a fruitless exercise, given the breadth of technical functions, as well as the regulatory challenges that this might pose. Nonetheless, it is encouraging to see the level of detailed consideration that has gone into the analysis in the paper. Treasury provides its views on a number of nuanced matters, heavily reliant on a technical understanding of the crypto asset ecosystem, which have been used as inputs into the proposals provided. In doing so, Treasury acknowledges some of the key existential challenges of regulating certain categories of crypto assets that operate technically independently of any 'promises, intermediaries or agents'. In particular, the annexures to the consultation paper provide brief explanations of core concepts in crypto assets that other regulators may draw on in their future considerations.

The consultation paper follows significant regulatory developments overseas. On 1 February, the United Kingdom's HM Treasury commenced consultation on its next phase of crypto asset regulation, which appears to be bringing the UK closer to the European Union's upcoming Markets in Crypto Assets (often known as MiCA) legislation. (See the overview by our alliance firm, Linklaters.) The Federal Government will have the opportunity to draw on the ever-growing body of foreign proposals (and implemented regimes) in developing its positions on crypto asset regulation.

Key concepts in the token mapping framework

The token mapping framework in the consultation paper relies on three core concepts:

  1. tokens – physical or digital units of information (whether bearer-like items or registry entries);
  2. token systems – procedures and protocols designed to ensure or facilitate a function, such as a particular crypto lending arrangement; and
  3. functions – benefits ensured or facilitated by a token system, such as receiving payment.

Any of these three aspects could be the subject of regulation.

The paper defines a 'crypto asset' as a 'token system' that is intrinsically linked to a specific crypto token – it is effectively an umbrella term for a crypto token and each of the benefits provided by its token system. In considering how the 'functional perimeter' of the current regulatory regime could apply, the paper suggests that the relevant question is whether the token system meets the relevant definition of financial product. However, it is not clear to us that focusing on the token system is the most sensible approach, and it may be more appropriate to apply the relevant definitions to the crypto asset as defined above.

Employing these concepts, the consultation paper proposes a high-level taxonomy of four kinds of crypto products grouped under two kinds of token systems:

  1. intermediated token systems:
    1. crypto asset services; and
    2. intermediated crypto assets; and
  2. public token systems:
    1. network tokens; and
    2. public smart contracts.

Treasury indicated that it considers a 'bespoke' and more detailed taxonomy for the purposes of designing regulation may have drawbacks. These include inconsistent regulatory treatment, co-mingled regulatory supervision responsibilities and opportunities for domestic regulatory arbitrage. Nonetheless, the consultation paper invites submissions giving reasons to the contrary. This may suggest that Treasury's preference is for the regulation of the crypto asset ecosystem to be similarly high level and based on functions, rather than being specific to particular tokens or token systems.

An overview of each element of Treasury's taxonomy is below.

Intermediated token systems

Intermediated token systems are described in the consultation paper as 'the link between crypto networks and the real world' (including with the existing financial system) and involve arrangements in which functions are performed by intermediaries. In intermediated token systems, consumers' dealings are with an intermediary service provider, rather than particular crypto assets or crypto networks.

Treasury's considerations for intermediated token systems:
Crypto asset services

A crypto asset service is defined as 'a token system that accepts crypto tokens as part of performing a function under a legal agreement or other arrangement', and is the most common method by which consumers are exposed to crypto assets. Crypto asset services include custodial wallets, crypto deposit products, over-the-counter crypto derivatives and mining/staking-as-a-service arrangements. As a result, a number of existing crypto asset services are already regulated under the existing financial services regulatory regime, as they satisfy the definition of a 'financial product'. Importantly, though, some of these are not so clearly captured – Treasury identified the strong need for consumer protection in relation to services where there is clear centralised control over user assets, where there have a number of high profile dramatic recent collapses (such as the demise of crypto exchange FTX). This largely crosses over with the regulatory scope of the crypto asset secondary service providers regime ('CASSPR' regime), on which consultation was sought on. Treasury is seeking feedback on whether particular arrangements should specifically be included in the definition of 'financial product'.

Intermediated crypto assets

Intermediated crypto assets are defined as crypto assets for which the link between the token and token system is created by a legal agreement or other arrangement. The relevant 'asset' for an intermediated crypto product is usually a bundle of rights or expected functions linked to a specific crypto token (eg a right to receive a fixed amount of fiat currency, as regards a fiat-backed stablecoin). The crypto token is a record of those rights or indicia of title, rather than an asset in itself.

The consultation paper further classifies intermediated crypto assets into:

  • 'wrapped real-world assets', which are arrangements under which a crypto token can be redeemed for another asset held by the issuer; and
  • 'other real-world assets', which are promises made regarding crypto tokens that do not relate to another asset held by the issuer (eg an in-game token that provides certain features within a video game).

As they involve 'arrangements', intermediated crypto assets are 'facilities' and therefore capable of being captured by the existing financial services regulatory system.

Regulatory and policy challenges for intermediated token systems

Treasury highlights the following regulatory and policy issues relating to intermediated token systems that require consideration as part of regulatory reform. Consultation questions are aimed at understanding these challenges, and determining how the existing regulatory framework might apply.

  1. When a crypto token is tradeable on a secondary market, subsequent holders are unlikely to be able to enforce rights against an issuer, as they have no rights against the original issuer.
  2. It may be difficult to identify the issuer responsible for obligations as to a particular crypto-asset.
  3. Insufficient transparency as to the underlying terms of an arrangement linking a crypto token to its underlying asset makes it difficult for holders to exercise rights and for regulators to determine whether the crypto asset is a financial product.

Public token systems

Public token systems are defined as involving functions being performed or ensured directly by a crypto network, rather than through an intermediary, and are functionally separate from any legal rights. In public token systems, crypto tokens represent the direct transactional relationships between the parties, which are created by the parties themselves (typically by using the same free open-source software simultaneously).

Treasury's considerations for public token systems:
Network tokens

Network tokens are defined as 'crypto tokens that are created as part of the consensus mechanism on public crypto networks, but that are used by holders for various other functions'. They are created by the crypto network to reward network participants who contribute to ensuring that all network participants agree to the same database. Examples include BTC (for the Bitcoin network) and LTC (for the Litecoin network). Network tokens can be used as a unit of account, store of value or means of exchange, and whether they constitute a financial product under the existing financial services regulatory regime depends on the individual cryptocurrency network.

Public smart contracts

The consultation paper defines a 'smart contract' as computer code that has been published to a crypto network's database, which is able to run in a predefined and deterministic manner without risk of intervention. They are not contracts per se, although they may exist in parallel to legal rights (but the software is able to run regardless of any conflicting legal rights). Public smart contracts are smart contracts that perform a function without the need for an intermediary. Examples include smart contract staking-as-a-service arrangements and debt or deposit tokens, and can extend to the complex set of protocols and systems that are described as 'decentralised finance' or 'DeFi'.

Regulatory and policy challenges for public token systems

Treasury highlights the following regulatory and policy issues relating to public token systems that require consideration as part of regulatory reform. Consultation questions are aimed at understanding these challenges, and determining how the existing regulatory framework might apply:

  1. The existing financial services regulatory framework applies to products that involve promises, intermediaries and agents, which are not necessarily present in public token systems. This represents a fundamental challenge for the application of current regulatory frameworks to these crypto assets.
  2. Public token systems may remove counterparty risk, but may introduce other risks related to technology and the soundness of the economic mechanism underlying the token system, compliance risks and other unknown risks.
  3. Without conduct rules and effective enforcement mechanisms, problems affecting traditional markets, such as conflicts of interest, anti-competitive conduct and information asymmetries, can affect public token systems.
  4. Public self-service software may not be amenable to traditional policy levers.

Treasury also seeks specific feedback regarding smart contracts that implement limited recourse collateralised lending arrangements and automated market makers.

Next steps

The findings of this token mapping exercise are expected to influence the Federal Government's upcoming consultation paper proposing a licensing and custody framework for crypto asset service providers, which Treasury has indicated will be released in mid-2023.

Anyone involved in providing services or dealing in crypto assets should consider making a submission by the closing date, 3 March 2023.