Regular readers will be aware that, unless crypto-assets stray into having characteristics that make them “securities”, crypto-assets themselves generally fall outside the financial services regulatory regime.
While it seems that situation will continue for the foreseeable future, indirect regulation of crypto-assets is now clearly on the horizon. At the same time, this provides a degree of regulatory recognition of the legitimacy of investments based on the qualifying crypto-assets.
On 30 June 2021, ASIC released a consultation paper (CP 343) outlining its proposed approach to regulating exchange traded products (ETPs) and other investment vehicles focusing on crypto-assets.
ASIC proposes to regulate such ETPs and investment vehicles through a combination of requirements applicable to:
(a) market licensees operating platforms on which crypto-asset-focused ETPs can be traded; and
(b) issuers of other investment vehicles that make crypto-asset investments, as well as market operators that list such vehicles.
ASIC recognises the rapidly increasing popularity of crypto-assets as an investment class, and suggests a principles-based approach to regulating managed or structured investments in them.
ETP market licensees
Existing ASIC Information Sheet 230 (INFO 230) sets out guidelines on how market exchanges that admit ETPs can meet their obligations to ensure that the market is fair, orderly and transparent (Market Obligations).
To account for the unique and novel features of crypto-asset ETPs, ASIC proposes to amend INFO 230 by confirming that certain crypto-assets may be appropriate underlying assets for an ETP, such that the ETP would be eligible for admission to a licensed market.
The proposed list of factors for determining appropriate underlying crypto-assets (referred to as the Crypto Eligibility Criteria) include:
- a high level of institutional support for the particular crypto-asset, availability of service providers to support the product (eg. custodians and market makers);
- a mature spot market for the crypto-asset; and
- the availability of robust and transparent pricing mechanisms.
At present, ASIC’s view is that the only crypto-assets that meet the Crypto Eligibility Criteria are bitcoin and ether, although it recognises that this may change over time.
ASIC also proposes to provide good practice information on how a robust and transparent pricing mechanism can be demonstrated.
Markets admitting listed investment entities
To avoid regulatory arbitrage, similar principles to those applicable to ETPs would apply to listed investment trusts (LITs) and listed investment companies (LICs).
Specifically, ASIC proposes to work with market operators to establish that for LITs and LICs with a material investment in underlying crypto-assets (5% or more):
(a) the approach used to determine and classify appropriate crypto-assets is the same as that set out for ETPs (refer to the Crypto Eligibility Criteria above); and
(b) in respect of the admission process, to be considered to have a structure and operations that are appropriate for a listed entity:
(i) a LIC that invests a material amount in crypto-assets is expected to have custody solutions, risk management systems and a robust and transparent pricing mechanism which mirror those proposed for ETPs; and
(ii) a LIT that invests a material amount in crypto-assets should value crypto-assets held by the LIT using an approach that is consistent with the expectations for robust and transparent pricing mechanisms proposed for ETPs.
Proposed regulation of investment vehicles
Responsible Entity obligations
Responsible Entities (REs) of managed investment schemes offering exposure to crypto-assets will be required to comply with certain additional crypto-specific obligations. These include:
(a) choosing a custodian with specialist expertise and infrastructure in crypto-assets;
(b) generating and storing private keys used to access the scheme’s crypto-assets in a way that minimises the risk of unauthorised access;
(c) multi-signature or “sharding”-based signing approaches – the latter involves splitting a single private key into multiple pieces, and allowing some subset of those pieces to be recombined to recover the key for signing a transaction;
(d) ensuring that REs and custodians have robust cyber and physical security practices with respect to their operations;
(e) conducting trading activity in crypto-assets on legally compliant and regulated crypto-asset trading platforms – the minimum baseline level of regulation is compliance with know your customer and anti-money laundering and counter-terrorism financing obligations; and
(f) from a disclosure perspective, considering additional disclosure concerning:
(i) the unique characteristics of crypto-assets, such as the technologies that underpin crypto-assets, how crypto-assets are created, transferred, and destroyed, how crypto-assets are valued and traded, and how crypto-assets are held in custody; and
(ii) crypto-specific risks such as market risk, pricing risk, increased regulation risk, custody risk and cyber risk.
Operators of registered managed investment schemes are required to hold an Australian Financial Services Licence (AFSL) that identifies the “asset kinds” held by the scheme. Crypto-assets are not currently covered by any existing asset kind.
ASIC therefore proposes to establish a new asset kind, namely “Crypto-asset scheme – this covers schemes that hold crypto-assets”.
The types of crypto-assets that will fall within the new asset kind will be restricted to those that meet the Crypto Eligibility Criteria for ETPs.
What will happen next?
ASIC is now assessing the submissions it received on CP343 and will publish its good practice information on crypto-asset ETPs and investment products in the third quarter of 2021. We will keep you posted.