In the committee's second interim report, it noted the extensive evidence it received on the need for more regulatory clarity and certainty in the emerging areas of blockchain technology, digital assets and cryptocurrencies. Submissions received in this final phase of the committee's work, continued to strongly reiterate this view, noting that a clearer regulatory framework would bring benefits for both consumers and businesses.
This chapter covers the evidence received by the committee in relation to possible options for reforming the regulatory framework for digital assets in Australia. A wide range of issues were canvassed by the committee, including:
broad arguments outlining the need for enhanced regulation of digital assets;
enhanced clarity and regulatory relief from the Australian Securities and Investments Commission (ASIC) and other regulators within the existing framework;
various options to bring certain types of crypto-assets within the scope of existing financial services regulation under the Corporations Act 2001;
options for regulating businesses that provide custodial and depository services for digital assets and markets licensing;
the need for clear categorisation of digital asset categories for the purposes of developing a regulatory framework;
issues relating to the taxation of digital assets;
new governance structures for decentralised organisations; and
issues relating to digital asset infrastructure.
Need for better regulation of digital assets in Australia
Swyftx, a Brisbane-based cryptocurrency broker with over 100 staff employed in Australia, summarised the need for improved regulation of digital assets as follows:
Australian consumers are demanding access to the digital asset industry – it should be the government’s aim to facilitate this access under a regulatory regime that balances competing interests but recognizes that bringing digital assets inside a tailored and sensible regulatory perimeter is a far better solution than forcing consumers to operate outside of it with unregulated, foreign providers. In addition, Australia’s entrepreneurs have leapt to the forefront of the global development of blockchain technology and associated crypto-asset fields, and are leaders in many areas. This technological leadership can translate into high-skilled jobs and an area for growth-oriented investment, if the right balance is struck by government in approaching regulation.
Blockchain Australia commented on the need for Australia to enact appropriate regulatory reform in order to keep pace with other jurisdictions:
Recent developments across the globe…have brought into sharp focus that Australia is lagging behind international jurisdictions in the development of a fit-for-purpose crypto-asset framework.
Australia has previously taken a proactive role in the regulation of crypto-assets, including implementing a robust AML/CTF framework for cryptocurrency exchanges. But our early mover advantages have now degraded. Australian policymakers and regulators have not established collaborative outward facing industry engagement opportunities that focus on reforms. As a result industry has not been provided the confidence to consider, review, implement and invest in projects.
Jurisdictional arbitrage, the search for greater regulatory clarity, will result in loss of talent at scale. Australian start-ups have moved, or are considering moving, to countries such as Singapore, Germany or the UK as these jurisdictions are being seen as more supportive of crypto-assets and blockchain. The key distinction to be noted here is that they are more supportive, they have not provided total certainty nor are they yet able to. This is not an insurmountable gap.
A common theme among submitters was that greater regulatory certainty is needed from ASIC, the ATO and other regulators to enable digital assets businesses to operate effectively while providing adequate protections for consumers.
Principles to be applied when regulating digital assets
Ripple proposed three principles upon which an Australian regulatory framework for digital assets should be founded:
The regulatory framework should be technology-agnostic, and should not explicitly or otherwise endorse any particular technology. In practical terms, this means that financial services using digital assets as a solution should not be treated differently from financial services embedding legacy architectures, and there should be parity in the treatment of all technology;
Given the dynamic nature of digital assets, prescriptive regulation risks obsolescence. Prescriptive regulation could also have the unintended consequence of hindering innovation. Therefore, we recommend the Committee consider a principles-based regulatory framework, which will guide market participants to regulatory and policy goals, without imposing an overly prescriptive and onerous process in doing so; and
The regulatory framework should use a risk-based approach to identify digital asset services that pose sufficient risk to warrant regulation, and where such risks are crucial to address. This is in order to build a simple, secure, and accessible digital assets ecosystem that will encourage investment into digital assets in Australia, while mitigating any potential risks.
R3 advocated for an approach that ensures digital assets that are analogous to a similar asset in its traditional form should face similar regulation to the traditional product:
Simplicity is key in designing frameworks. Layering additional regulations on top of already robust and effective frameworks would only complicate the industry and inhibit innovation with no resulting upside.
With digital assets, it is important to emphasise that the regulatory regime should not create a scenario in which the same instrument in digital form is subject to heightened regulation from when it is in traditional form. Also, it is important to ensure that there is no regulatory confusion created by the development of a second and potentially overlapping regime for some assets.
Therefore, we propose that the Australian government aligns digital asset regulations with requirements imposed on the same asset in its traditional form, with the principle of ‘same risk, same activity, same treatment’.
Swyftx commented that application of existing financial services regulations to digital asset businesses must take into account the necessity of working with third parties for these businesses to meet some requirements:
[A]s is the case with de-banking by the traditional banking providers, consideration must be given to ensuring a level playing field for digital asset service providers. For example, any application of the existing financial services regulatory regime to digital asset businesses that would require compulsory professional indemnity insurance should take into account the current lack of availability of such insurance for digital asset service providers. That is, implementation of a regulatory regime where compliance is not possible, has the same effect as an outright ban on the activities.
Immediate regulatory clarity and relief
A number of submitters and witnesses expressed the view that, even absent any other regulatory changes, ASIC should be providing further guidance as to the status of different digital asset products.
Holley Nethercote Lawyers submitted:
Because of the breadth and depth of virtual assets and the speed of innovation, there is no clarity in Australia about whether or not most virtual assets are financial products.
ASIC has released information sheet 225 which we are instructed by DCEs is inadequate. Whenever listing a new virtual asset, DCEs must decide whether to seek legal advice on that virtual asset, or whether to “risk it and list it” because of a perception that “if everyone else in Australia is listing it, it must not be a financial product.” In this environment, the participants with a more conservative appetite to legal risk are at a disadvantage.
ASIC has power to grant relief in some situations, and it can take no action in others. It can also provide further clarity on whether certain virtual assets are financial products. ASIC should include a frequently updated list of Top 10 virtual assets that it believes are not financial products, and Top 10 virtual assets that it believes are financial products (and if so, what type).
Holley Nethercote submitted that the government should work with ASIC 'to issue relief and no-action positions' in relation to Market Licence and Australian Financial Services Licence (AFSL) obligations for digital asset businesses, with ASIC to clarify 'which activities are captured by the relief and which are not using practical examples and adopting industry language'.
Need for transitional arrangements and 'safe harbour' provisions
Several submitters argued for the extension of a 'safe harbour' period while broader regulatory changes for digital assets are developed and implemented, so that existing businesses are not forced out of the industry prematurely due to regulatory uncertainty or new requirements being imposed without adequate lead time.
For example, Blockchain Australia submitted:
There can be no short term forward movement in the sector without safe harbour guidance for business. Failure to provide transitional arrangements creates far greater risk in the flight of capital and a greatly reduced prospect of inbound investment being attracted into Australia.
Given the complexities that public and private institutions are grappling with in relation to crypto-assets, it is important that reforms are developed and implemented carefully. However, regulatory uncertainty must be tackled with a sense of urgency, to retain and develop jobs and growth in the Australian crypto-asset economy. To resolve these conflicting goals, the precedent that has been established by like minded jurisdictions has been to allow a regulatory ‘safe harbour’ or other transitional arrangement. Blockchain Australia strongly encourages this approach in Australia. Our companies cannot afford to wait years for regulatory clarity, and Australian consumers require confidence that they are able to access the products and services they desire at home, via legally regulated and compliant professionals, rather than by seeking out risky services in unregulated locations.
Blockchain Australia recommended that the government and relevant regulators 'should provide crypto-asset providers a safe harbour until such a time that they introduce guidance or legislation', and that subsequent legislation 'should contain an appropriate transition period and not apply retrospectively'.
The Digital Law Association submitted:
A Safe Harbour would better achieve the objectives of protecting consumers and financial stability and reducing systemic risks in the short term, as well as informing ‘fit for purpose' appropriate and adapted laws for markets and financial services for decentralised, open and global technology infrastructure.
The Digital Law Association provided a detailed model of what a safe harbour scheme could look like. It submitted that such a scheme: should include threshold conditions to access, and further conditions to be met over a defined go-forward period of 2 to 3 years. It should apply to digital asset ‘issuers’, digital asset ‘market operators’ and digital asset ‘scheme operators’.
Market licensing for digital assets providers
Establishing a Market Licence regime for digital asset providers, or a subset of these businesses, was also raised as an option for regulatory reform.
In Australia, a financial market is a facility through which offers to buy and sell financial products are made and accepted. In order to operate a financial market, a company must hold an Australian Market Licence or be exempted by the Minister. ASIC has regulatory responsibility for issuing market licences and overseeing the operation of financial markets. Market licensees are subject to a range of licence obligations including reporting requirements, operating rules and key personnel requirements.
ASIC's Info Sheet 225 notes that where a crypto-asset meets the legal definition of a financial product (whether it is an interest in a managed investment scheme, security, derivative or non-cash payment facility), then 'any platform that enables consumers to buy (or be issued) or sell these crypto-assets may involve the operation of a financial market'. It states that there are currently no licensed or exempt platform operators in Australia that enable consumers to buy or sell crypto-assets that are financial products, and warns that platform operators 'must not allow financial products to be traded on their platform without having the appropriate licence as this may amount to a significant breach of the law'.
Blockchain Australia recommended that 'a full review of the markets licence framework is conducted and amendments implemented to ensure that the licensing regime accounts for the unique nature of crypto-assets'. It argued that this is necessary to enable crypto-assets such as digitally native derivatives to be accessed in Australia:
Access to a derivatives market is a key facet of a robust and mature financial services market. These are important as they allow investors to hedge their positions alongside offering other opportunities. This principle applies equally for crypto-assets and is arguably more important given the relatively higher volatility of crypto markets.
[D]igitally native derivatives have their own unique characteristics which combine the hedging opportunities provided by derivatives such as the management of risk with the technological benefits of the blockchain including being underpinned by a smart contract. Because they are tokenised, they can also be traded between exchanges or withdrawn to a user’s wallet.
Australia’s regulatory framework does not take into account such products. Our traditional securities legislation has evolved over time and there is a deep understanding as to how these are structured. However, the nature of these digitally native derivatives means that they are fundamentally different in structure.
Blockchain Australia concluded that without a properly designed market licence, Australia will miss out on the opportunities that are afforded by some of these innovative new products, and stated:
In addition, investors will not be provided the legal protections that a market operator must comply with such as acting fairly, efficiently and honestly.
Therefore local investors are forced to make a difficult choice: they must either forgo the protections afforded to them under a regulated market operator or not access new and innovative financial products or hedging mechanisms.
Applicability of existing Market Licence regime to digital asset businesses
FinTech Australia stated that the Australian Market Licence regime ‘is not currently designed for large volumes of applicants’, noting that there have only been a small number of licences granted to date and the process for obtaining a Market Licence ‘remains relatively bespoke depending on the nature of each business’. It argued that the application process for this licence is extremely complicated, and that it is clear that the licence obligations ‘are not designed for smaller businesses, like fintechs, due to the large capital requirements and procedural and operational requirements’.
FinTech Australia argued that, in its current form, adopting a market licence approach for crypto-asset businesses ‘would act as an unfair barrier to entry for fintechs and stifle innovation and growth in the crypto-asset sub-sector’. It argued that instead, an obligation to attain an AFSL would be an appropriate requirement for crypto-asset businesses looking to provide crypto-assets that fall within the definition of a financial product. It argued that a new category of authorisation under the AFSL framework could be created specifically to deal with crypto-asset exchanges.
FinTech Australia also emphasised the need for the government to clarify how any new regime would apply retrospectively for companies that already hold a market licence.
Regulation of DCEs and market licence issues
Much of the discussion around market licencing is in the context of the current minimal regulation of Digital Currency Exchanges, which are the crypto-asset businesses most analogous to the market operators required to hold Market Licences for traditional financial products.
The committee heard that the current requirement for DCEs to register with the Australian Transaction Reports and Analysis Centre (AUSTRAC) for the purposes of AML/CTF regulation amounts to a very 'light touch' regulatory approach to these businesses, and that enhanced regulation is needed.
For example, Mr Adrian Przelozny, CEO Independent Reserve was of the view that the current bar for registration with AUSTRAC is set too low:
You basically need to have an AML/KYC [know-your-customer] policy, which is pretty easy to obtain. There are providers that can basically provide a prewritten AML/KYC policy that a potential exchange could just use without having to do much work on it. I don't believe there's a fee to register with AUSTRAC, but there might be. Ultimately, it's just an online form after that. I think you could probably get everything done in a couple of days with a budget of maybe $3,000 to $4,000. So I think the bar to entry is very low, which is why we've seen that quite a large number of exchanges, or companies that try to say that they're exchanges, have registered themselves with AUSTRAC. It's quite surprising. Every time we have a meeting with AUSTRAC, they give us some huge number, like 100 registered exchanges in Australia or something ridiculous like that. We know there actually aren't that many exchanges. The bar is very low and anyone can register.
Mr Duncan Tebb, Head, Risk and Operations, Independent Reserve, summarised the process of registering with AUSTRAC:
So your obligations are…to buy a policy, fill out the online form and have an ABN, and you're done, and you'll be registered for three years. At the end of three years, you have a renewal process. The renewal process is to again make a declaration that your AML/CTF policy is correct and up to date, and you will be extended.
Mr James Manning, Chief Executive Officer, Mawson Infrastructure Group, was also concerned about the registration process:
There are no standards, so you don't have a compliance obligation. If you don't have a standard to hold someone to, how do you get them to comply with it? You're relying on your counterparty to act in good faith. That leaves a lot to be desired. There's no audit obligation. As you pointed out, there's no capital adequacy obligation. There's no-one verifying this, yet some of these exchanges are holding billions of dollars of assets.
Mr Bradley, Brown National Manager, Education, Capability and Communication, AUSTRAC, commented that AUSTRAC would be looking for businesses to provide more than a pre-written compliance program:
We are certainly of the view… that you can purchase programs for a value of money. We in AUSTRAC certainly wouldn't consider a purchased AML/CTF debt program that hasn't had regard to the individual risks of the business, that it would not be up to scratch in what we are having a look at.
Swyftx Pty Ltd suggested that there is scope for the AUSTRAC registration process, and the on-going review process thereafter, 'to be enhanced and strengthened to ensure a level of confidence that registered entities have met and continue to meet the standards expected of them'. Swyftyx noted further:
A cornerstone of many of the overseas jurisdictions’ approaches has been to recognize digital asset service providers as a specific category of “money transfer”-like business and to provide for a rigorous registration process for them.
Mr Paul Derham Managing Partner, Holley Nethercote Lawyers, suggested some form of licensing regime:
Registration with AUSTRAC, as you heard previously, is really easy. It's like registering a car. A licensing regime requires the driver to have competence. We would be suggesting some type of Australian financial services licensing regime for some aspects of what we've been talking about.
FinTech Australia acknowledged that under the current regulatory framework, if cryptocurrencies were to become designated as financial products, a crypto-asset exchange would then need to hold a market licence. It recommended that, if this becomes the case, additional guidance and streamlining of the application process from the government and from ASIC will be necessary to help DCEs navigate the process. It cautioned further that a balance will need to be struck to ensure that local DCEs are not forced out of the industry by larger international operators:
[T]he government must be careful to ensure that the obligations required for an AML [Australian Market Licence] are not watered down. Doing so may allow large international players in traditional markets to threaten the market share of Australian companies and start-ups if they were able to obtain an AML. We acknowledge that while there are currently a large number of cryptocurrency exchanges in the market we predict consolidation at least in the domestic market over time. Ultimately, a balance is required to ensure fintechs can more easily apply for an AML, without reducing the necessary protections to ensure efficient and fair markets, or enabling international players to dominate domestic players.
Aus Merchant expressed the view that any requirements for DCEs to hold a market licence should not make this opportunity available only for large, established businesses:
The crypto industry in Australia is currently driven by disruptive start-ups, and regulation should not create a barrier of entry which is too high for start-ups. This is especially important as established and institutional companies enter into the crypto industry. Established businesses not only have a financial advantage over startups but also have existing relationships with banking and insurance providers. One example where the need for regulation to be both fit for purpose and not pose a barrier to entry is in relation to prospective market licenses for digital currency exchanges. DCE have similar functions and features to [Over The Counter] trading. Any potential introduction of market licenses for DCE should reflect the features and technology of DCE, as a market license is a large undertaking for a start-up. The regulator’s approach to Buy Now Pay Later (BNPL) regulation highlights the benefits of enabling a low barrier to entry. BNPL operated in a regulatory ‘grey zone’ and were able to build successful and respected services.
FinTech Australia commented on the need to enhance regulation of DCEs without creating a system that drives operators offshore:
The current AML/CTF compliance and reporting obligations that apply to registrable [DCEs], businesses that exchange cryptocurrency with fiat currency, do not take into account what we would usually expect a market operator to consider in any other sort of financial market. As such, merely bolstering AML/CTF obligations is unlikely to provide adequate protections to those accessing the market, or to ensure [its] efficient operation. On the other hand, over-regulation of DCEs will lead to investors looking offshore to find friendlier jurisdictions. A careful balance must be struck in fostering a fair and proportionate regime which aligns with the principles of financial markets, protection of consumers and the flexibility of a growing data and technology enabled industry.
The ASX commented that any regulation of crypto exchanges should be designed to ensure the following points are considered:
Responsible conduct obligations;
Proper segregation of participants’ assets and private keys from the marketplace’s own assets;
Appropriate record keeping;
Maintaining policies and procedures to protect a participant’s assets from theft or loss;
Due diligence on partners and participants;
Sufficiency of resources (including financial, technological, people); and
Custodial arrangements for digital assets
There was significant discussion in evidence to the committee around the specific need to have enhanced requirements in place for businesses that provide custodial and depository services for digital assets.
Australia has a large and well established industry for custodial services of traditional assets, with approximately AUD $4 trillion in value held by custodial service providers. Within the framework of the Corporations Act and Corporations Regulations, ASIC provides guidance as to the requirements in respect of custodial services for traditional financial assets. These are articulated in ASIC's Regulatory Guide 133 Funds management and custodial services: Holding assets (RG 133), which applies to certain classes of AFSL holders who hold assets on behalf of registered investment schemes or other clients. RG 133 sets out minimum standards for asset holders to ensure that they meet their obligations under their AFS licence or delegation.
Blockchain Australia provided an overview of the similarities and differences between custodial arrangements for traditional and digital assets:
In traditional finance, one of the primary roles of a custodian is to safely hold an investor’s assets. They may hold assets in electronic form (such as a share register) or physical form (such as gold in a vault) and charge investors a fee for this service. Custodians agree with investors that they will temporarily hold these assets for safe keeping and return them upon request.
Custodians of digital assets perform similar functions to traditional custodians but operate through different methods. Crypto-assets are secured through the use of cryptographic keys. For a transaction to be executed, the correct private key must be matched with the public key. This means that whoever controls the private key effectively has control over that asset. Given the irreversible nature of public blockchain transactions, it is important that this private key is held securely.
Piper Alderman summarised this risks associated with custodianship of digital assets:
A key risk to holders of digital assets, be they director holders or indirect investors is the custody risk of digital assets.
The nature of blockchain technology means that, if the private keys to digital assets are compromised, those assets can be permanently lost with no prospect of recovery. To paraphrase, the saying in the digital asset world is “not your (private) keys, not your Bitcoin”. In the last twelve months there has been an explosion in demand for custodial services in digital assets as it appears the case that many users of digital currency exchanges are content to leave their assets “on-exchange".
Blockchain Australia submitted that there are currently a number of options for digital custody:
Users may wish to hold their private keys themselves, such as through a hardware device or a software solution (self-custody). Alternatively, users may wish to give control of the management of the private key to a crypto-asset business and manage their assets through an online wallet. For those users who wish for greater separation from their private keys but do not want the additional burden of maintaining self-custody, they may engage a third party custodian. Third party custodian solutions can often provide specialised services including physically secured infrastructure (such as bunkers where hardware devices containing private keys are held) and insurance. It can be costly for retail users to engage a third party custodian so these are typically only used by institutional investors.
The ASX argued that both self-custody and custody through DCEs can present particular problems and risks:
Crypto exchanges can provide a user experience which is attractive to many Australians who wish to invest in crypto assets, including the experience of a password-based login. However, as others have noted, there are risks in these custodial arrangements for digital assets. Many of these risks are associated with the management of private keys. A parallel can be made between management of user passwords and user private keys, however, we note below an important difference.
Crypto exchanges can also be vulnerable to cybersecurity risks, and there have been some prominent examples of this. In this sense they are no different to other businesses that may be subject to this risk, and investors commonly use third parties to hold assets in custody and safekeeping. However it is important that these decisions can be made in the confidence that the custodian is appropriately regulated, well capitalised, carries appropriate insurance, maintains data and operational systems in accordance with industry best practice security standards, and so on.
It is also true to say that users who choose to manage their private keys directly are vulnerable to risks. If using a ‘hot wallet’, which remains connected to the internet, they open themselves up to some of the security risks faced by cryptocurrency exchanges, but potentially without the benefit of the systems, insurances and so on that may be maintained by a crypto exchange. If using a ‘cold wallet’, which is kept offline, the user risks physical theft, loss or destruction with limited avenues for recovery other than through law enforcement in appropriate cases.
The ADC Forum submitted that in recent years, while fintech has grown exponentially in complexity, 'one missing component to date has been the availability of appropriate custody services for the safekeeping of digital assets'. It noted that a major challenge in this area remains the lack of independent third-party digital asset custodians:
In traditional financial services, these service providers fulfil three key functions, namely validation, security and trust. In the absence of digital asset custodians, first-party custodianship remains the main form of safeguarding clients’ assets. This is a fundamental security concern given that loss of the private key relating to the assets equates to losing the ownership rights to the digital asset. A few businesses providing digital asset custodian services are now emerging.
Can digital assets be appropriately custodied under existing regulations?
Piper Alderman expressed the view that digital assets can be appropriately custodied by a third party custodian under the current regulatory regime for custodied assets, if they follow the requirements of RG 133:
For custodians that are familiar with the attributes of, and appropriately aware of how to keep private keys for digital assets safe, there is no legal barrier to those custodians satisfying the organisational structure, staffing capabilities, capacity and resources requirements and the ability for assets to be held on trust as required in the regulations.
Blockchain Australia submitted that while RG133 does not discuss custody of crypto-assets, it is 'not aware of any reasons why custody of crypto-assets would breach any other regulations or obligations'. It argued that an explicit statement to this effect from ASIC 'would provide reassurance to those offering custodial services in Australia that there are no regulatory impediments to doing so', and recommended that ASIC make it plain that licensed custody providers can provide crypto-asset custodial services through an update to RG 133.
The ADC Forum submitted that updates would be required in order for the existing regulatory framework to apply to digital assets:
While the regulators do issue custodian licences, the existing regulatory framework applicable to these licences, unless appropriate updates are made, is not directly applicable to the safekeeping of digital assets. In the eventuality the regulators may wish to license entities providing custody services for digital assets, an important aspect to be considered is the cyber resilience of these service providers, i.e., their ability to limit the impact of security incidents.
The Australian Custodial Services Association (ACSA) stated that a range of considerations should be taken into account in determining how to best regulate custodial services for digital assets. It submitted:
Firstly, for context, custodians are agents for the principal investment decision maker (including superannuation fund trustees and managed investment scheme responsible entities). There is an extensive regulatory framework already in place governing the formulation and implementation of investment policy that is agnostic to asset type and that already specifies licensing, capability, capital and resilience requirements of appointed material service providers including custodians (all with independent audit verification and oversight by APRA/ASIC). These should equally apply to entities providing custody of digital assets.
ACSA submitted that other relevant considerations should include the following:
A broad and consistent baseline level of KYC, AML/CTF regulation should apply to crypto asset exchanges/trading platforms and custodians. Exchanges/platforms on which crypto assets trade must provide the ability to identify remitters and beneficiaries.
Regulation should be formed within a clear principles based policy framework. The framework needs to be largely principles based (not prescriptive) given the pace of technology change and market evolution.
Policy should guide whether the starting point should be to provide equivalent safeguards that are already in place for today’s range of investment types.
Policy formulation and regulation should recognise that many of the risks and market constructs are not new and apply to existing assets and markets. Accordingly, an entirely new framework is not required, but rather the existing framework should be adapted at the margin to accommodate unique crypto asset features.
ACSA provided a range of detailed information about the differences between custodial arrangements for physical and digital assets, as well as specific considerations for the regulation of custodial services for digital assets.
Options for licensing digital asset custodians
In addition to arguments that existing licensed custodians should be explicitly authorised to provide these services for digital assets under the existing regulations, some submitters and witnesses advocated for a separate or amended set of standards and licensing requirements for businesses specifically dealing with digital asset custody.
Aus Merchant submitted that digital assets have unique technological features and risks that mean current custody regulations are inadequate. It stated that the development of a tailored licence for digital asset custody 'will raise overall regulatory standards for digital asset service providers and create further evidence of regulatory compliance to banking providers'.
Independent Reserve submitted that Australia should introduce minimum standards for digital asset custody service providers, along with a licensing program for these providers. It noted that 'there have been numerous examples in the past of digital asset custody providers and exchanges losing millions of dollars of customer assets':
This has created a perception that using a professional company to house digital assets is a risky proposition. This has had the flow-on effect of making insurance for reputable custody service providers either prohibitively expensive or simply not available.
Independent Reserve recommended that the Australian Government define a set of minimum standards for any company offering digital currency custodial services, covering:
minimum net capital requirements for all custodial service providers;
IT security arrangements;
redundancy arrangements (to eliminate key person risk);
segregation of customer/house assets;
record keeping/holder entitlement;
reconciliations/proof of ownership; and
regular external audit of security procedures.
Independent Reserve stated that minimum standards requirements and licensing would have other benefits including:
providing confidence in the sector to support service providers (auditors, insurance companies, underwriters, consultants, etc.), leading ultimately to insurance, audit and controls assurance services to be made available at reasonable prices to the industry;
promoting financial product innovation including the development of ASX-traded digital asset and cryptocurrency funds domiciled within Australia; and
increasing use of audit and assurance services locally boosts the professional services industry in Australia, as well as increasing foreign investment into Australia.
The ADC Forum pointed to Mauritius as an example of a jurisdiction that has implemented a successful licensing regime for the custody of digital assets. Under this licensing scheme introduced in 2019, parties intending to provide custody services for digital assets in Mauritius are required to obtain a Custodian Services (Digital Asset) Licence from the Mauritius Financial Services Commission. Features of this licence include the following requirements:
Mandatory compliance with Mauritius' AML/CTF legislation;
Requirement to maintain an authorised representative in Mauritius, conduct core business activities in Mauritius and have a governance structure that can provide effective oversight of its activities, taking into account the nature, scale and complexity of the business;
Minimum capital requirements of at least 6 months’ operating expenses, as well as adequate skills and infrastructure to maintain operations;
The custodian should have a comprehensively documented operational risk management program, with systems tests undertaken in accordance with industry best practice quarterly, and a comprehensive third party audit undertaken annually;
Safeguards and best practice requirements to manage the creation and management of private keys by the custodians, including cold (that is, offline) storage standards for private keys;
Client asset segregation rules to prevent the possibility of bulk theft of client assets;
Multi-signature authorisation for client transactions;
Adequately secured physical infrastructure, documented processed for protecting digital assets in the result of a security breach, and documented disaster recovery plan; and
Recordkeeping and statutory reporting obligations.
Submitters noted that ASIC's recent Consultation Paper 343 (CP 343) on the use of crypto-assets as underlying assets for exchange-traded products (ETPs) and other investment products included detailed discussion around what appropriate custody requirements could be for crypto-assets underlying an ETP. Aus Merchant stated that it agreed with the standards for digital asset custody discussed by ASIC in consultation paper CP343, which are:
specialist expertise and infrastructure for digital asset custody;
segregation of crypto assets on blockchain - unique public and private keys for each client;
private key generation and storage in a way that minimises risk of unauthorised access;
multi-signature or sharding based storage;
practices for receipt, validation, review, reporting and execution of instructions; and
robust cyber and physical security practices.
Piper Alderman commented that ASIC’s CP343 'demonstrates progress towards a position where custody of digital assets may be more widespread'. It commented further:
At present we are not aware of any licensed custodian actively offering custody services for digital assets. We agree with ASIC’s approach to a best practice for digital asset custody and applaud their forward thinking presentation in CP343 and setting out detailed guidance. The good practice guidance may provide certainty for licensed custodians to consider digital asset custody, at least in regards to exchange traded products.
Further urgent guidance should be provided to encourage licensed custodians to offer services for asset custody outside of only ETPs, so that digital currency exchanges can reduce the risk for their clients that digital assets left “on exchange” will be at risk of theft. The major digital currency collapses in the history of digital assets may well have been prevented had custody been in place for client assets.
Should licensing requirements for custodial providers be a full AFSL?
Independent Reserve noted that for 'all financial products in Australia, any business providing a custodial or depository service must hold an Australian Financial Services licence'. It stated that applying for an AFSL 'is a non-trivial matter and carries a range of responsibilities for licensees'.
Independent Reserve did not consider that an AFSL should be required to provide a custodial service for digital assets and cryptocurrency, submitting that holding an AFSL 'carries many requirements that are not appropriate or relevant to the digital currency sector as it currently stands'. It recommended an alternate licensing scheme, whereby businesses that want to provide a custodial service for digital assets and cryptocurrencies 'must be issued an authority/licence to do so prior to offering services to customers', with the following requirements:
minimum capital requirements (net tangible assets) of at least $5 million AUD;
audit certificate/external assurance of custodial procedures;
segregation of customer and operational funds/assets;
annual compliance requirements for audit/external assurance; and
a Responsible Person with adequate experience.
It argued that the benefits of this arrangement would be as follows:
Setting a high bar for the storage and security of customer assets elevates consumer protection from unscrupulous operators and businesses that do not invest adequately in security. It will also serve as an incentive to reputable operators to sufficiently invest in security and systems and to have these systems regularly tested by external firms.
The Digital Law Association, which did advocate for the introduction of a new authorisation class within the AFSL regime to cater for digital assets, noted that such a change would need to deal specifically with issues relating to custody:
[P]ractical issues such as the lack of availability of insurance or licenced digital asset custody providers will need to be considered and accounted for so that compliance with such a license is not rendered impossible. This could be achieved by, for example making clear that custody of digital assets may be provided by existing licensed custodians.
Bitcoin Babe argued that in considering potential regulatory requirements for custodial service providers of digital assets, there are several types of DCEs that do not take custody of customer cryptocurrency or funds. As such, these types of services 'require recognition and leniency where custodial requirements are concerned, which should be clearly defined in any application or dealings with ASIC or other interested industry bodies'. Bitcoin Babe argued that custodianship attributes must be clearly defined in any new arrangements; for example, through clearly defining the necessary duration of a DCE's custody over a customer's funds or cryptocurrency in order for it to be considered a formal custodial agreement.
Comments on overseas and local custodial providers
Piper Alderman suggested that, in order to further attract investment and retain FinTechs locally, a preference towards Australian based custody solutions for digital assets be made:
Australian based digital custody would have clear benefits in terms of jurisdictional risk and in making audits of systems / wallet balances and processes potentially simpler. To our knowledge, all of the recent fund products involving digital assets are using North American or European based custody providers.
A signal that digital assets can be custodied under existing regulation will help catch up with other jurisdictions that are pioneering digital asset custody and financial products backed by digital assets. For example, there are 25 digital asset backed products listed on the Toronto Stock Exchange which mostly involve Bitcoin and Ether, while in the US continued applications for ETPs involving digital assets are being made.
Custodians of these funds manage their digital assets using a combination of a custodian and a sub-custodian. These custodians hold the private keys to the underlying digital assets which are the assets of the fund.
Independent Reserve outlined that introducing minimum standards and licensing for digital asset custody would give customers certainty that their digital assets are secure, and ensure that these assets are held within Australia rather than by overseas platforms:
With customers having assurance that assets can be held securely by a business, it has the added benefit that Australian-owned assets are kept in Australia, by Australian businesses and customers are then protected under existing consumer protection laws. Currently the largest providers of custody services globally are not domiciled in Australia. Should customers of these offshore businesses have a dispute with the provider, the individual customer must negotiate international laws and jurisdictions to try and resolve the dispute and recover their assets. Providing a custody standard and requiring businesses to be financially viable, domiciled in Australia and adhering to minimum standards would ensure Australian assets stay in Australia and customers are afforded the range of consumer protections already in place for Australian consumers.
In contrast, Aus Merchant argued that Australian DCEs should not be required to store assets in Australia, but be able to utilise custody service providers based overseas:
[P]otential change to digital asset custody regulation may include requirements for digital assets in custody to be stored in Australia. Digital asset custody is not suitable for on shore storage. This is due to the lack of experienced digital asset custody providers with sufficient technological capabilities based in Australia. Digital asset custody is a developing area, with international companies spearheading the development of robust technology and safe services. These companies have high regulatory standards and maintain compliance in multiple jurisdictions… Requiring digital asset custody to be hosted in Australia would create difficulty to ensure high quality custody of digital assets and severely impact the ability for Australian companies to provide custody of digital assets to their clients. Access to private keys and transfer instructions are ultimately managed by the head of compliance, who is domiciled in Australia. This key person is subject to police checks, staff due diligence and Australian law, even if the assets are held internationally.
Aus Merchant added that creating a regulatory environment supportive of digital asset custody 'could entice these international companies to establish offices in Australia'.
Blockchain Australia stated that it 'is not aware of any jurisdiction that requires entities that operate in that country to use an on-shore custodian'. However, 'there is an opportunity for Australia to develop a digital asset custody industry'.
Bringing classes of crypto-assets directly into existing Corporations regulation
Some stakeholders argued for bringing some digital assets within the scope of existing financial services regulation.
The Digital Law Association recommended 'the introduction of a new authorisation class(es) within the Australian Financial Services licence explicitly designed to cater for digital assets and digital asset businesses as financial products and services', including changes to Part 7 of the Corporations Act if this is required to facilitate this new authorisation class. It stated:
[I]t is currently unclear how to practically license and register digital asset products and services. This is because increasingly complex, new and creative methods of economic interaction, from fractionalised fundraising to yield farming, or from tethering and stable coins to wrapped non-fungible tokens (NFT), are yet to be successfully reconciled neatly to the traditional regulatory process and in particular the current Financial Product & Service classes of security, managed investment scheme, derivative or non-cash payment scheme.
The flow on effects arising from the introduction by ASIC of a bespoke digital asset friendly classification category for financial products and services, would be greater certainty for those requiring market licences that need to extend to cover digital asset financial products and services, as well as positive impacts on both traditional stock exchanges and digital exchanges, where there is considerable uncertainty as to the regulatory implications of listing tokens or platform providers that are not licensed.
Mr Kevin Lewis, Special Counsel, Regulatory Policy at the ASX, summarised the argument that certain classes of crypto-assets should simply be incorporated into the current regulatory framework for financial products in Chapter 7 of the Corporations Act:
Our submission is primarily directed to what we would call cryptofinancial products, as opposed to other broader crypto-assets. We say in relation to the cryptofinancial products that we think they should probably be treated in the same manner, from a regulatory standpoint, as other financial products. Of course, we have a well-established regulatory regime for financial products in chapter 7 of the Corporations Act. We think that one mechanism for achieving a solid regulatory framework would be to rely on chapter 7 and to bring cryptofinancial products within chapter 7. There is a mechanism in the Corporations Act for doing that, and that's the passage of a regulation simply stating that cryptofinancial products are financial products for the purposes of the Corporations Act.
Herbert Smith Freehills (HSF) put forward a specific proposed set of amendments to along these lines. It recommended an amendment to s764A of the Corporations Act to include 'digital asset' as a facility specifically taken to be a financial product for the purpose of Chapter 7, where 'digital asset' is defined as:
A record that is either created, recorded and transmitted, or stored in a digital (or otherwise intangible) form by electronic magnetic or optical means (or by any other similar means) and is:
(a) a digital representation of value that:
(i) functions as a medium of exchange, a store of economic value, or a unit of account; and
(ii) is not issued by or under the authority of a government body; and
(iii) is interchangeable with money (including through the crediting of an account) and may be used as consideration for the supply of goods or services; and
(iv) is generally available to members of the public without any restriction on its use as consideration; or
(b) a means of exchange or digital process or crediting declared to be a digital asset by the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (Cth) and the Australian Securities and Investment Commission Act 2001 (Cth),
but does not include any right or thing that, under the Corporations Act, is taken not to be a digital asset for the purposes of this Act.
This would be complemented by an amendment to s765A to 'exclude any digital asset that is not used to make a financial investment, manage financial risk, or make non-cash payments, by a person'.
HSF submitted that as an alternative approach, the Corporations Act regulations could be used to introduce specific digital asset financial product inclusions and exclusions.
HSF stated that by 'unequivocally bringing those digital assets that are used to make a financial investment, manage financial risk, or make non-cash payments' into the scope the Corporations Act, 'there will be a waterfall effect that enlivens the clear application' of the AFSL and Market Licence regimes. It argued that this will help:
provide clear legal guardrails for compliance by good actors in industry;
provide clear legal guardrails to underpin enforcement actions for non-compliance by bad actors in industry;
give clear legal guardrails to market licensees; and
create markets where retail investors are only offered regulated financial products and services.
HSF expressed the view that this reform would make Australia an attractive destination for innovative financial products and services and other digital asset businesses, as well as meeting regulatory objectives including for confident and informed decision making by consumers of financial products and services, while promoting efficiency, flexibility and innovation in the provision of these products and services. Further it would 'move large numbers of digital asset transactions and their accompanying value, that are currently not being regulated notwithstanding that they should be, back within the appropriate regulatory frameworks'.
TCM Capital argued that digital assets should be regulated to provide legal certainty for investors, and that this should be achieved by applying existing legal definitions to digital assets. It advocated for amending section 763B of the Corporations Act, which outlines the legal definition of when a person makes a financial investment, to broaden this definition and include investments into digital asset products.
Limiting DCE regulation to certain conduct obligations
Holley Nethercote Lawyers argued that established DCEs should be subject to laws relating to market misconduct and general obligations, without necessarily being subject to the full requirements of other AFSL and Market Licence holders:
[M]arket manipulation laws don’t apply where the trading does not relate to a financial product, and many virtual assets are treated as if they are not financial products.
Given the nascent status of many virtual assets, DCEs are required to engage liquidity providers with large stores of the new virtual asset before listing it, so as to maintain a stable market when the virtual asset is listed. Internationally, our view is that insider trading connected with this practice is rampant. In Australia, insider trading prohibitions are tied to inside information which relates to financial products. So, they are unlikely to apply to many of the domestic coin listings.
Further, licensees in multiple categories in Australia are required to comply with general obligations, such as the obligation to provide financial services “efficiently, honestly and fairly”. Imposing these obligations on established DCEs would mean ASIC has jurisdiction over contraventions of the general conduct obligations… These recommendations could be achieved by the Government declaring that virtual assets are financial products. There are existing mechanisms to exempt or provide relief from certain requirements in the current regulatory framework, so that only relevant parts of the general obligations and market misconduct provisions apply to DCEs.
Licensing to enabling the provision of financial advice relating to digital assets
Several submitters argued for the introduction of an Australian Financial Services financial product category that covers crypto-assets so that financial planners can provide licensed financial advice in relation to these assets.
Caleb and Brown, a Melbourne-based cryptocurrency brokerage, submitted:
At present, while Caleb and Brown takes all measures possible to ensure consumers are protected against risks when trading cryptocurrencies, Caleb and Brown brokers are unable to lawfully provide financial advice to consumers. Due to the fact that crypto-assets are yet to be determined to be “financial products” for the purposes of ASIC’s Regulatory Guides and for the Corporations Act generally, Caleb and Brown as an entity is unable to avail itself of AFS licensing and, therefore, our brokers are unable to use RGs 36 and 244 to structure both general and scaled advice to consumers. As such, despite providing our services in a manner through which clients have direct access to a knowledgeable and skilled broker, our brokers are currently unable to provide anything beyond purely factual information to clients.
Caleb and Brown argued that this inability to provide general and scaled advice poses a risk to clients:
While Caleb and Brown operates internal policies to ensure only tokens with sufficiently low risk profiles are available to trade, it is still possible for an inexperienced client to engage Caleb and Brown with the intention of trading based on an unreliable tip or an erroneous calculation of a crypto-asset’s risk profile. In these situations, Caleb and Brown brokers have no method by which to adequately mitigate the client’s risk. These brokers are unable to provide general or scaled advice that would seek to take into consideration the client’s inexperience or that would attempt to re-characterize for the risk profile of the crypto-asset for the client.
Blockchain Australia recommended that a new licensing regime, modelled off the existing AFSL, should be developed so that entities that wish to provide general or personal financial advice in relation to crypto-assets as part of their business model can be authorised. It commented:
The crypto asset class has arrived. Professional advice with respect to the asset class has not, and consumer protection is being compromised as a result.
A new licensing category, modelled off the requirements to hold an AFSL, that allows for the provision of crypto-asset financial advice would allow competent and qualified advisors to provide advice that is tailored to an individual and takes into account their circumstances and risk profile. A new category of licensing would avoid the problems that would arise by attempting to fit crypto-assets into a framework that is not suited to these assets.
Classifying digital assets and 'token mapping'
As digital asset technology is evolving so rapidly, a challenge for policy makers and regulators is developing an adequate understanding and articulation of the different types of digital assets available in the market, in order to determine what regulatory requirements should apply to different types of products.
Jurisdictions overseas have taken a variety of inconsistent approaches to token classification and categorisation of digital assets. Token classification 'has formed the basis of many overseas crypto-asset frameworks, providing definition and clarity as to those characteristics or activities that are excluded or captured by regulation'. A number of submitters and witnesses expressed the view that Australia needs to undertake a detailed 'token mapping' exercise to create a best-practice framework for characterising digital assets, taking into account the approaches being used internationally.
CPA Australia commented on the lack of standardisation in terminology across jurisdictions:
At present, different jurisdictions adopt different terminology to describe what the Committee refers to as ‘cryptocurrencies’ and ‘digital assets’. The Canadian government refers to Bitcoin and other cryptocurrencies as ‘digital currencies’. In Europe, the term ‘crypto-assets’ is applied, which appears to be an umbrella term capturing cryptocurrencies, stablecoins, CBDCs, different forms of tokens (e.g. utility and security) and others, identifying each as subsets of crypto-assets. The European Commission, in Article 3 of its Proposal for a Regulation of the European Parliament and of the Council on Markets in Crypto-assets (MiCA), distinguishes between the characteristics of those subsets or types of crypto-assets and consolidates divergent definitions and taxonomies used across different European jurisdictions.
With regards to other jurisdictions, we note that several regulators propose vague, catch-all definitions. However, more clarity is needed with respect to the distinction between crypto-assets that may be characterised as financial instruments (falling under the scope of existing financial regulation) and those which would fall under the scope of other amended or new regulation. Definitions must also be ‘flexible’ and technology-neutral to allow for future developments.
Ripple noted that there is 'no single or generally recognised definition of digital assets at present', and submitted that these assets:
…should not be solely defined relative to a specific technology (e.g., cryptography), but, for the purposes of regulation, should instead fall under a broader heading such as “digital assets”, and subsequently classified depending on the particular economic function and purpose they serve.
Ripple noted that this approach is consistent with that taken by the UK and Singapore, 'which have issued classifications that do not depend on whether a business model uses distributed ledger technology or not'. It recommended that Australia adopt a digital asset taxonomy consistent with such global practices in order to provide 'clarity to the legal character of digital assets in Australia'. It recommended that this taxonomy provide clear distinctions between payment tokens, utility tokens, and security tokens, as follows:
Payments or Exchange tokens: to describe non-fiat native digital assets that are used as means of exchange and have no rights that may be enforced against any issuer;
Utility tokens: to describe those digital assets that create access rights for availing service or a network, usually offered through a blockchain platform; and
Security tokens: to describe tokens that create rights mirroring those associated with traditional securities like shares, debentures, security-based derivatives, and collective investment schemes.
These three categories of tokens have also been recognised by the OECD, as shown in Figure 3.1.
Figure 3.1: Common categories and types of crypto-assets (OECD)
Source: OECD, Taxing Virtual Currencies: An Overview of Tax Treatments and Emerging Policy Issues, October 2020, p. 12.
FinTech Australia argued that 'care should be taken when seeking to define crypto-assets under any regulatory or legislative framework', adding:
In particular, where a broad approach to the definition of “crypto-asset” was taken in Singapore, this has captured a wide-range of crypto-assets within a regime which is structured for financial product and payments. In particular, the Singaporean regime does not adequately differentiate between asset classes or tokens under its regime. As such, there is concern that blockchain businesses using NFTs as part of their underlying technology are caught under this regime. Further, significant consideration should be given if existing financial products were to be caught under a new regime merely by virtue of also being a crypto-asset.
Any new laws, regulations or policies should adhere to technological neutrality principles so that they do not apply based on what technology underpins a given asset, but rather has regard as to the rights given to the recipient of the asset. Separately from these unintended consequences, such an approach may also entrench certain technologies, preventing the adoption of new technologies which are developed.
CPA Australia recommended that the government 'establish a glossary of terms, which categorises and defines existing crypto-assets while leaving sufficient flexibility for future innovations'. It argued that this glossary should differentiate crypto-assets by certain characteristics (as proposed in the European Commission’s MiCA) and/or apply criteria proposed by the Bank for International Settlement (BIS). The BIS distinguishes between various types of crypto-assets by criteria including: the functionality of the crypto-asset (e.g. payment/exchange, investment, utility); underlying stabilisation mechanism (e.g. asset-backed, algorithm-based); and systematic importance (i.e. global or non-global reach).
The Digital Law Association submitted that 'the most useful taxonomy of Digital Assets will be one that is developed after the development of new and clear authorisation classes for Digital Asset Financial Products'. It explained further:
We should not mistake what are currently commonly issued token features, (or combinations of features) to be demonstrative of the types of tokens business would like to deal in. Rather they are very often demonstrative of development undertaken to avoid regulatory oversight (e.g attempts to stay within the feature setlist often identified as a “Utility Token”). If regulatory oversight was simplified and ASIC could provide clear categories of acceptable licensed behaviour, we anticipate that token businesses would evolve their products to meet those authorisation class requirements.
The Digital Law Association noted several other factors that will influence how digital assets can be classified:
Tokens can change characterisation over time. For example, the analysis of whether a digital asset is offered or sold as a security is not necessarily static.
There is a great deal of overlap between classification classes. Modifying a token’s function (even in a small way) may move a Digital Asset from one classification category into another classification category, and/or dictate that it straddles more than one category.
How a token should be classified and therefore regulated, is also a product of the relationship that token has with other digital assets, or its milieu of operation. For example an NFT in isolation is its own class… if however it is wrapped or tethered to a security token, that will likely change the nature of the NFT such that it also should be a regulated token.
Independent Reserve put forward the view that classification of tokens should not be a prerequisite for implementing licensing requirements for digital asset businesses in Australia:
Token and coin classification is a complex issue that has yet to be solved in an elegant manner in any jurisdiction around the world. For example: the recent licensing developments in Singapore require a legal opinion from every participant seeking to list each token and all stable coins are treated as e-money and fall under a prohibitive section of legislation.
If any near-term solution requires a comprehensive token classification mechanism to enable the digital currency and cryptocurrency sector to slot into the existing Corporations Act, then it is unlikely to happen prior to an established international standard.
For this reason, it is important that the Committee focuses on what can deliver meaningful improvements to the Australian industry and consumer protection. Independent Reserve recommends that any licensing of custody services to the digital asset and cryptocurrency industry should be token neutral and allow any licensed business to offer custody for any digital asset and cryptocurrency.
The Digital Law Association recommended that, as an interim measure before a more comprehensive digital asset policy framework is legislated, Treasury should 'lead the preparation and release of a multi-agency working taxonomy of Digital Assets that sets out the Australian legal and tax implications of digital asset businesses and transactions', with input from other relevant regulators.
Blockchain Australia recommended that a comprehensive token mapping exercise be undertaken in Australia, including examining the work done on token classification in overseas jurisdictions, 'as the first step in a broader, fit-for-purpose regulatory framework'.
Other issues relating to the AML-CTF framework
In addition to AUSTRAC registration being an insufficient form of regulation for DCEs, as mentioned above, submitters and witnesses raised several other issues in relation to the AML/CTF framework administered by AUSTRAC.
FATF guidance and the 'travel rule'
Industry submitters were generally supportive of the way AUSTRAC has sought to engage DCEs in developing changes to its AML/CTF guidance.
One are of concern relates to the potential implementation of the FATF's 'travel rule' in Australia. The ‘travel rule’ was released by FATF in 2019 as part of its guidance on the AML/CTF regulation of cryptocurrency/digital asset services. It requires financial institutions to include verified information about the originator (payer) and information about the beneficiary (payee) for wire transfers and other value transfers throughout the payment chain. However, technological solutions to enable virtual asset service providers to comply with the ‘travel rule’ are still under development and only beginning to be rolled out globally.
The travel rule has been implemented in domestic regulation in a number of jurisdictions since 2019 through a variety of mechanisms, but has not yet been implemented in Australia. Submitters expressed concern that if the travel rule were implemented in a strict way in Australia, this would create significant damage to the digital assets sector.
For example, Revolut Australia commented:
The travel rule requires that the originators and beneficiaries of all transfers of digital funds must exchange identifying information. This puts a huge burden on cryptocurrency service providers which do not presently have access to detailed beneficiary information. These guidelines are likely to stifle innovation and fails to understand that blockchain analysis has the potential to be a more effective tool at preventing money laundering and terrorism financing than the manual collection of beneficiary information.
Bitaroo recommended that discussion around the ‘travel rule’ in Australia be postponed 'until other countries discover the multiple issues around implementing it', and if Australia eventually implements the rule, it should 'elect for the lightest touch possible that FATF will allow'. It submitted:
Proposed ‘Travel Rule’ legislation, whereby digital asset providers would be required to share and disclose the personal details of its customers and their transactions is one example of a restrictive policy that we believe to be individuals’ breach of privacy.
It is regulations such as this that will only act to encumber growth in this sector.
Blockchain Australia submitted that industry participants 'have well founded concerns that the implementation of the travel rule will place unnecessarily burdensome cost pressures on business':
We caution of the real risk that the premature or rushed implementation of the travel rule, as seen in other jurisdictions, would be a significant competitive disadvantage and inhibit innovation.
Blockchain Australia noted that in FATF's most recent review of implementation of its guidelines, in July 2021, FATF found that that adoption of the travel rule remains poor and that 'FATF members should implement the travel rule into their domestic legislation as soon as possible, including consideration of a staged approach to implementation as appropriate' to avoid VASPs engaging in jurisdictional arbitrage. Blockchain Australia recommended that AUSTRAC 'accelerates engagement with the industry on the consideration, application and implementation of the travel rule and to ensure that there is a sufficient consultation and transition period'.
Mr Aidan O'Shaughnessy, Executive Director, Policy at the Australian Banking Association, expressed the view that the travel rule should be implemented to provide a level playing field between traditional and digital financial products:
I think the [banking] industry's view is that the FATF standards on virtual assets—once they finalise the update of the guidance in 2021, this year—should be adopted in Australia. As part of that adoption, I think, yes, the travel rule should be adopted in Australia. I do take the point…that, in a decentralised environment, what is acceptable and works in a traditional financial system might not work in this environment. But I heard Revolut talk this morning—technology is actually solving this problem.
The travel rule, in its essence, is: you must know where the money is coming from and where the money is going to. If we believe that the objective of the anti-money-laundering and counterterrorism financing legislation is to prevent money laundering, prevent terrorism financing, and we put that obligation on the traditional financial system, it is logic that we would put it onto this alternative system as well. If there is a non-level playing field, what I think might ultimately happen is that, in the digital environment, all the illegal activity will flow to that environment, because it will be less regulated and it will still have that level of anonymity.
When asked whether early adoption of the travel rule may damage Australia's competitive position, Mr Daniel Mossop, Assistant Secretary, Transnational Crime Policy Branch at the Department of Home Affairs, commented:
I think there is certainly merit in that argument. I think it depends on the way that it is implemented. A technological solution that takes a lot of the leg work out of that would be a game changer in the way that it was able to be rolled out worldwide. I think that would be quite a different story. We are not at the point where, globally, there is such a technological solution. Before that's the case, I think in every opportunity that you have to look at that you have to consider the impacts we would have and whether there was too much of a detriment to industry in terms of rolling out a solution based on the technology that's available at the moment.
We also have other regulatory options, including a policy principles period while technology comes up to scratch.
When asked whether options could include amendments to the AML/CTF legislation and regulations, Mr Mossop stated:
Changing [the regulations], delaying the implementation or having a different approach to how AUSTRAC regulates, whether it's through guidance—there are a myriad of options that you might look at, but I think from Australia's perspective we'd be looking for a solid basis for a technological solution to be able to facilitate that. That seems to be where a lot of jurisdictions in the world are coming out at the moment.
Publication of list of DCEs registered with AUSTRAC
It was also pointed out by Mr Alex Harper, CEO, Swyftx Pty Ltd that it is not possible to search and identify the DCEs registered with AUSTRAC. CPA Australia made the same point, noting that AUSTRAC discloses on its website which DCEs have had their registration cancelled, suspended or refused, but does not list currently registered DCEs, making it difficult to compare the number of these businesses in Australia with other countries. CPA Australia recommended that the names of AUSTRAC-registered digital currency exchange providers should be made publicly available, to increase visibility over the size and nature of this sector.
Piper Alderman submitted that regulators 'have a key role to play in addressing market hesitation in regards to risk profiles for certain [DCEs] and also consumer protection in this regard', and commented:
It can only be beneficial for the protection of consumers, for a public list [of DCEs registered with AUSTRAC] to be made available and we respectfully suggest such a register be made available at a “website level” such that visitors to a website can verify for themselves that the website is connected to a registered digital currency exchange.
On this issue Mr Bradley Brown, National Manager, Education, Capability and Communication, AUSTRAC, responded:
When the legislation was established in the past, in 2017, and implemented in 2018, we had significant engagement with the sector, in terms of industry associations representing businesses at that time that we knew were in operation. Certainly, there was a significant concern given its infancy, in terms of regulation, that, if there were a public register of those businesses, they would likely not be able to hold and retain bank accounts. That certainly is a matter that is also under the consideration of this committee. Hence AUSTRAC didn't publicly list the register at that time. We are further considering the merits of the release of that register now that we are three years into the operation of the digital currency exchange regulations in Australia. We are engaging with businesses in relation to the merits and what we would need to consider in relation to its release.
Mr Daniel, Mossop, Assistant Secretary, Transnational Crime Policy Branch, Department of Home Affairs, added:
The issue of not being able to obtain or hold a bank account was certainly a concern for industry at the time. There was also the related issue that the public release of a register and the technical differences between registration and licensing of AML/CTF regulation versus other regulation about the proprietary of a business might not be as transparent to the public as you would hope, or it might not be as obvious to the public as you would hope, and there would be a quasi sign of government endorsement rather than a list of entities that are registered with AUSTRAC for ongoing supervision. We didn't want to confuse the market with that nuance. They were the two reasons why the list was, at the time, not made public.
Tax treatment of cryptocurrencies and other digital assets
A number of submitters and witnesses raised issues relating to how cryptocurrencies and other digital assets are treated for tax purposes in Australia.
The Australian Taxation Office (ATO) provided an overview in its submission of how cryptocurrencies are currently treated for taxation purposes in Australia. Different rules apply depending on whether the asset is held as an investment or for other purposes.
Where cryptocurrencies are held as an investment, Capital Gains Tax (CGT) rules apply when these assets are disposed. Under the current ATO guidance, disposal of a cryptocurrency asset can occur when someone:
sells or gifts cryptocurrency;
trades or exchanges cryptocurrency (including the disposal of one cryptocurrency for another cryptocurrency);
converts cryptocurrency to fiat currency, such as Australian dollars; or
uses cryptocurrency to obtain goods or services.
The ATO explained the background to assessing cryptocurrencies as CGT assets:
In response to growth in the use of cryptocurrencies, the ATO provided public guidance in 2014 that took the view that cryptocurrencies do not fall within the definition of a ‘foreign currency’ for tax purposes. That view is based on the concept of a ‘currency'...that is legally recognised and adopted under the laws of a country as the monetary unit and means of discharging monetary obligations for all transactions and payments in that country. This view was supported by the Administrative Appeals Tribunal decision on 16 June 2020 in the Seribu Pty Ltd case.
As a consequence a cryptocurrency being a CGT asset and not a foreign currency for income tax purposes, the large majority of clients will account for any gains or losses on capital account. One benefit of this treatment is that taxpayers who hold their cryptocurrency for at least 12 months as an investment can access the 50% CGT discount. This is akin to how investors holding company shares account for their gains and losses.
Cryptocurrency that is kept or used mainly to buy goods and services for personal use (e.g. clothes, food or pay personal bills) is not subject to capital gains tax.
For businesses trading in cryptocurrencies, similarly to a share trader, trading stock rules apply, and not the CGT rules. Proceeds from the sale of cryptocurrency held as trading stock in a business are ordinary income, and the cost of acquiring cryptocurrency held as trading stock is tax deductible.
Businesses or sole traders that are paid cryptocurrency for goods or services, will have these payments taxed as regular income, based on the value of the cryptocurrency in Australian dollars at the time of the transaction. This is the same process as receiving any other non-cash consideration under a barter transaction.
ATO visibility of tax accruing from crypto-asset holdings
The ATO noted that it is difficult to accurately estimate how much CGT revenue is raised specifically from cryptocurrencies, as a taxpayer's capital gain or loss for an income year is reported 'as a single figure which may comprise gains and losses from the disposal of a cryptocurrency as well as disposals of other CGT assets such as shares, property and collectables'.
The ATO operates a data-matching program to collect details of cryptocurrency transactions from Australian based cryptocurrency exchanges, to identify where taxpayers are inadvertently or deliberately misrepresenting their cryptocurrency activities in their tax affairs. The ATO noted that it is generally unable to acquire this data from DCEs operating internationally, however this is partially mitigated by the fact that the ATO can detect incoming and outgoing funds to offshore DCEs through AUSTRAC and International Funds Transfer Instruction (IFTI) transactions.
OECD work on tax treatment of crypto-assets
Internationally, the OECD is progressing work on the tax treatment of crypto-assets, publishing a paper in October 2020 Taxing Virtual Currencies: An Overview of Tax Treatments and Emerging Tax Policy Issues, which examined the current approaches taken to these issues in over 50 jurisdictions. The ATO noted that the OECD is currently developing a tax transparency framework for Crypto-Assets and digital money products, which 'seeks to address the risks associated with the lack of transparency in Crypto-Asset and digital money products, by establishing a new reporting regime for these sort of products'. The ATO stated that it 'is hoped a draft will be available in late 2021'.
Awareness of tax rules for cryptocurrency transactions
The ATO noted that there is widespread misunderstanding around the tax implications of investing in cryptocurrencies, particularly among retail investors. Mr Adam O'Grady, Assistant Commissioner, Risk and Strategy, Individuals and Intermediaries at the ATO, told the committee:
[There's] a lack of understanding of how [cryptocurrencies] interact with the tax system, which is why we've increased a lot of our public advice and guidance in the last couple of years. We've had formal rulings for some time, but we've gone out and created more streamlined fact sheets, which we did this tax time as part of our media campaign. We've put out other messages to the community to spread that information about what they're expected to do if they're investing in cryptocurrency, including what the record requirements are.
Some submitters and witnesses put forward the view that further guidance and educational efforts to increase awareness of the taxation implications of digital assets are required.
Blockchain Australia submitted that while the ATO 'has elevated information campaigns surrounding the need for consumers to report gains/losses from participation in the cryptocurrency sector', education and clarity concerning the tax implications of cryptocurrency and digital assets is still lacking for the average consumer without the assistance of professional taxation advice. Further:
It is also our experience that fundamentals have not been well communicated to consumers who continue to seek advice in relation to their obligations with insufficient guidance or assistance from the ATO. Broadly speaking the accounting profession has not moved quickly to assess or address the burgeoning downstream implications of this asset class.
In the short term we encourage the ATO to engage with industry to better understand the development of the technology. We also encourage the ATO to provide greater baseline guidance on the current tax treatment of digital assets and cryptocurrency. Including the capital gains tax regime implications for investors that are using smart contracts and nodes.
CPA Australia submitted it has observed 'mixed levels of awareness amongst cryptocurrency holders as to their Australian tax obligations, as well as the potential international tax issues that may arise when trading in international markets'.
Submitter views on tax rules for cryptocurrencies and other crypto-assets
A range of submitters and witnesses commented on the need to update Australia's taxation regulations and guidance in light of the rapidly evolving changes in technology and the digital economy.
Mr Scott Chamberlain, Entrepreneurial Fellow at the ANU School of Law, commented that Australia's tax laws do not compare favourably
Our tax laws unavoidably complicate the establishment of Digital Asset Projects compared to competing jurisdictions like Singapore that have favourable income tax laws and do not have CGT or GST.
Any digital asset project will inevitably have significant tax issues to solve about how staked and pre-mined assets should be treated from a tax perspective when created and distributed. One particular example is the impossibility of a miner giving a complying Tax Invoice in return for fees paid to include a transaction in one of the miner’s blocks.
FinTech Australia submitted that current CGT arrangements are incompatible with the products and services offered in the digital and crypto-asset industry, particularly for DeFi products. It stated that the central concern is 'a lack of guidance from the ATO about the application of existing principles to new and emerging technologies', and explained further:
One of the most considerable barriers to entry for the mainstream adoption of DeFi products is the numerous taxable events that arise when a crypto-asset token interacts with a protocol. Under the current regime, whenever a token interacts with a protocol where it is swapped, accessed, burned, staked or exchanged a CGT event may be triggered. Many of these interactions are merely features of the technology and not taxable events, as they don’t give rise to any gain or right to the asset itself. It would be particularly onerous to have to consider the tax impact on each protocol interaction, especially in that context. Generally speaking, it would be akin to having to consider the income tax regime each time your computer sends a TCP/IP packet to a website on the internet. If this level of friction existed for early users of the internet, the innovation, products and industry we have today would likely never have been created.
The consequence of this is that any user who is trying to interact with these protocols in order to gain the benefit of its utility may not only trigger a taxing event but also reset the acquisition date for the CGT asset, which would impact the taxpayer’s eligibility for the 50% CGT discount for assets held for at least 12 months. These tax frictions can result in users being less willing to use these innovative platforms.
An example of a swap event where the application of CGT would not appear to be reasonable is a token swap where the underlying blockchain that supports the token is being upgraded or replaced; in this scenario, one digital token is replaced for another at a predetermined rate, and the original token(s) are discarded rather than traded. This event is more akin to a stock split for traditional securities than a trade between assets. A further example raised would be the use of a cryptocurrency (e.g. Bitcoin or Ether) to purchase an NFT; in this instance, the use of the cryptocurrency could potentially be taken to represent a CGT disposal event, regardless of whether an actual gain or loss has been realised from the purchase of the NFT.
FinTech Australia noted that ATO guidance has not kept pace with developments in DeFi and related technology, stating that current guidance 'does not distinguish between types of transactions in determining tax outcomes':
The lack of legislative or regulatory guidance in turn increases uncertainty with respect to cryptocurrency and DeFi, and disincentivises entrepreneurs from launching platforms in Australia (in favour of other jurisdictions with more attractive tax regimes, such as Singapore).
FinTech Australia recommended that the government should 'consult with industry to improve the tax regime’s application to crypto-assets and DeFi and provide greater tax certainty to the industry'. Further, it recommended that the ATO should 'issue more up-to-date and detailed guidance in respect of crypto-assets beyond general guidance around crypto-crypto-and crypto-fiat disposals'.
Ms Razwina Raihman raised the issue of CGT treatment when a cryptocurrency is deposited or lent into a cryptocurrency interest account:
Certain platforms which operate in a bank like way offer interest on cryptocurrency deposits and lending. For example, one can currently deposit 1 Bitcoin into a Nexo…interest bearing account and earn 4% interest in kind per annum. The cryptocurrency is used much like banks use money to generate interest.
An issue has arisen, however, in that the ATO has intimated that depositing or lending cryptocurrency into such an interest bearing account is considered a disposal of the cryptocurrency thus triggering a capital gains tax event.
Ms Raihman argued that, similarly to making a deposit into a bank account to earn interest, a deposit of cryptocurrency into a cryptocurrency account should not trigger a CGT disposal:
It is clearly not the intention of investors to dispose of the cryptocurrency because they retain the right to withdraw exactly the same amount of cryptocurrency they deposited plus any interest. It is unfair to impose a capital gains tax burden on such investors when they are not intending to or not truly effecting a disposal.
It is submitted that the tax laws should be amended so that cryptocurrency deposits or lending into interest bearing accounts should be exempt from capital gains disposals.
A joint submission from a number of academics from RMIT University (RMIT academics' submission) agreed that the current CGT treatment of cryptocurrency is in need of reform:
Operating in what is treated as a barter economy, where transactions can occur multiple levels beyond fiat currency, means the compliance burden for taxpayers is increasingly complex and uncertain. Taxpayers’ compliance becomes increasingly abstract and therefore increases the risk of inadvertent non-compliance.
The RMIT academics' submission recommended the introduction of 'a new CGT asset/event class that enables specific concessions or exemptions to be applied and confirm the timing and approach to taxable events', with the aim of simplifying the CGT regime, reducing regulatory burdens and encouraging compliance. Modifications in this area could, for example, ensure that for certain crypto-assets, taxable events would occur only when: cryptocurrency is exchanged with fiat currency (most commonly the Australian dollar); cryptocurrency is used in the acquisition or disposal of a non-fungible token (such as a piece of digital art); or cryptocurrency is used in the acquisition or disposal of non-tokenised/tangible goods or services.
The proposal for an alternative taxing point, where crypto-to-crypto transactions are ignored for CGT purposes and CGT is only triggered when crypto assets are transferred to Australian dollars or fiat, was supported by FinTech Australia for cryptocurrency trading transactions, on the basis that ‘the current tax treatment of crypto asset transactions is a disincentive for taxpayers to invest in crypto assets’:
Under the current regime, tax liabilities arise for taxpayers in respect of transactions (i.e. crypto-to-crypto trading transactions) where the taxpayer does not receive cash to support payment of the actual tax liability. This is compounded by the fluctuating and sometimes volatile value of crypto assets which can result in potentially large tax liabilities. The proposed Alternative Taxing Point would decrease the compliance burden for taxpayers and it would drive revenue over time through increased trade volumes and increased participation in the crypto market, which would offset any short term loss of revenue as cost to the ATO.
FinTech Australia suggested that one option for implementing this proposal could be a CGT roll-over for crypto-to-crypto transactions:
[A roll-over] could allow the transfer of like-for-like cryptocurrency without an adverse tax impact, by allowing any taxing point to be deferred until the disposal of the crypto currency for fiat or cash. This would have the effect of not eliminating the ATO’s collection of revenue, but deferring the taxing point to a point in time where the taxpayer actually made a gain to enable them to cover any tax liability owing to the ATO.
FinTech Australia emphasised however, that while the proposal to remove crypto-to-crypto CGT taxation points is welcomed in respect of crypto trading transactions, further discussion is required surrounding tax solutions to transactions beyond crypto trading. It commented that in characterising crypto-assets for the purpose of tax law, crypto transactions cannot all be simplified as being the equivalent of traditional share trading, 'as there are a range of crypto use-cases and asset types that expand beyond cryptocurrency trading and this is an area that is continuing to evolve'. Further:
To date, the ATO guidance on the tax treatment of crypto transactions has focused on cryptocurrency trading (with the majority of its guidance being released in 2014). This contributes to significant uncertainty in the industry, especially as the current guidance does not distinguish between types of crypto asset transactions in determining tax outcomes. For example, NFTs are a type of crypto asset which have been utilised more broadly in recent years... The ATO has only published a single private ruling which is binding only for the intended recipient and provides that the taxpayer’s specific NFT artworks are CGT assets. An NFT can be more than artwork, and clear guidance would assist to improve certainty in the market and ultimately increase use of crypto assets. NFTs are just one example of the new and emerging technologies that have been developed since the ATO last published its guidance in 2014. The industry is continuously developing new DeFi protocols that allow users to stake, lend, borrow, and generate interest in novel ways, such as yield farming.
FinTech Australia stated support for the establishment of a cryptocurrency working group by the ATO ‘to assist it in issuing guidance on the taxation of cryptocurrency (including DeFi protocols) in a timely manner so as to provide greater certainty to the sector’. Blockchain Australia submitted:
There is a lack of clarity as to the tax treatment of some increasingly popular uses for crypto-assets, and Australia’s tax system is not suited to handle crypto-assets or decentralised finance in any practical sense. Given the complexity involved in discussions of tax, our view is that the ATO and Treasury should aim to be more collaborative in their dealings with industry so that policymakers can better understand the practicalities involved.
Cointree noted in its submission that several overseas jurisdictions have tax settings more favourable than Australia's for the treatment of digital assets:
In the EU cryptocurrencies are exempt from Value Added Tax (VAT), in the UK their VAT is only applicable to goods purchased with cryptocurrencies, and Singapore has no GST on cryptocurrencies. Singapore already has a low corporate tax rate of 17% while Hungary specifically dropped their capital gains tax on cryptocurrency from 30.5% to 15% to attract more investment. It’s clear that leading nations recognise that low crypto taxes are a key factor in growing their cryptocurrency ecosystem.
Cointree recommended increasing Australia's competitiveness by extending the 'personal use' exemption for individuals' cryptocurrency holdings:
[Australia] could give clear regulations that classify cryptocurrency as a personal asset, so that any purchases below $10,000 can be disregarded for CGT purposes.
This reinforces retail consumers' role in the ecosystem, as their individually small investments are collectively sufficient to bootstrap innovative projects until larger institutional players are ready to adopt them. It will also attract significant capital to Australia.
Carta, an Australian DeFi start-up, submitted that 'founders, investors and other stakeholders are worried about the tax treatment of fund raising using any form of token sales' for DeFi applications. Carta noted that there is uncertainty about whether DeFi tokens will be treated as a utility or an investment for tax purposes, and commented:
On the one hand, if tokens are treated as a utility by the [ATO] and [ASIC], they will be subject to [GST]. This tax treatment is not an appealing feature for most investors and users of the ecosystem. As a result, this tax treatment will prevent or impede newcomers into the Australian FinTech/DeFi market, and limit competition in the financial services market as a barrier to entry.
If, however, the use of tokens for fund raising by start-ups is categorized as an investment by ATO and ASIC, it will be subject to Security laws. The approach by regulators in Australia… The major drawbacks of securities laws as applied to token sales (ICOs) are:
1. It expects companies to disclose both historical financial data and “forward-looking” information. These FinTech start-ups depend only on white papers.
2. It requires company financial statement to be reviewed by a certified auditor. It is difficult to audit an extraordinarily complex code that underlies the DeFi application. It requires a careful review of even the most basic aspects of the code.
3. It requires…extensive information about a company’s board of directors and management. Given the nature of technology, developers are the decision makers.
The statutory designation of token sales (ICOs) as “securities” will not automatically place them in an efficient regulatory scheme that supports innovation and free flowing capital.
Need to evolve tax settings as cryptocurrencies become utilised as currency
CPA Australia expressed the view that the Australia's current tax settings are generally acceptable, but may need to evolve further over time:
The tax treatment of cryptocurrency should reflect the evolving nature of the market and the range of regulatory responses by governments across the globe. The ATO’s current application of existing rules to cryptocurrencies is, in our view, correct with different treatments depending on whether the cryptocurrency is held as an investment or for business.
If the function of cryptocurrencies evolves from a speculative asset to one that more closely reflects money (e.g. Bitcoin used in the same way as EFTPOS) and that a range of associated financial instruments (e.g. Bitcoin-linked funds) will be introduced, the government may wish to assess the flexibility of existing legislation such as the tax rules for foreign exchange gains and losses, and the taxation of financial arrangements to accommodate cryptocurrencies and to identify any areas where further legislative clarity is required.
Several submitters argued that, given some other jurisdictions are recognising Bitcoin as legal tender (with El Salvador having implemented this measure and other jurisdictions reportedly considering it), the ATO's current position that Bitcoin is not a foreign currency for tax purposes may have to shift.
The RMIT academics' joint submission called for the ATO to update guidance 'to reflect the changing global position of Bitcoin and consider that Bitcoin may now meet the definition of a financial currency and therefore may be captured within the foreign exchange regime'.
Bitaroo, an Australian DCE, argued in its submission that Bitcoin should be reclassified as a foreign currency for tax purposes, and that foreign currencies should be made CGT exempt:
Earlier this month El Salvador passed the ‘Bitcoin Law’, a bill that classifies Bitcoin as its legal tender. The effect this will have on the economy of El Salvador and particularly on its unbanked citizens is profound. It is expected that other countries will soon follow suit.
The UK…exempts gains (and losses) on foreign currencies. Not so in Australia. This leads to a strange scenario in which if one buys USD (thinking they would spend it overseas) but then later exchanges all or part of it back to AUD, this becomes a taxable event.
By recognising Bitcoin as a foreign currency and by exempting capital gains tax on foreign currencies, Australia has a unique but rapidly diminishing opportunity to position itself as a global and forward-thinking leader in this space.
Other proposals relating to taxation of digital assets
Some submitters argued that in addition to CGT issues, other taxation issues relating to digital assets need to be considered.
Arguments for a broader taxation review dealing with crypto-assets
The Digital Law Association argued for a root-and-branch review of Australia's tax laws to make them suitable for the emerging digital and decentralised economy. It stated:
Australia’s tax settings are outdated, are not fit for purpose in the digital and decentralised economy and are not technology neutral. The current Australian tax settings do not make Australia an attractive jurisdiction to launch, undertake or participate in digital asset businesses. The ATO is not sufficiently resourced to produce timely guidance that deals with the complexities of digital asset transactions, particularly DeFi transactions.
The DLA noted that various industry proposals in recent years in relation to the tax issues associated with issuing, holding and transacting with digital assets have been implemented in legislation, 'at a cost to the attractiveness of Australia as a place for digital asset business activity'. It recommended that the Treasurer instruct the Board of Taxation to undertake 'a comprehensive review of the federal, state and territory tax systems' by April 2022, to recommend amendments required 'so the tax law does not produce anomalous outcomes to the economic intention of digital transactions'.
Blockchain Australia endorsed the DLA's recommendation for a comprehensive review of Australia's tax settings in light of the emergence of digital assets. It submitted:
In our view, the ultimate outcome of such a review, as proposed by the Digital Law Association, should be that the ATO is empowered to issue more practical tax guidance for consumers and businesses such that tax enforcement is grounded in the reality of how digital asset technology is used by its adopters.
The technology underpinning the development of the digital asset and cryptocurrency sector is borderless. The implications of this fundamental shift in the high speed delivery of data, representing tangible value, requires a root and branch review of tax policy.
Tax treatment for stablecoins backed by fiat currencies
The RMIT academics' joint submission recommended that stablecoins that are backed by fiat-currency should be treated as that currency for the purposes of taxation (for example, under this arrangement if a business receives USDC, a US-dollar backed stablecoin, as payment, then the business is taken to have received US dollars). The submission explained:
Business is now being done in stablecoins—including for internal transactions inside a corporate group, between cryptocurrency exchanges, as payment for services, and for blockchain foundation grants. This technology allows cheaper, quicker and more secure transactions. Stablecoins (and other cryptocurrencies more broadly) could be considered a “non-cash payment facility” requiring licensing and product disclosures. For tax purposes, it is not consistent to treat US dollars in an online bank account (for which there are well-established tax rules), for example, and US-backed stablecoin in an online cryptocurrency exchange wallet differently when these are functionally the same transaction.
Organising taxation around cryptocurrency digital wallets
The RMIT academics' submission noted that cryptocurrency transactions undertaken directly between individuals (i.e. direct from one individual's digital cryptocurrency wallet to another's) are at heightened risk of money laundering and terrorism financing vulnerabilities, compared with transactions mediated by a DCE. The submission stated that cryptocurrency wallets:
…represent a core infrastructure of the digital economy and a natural point of asset and income flow. Therefore, wallets represent a key point in the blockchain architecture to capture the tax burden for crypto-economic activities.
The submission argued that as such, the government should take steps to adopt a wallet-centric approach to cryptocurrency taxation:
The Federal government should introduce a set of standards, or whitelist, for wallets to signify compliance quality (such as public accessibility, integration with ATO API, taxpayer identity, and key storage requirements). This would enable greater ability for streamlining taxation points and compliance burdens. Further, whitelisting wallets opens opportunities in time to enact automated tax collection, such as final taxing of crypto-activities and wallet-centric simplified taxation regime.
Clarity around tax status for not-for-profit blockchain foundations
Mr Scott Chamberlain, Entrepreneurial Fellow at the ANU School of Law, argued that Australia should clarify the ability for not-for-profit blockchain foundations to operate with tax emptions:
Australia does have one area of comparative advantage in respect of tax: tax exempt not-for-profits (NFPs). Most Digital Asset Projects involve an NFP foundation at the heart of the ecosystem. This entity is responsible for promoting and curating the community assets. In some cases, it might also act as the treasury. This is a wholly appropriate function for an NFP.
In Australia, an NFP is tax exempt if it is established for the principal purpose of the development of Australia’s information technology resources. At first glance, this would appear to include undertaking the functions of a foundation of blockchain ecosystem.
If Australia could make it easy and certain to establish a tax exempt NFP for a blockchain ecosystem this would greatly improve Australia’s attractiveness as a destination jurisdiction for Digital Asset Projects and remove many tax problems.
Regulatory framework for new types of decentralised organisations
A number of submitters presented evidence on the growing use of 'new forms of governance and community participation' for blockchain projects, which are necessitated by the decentralised nature of these projects.
Mr Scott Chamberlain stated that these nascent governance structures have taken many forms, including:
Decentralised Autonomous Organisations (DAOs): these amount to common law partnerships, syndicates or unincorporated associations whose activities and investment decisions are co-ordinated by code or smart contracts.
Legal Autonomous Organisations (LAOs): traditional legal entities whose internal management is coordinated through code or smart contracts.
Code Coordinated Communities (CCCs): a catch-all term for coordination via code that includes situations where the parameters of the blockchain protocol itself can be altered by agreement between its users.
Mycelium, a Brisbane-based technology firm working in areas including decentralised finance, submitted that DAOs are one of the two most common kinds of decentralised systems currently being used (with the other being public blockchains such as Bitcoin and Ethereum).
The RMIT academics' submission noted that DAOs represent a new category of organisation that operates on decentralised blockchain infrastructure, whose operations are pre-determined in open source code and enforced through smart contracts.
DAOs are being used globally for many purposes including investment, charity, fundraising, borrowing, and buying NFTs. For example, a DAO can accept donations from anyone around the world and the members can decide how to spend donations.
Currently, DAOs and other blockchain projects with decentralised governance structures are not readily recognised within existing regulatory categories under Australian law. Mycelium submitted that this means that DAOs are not recognised as entities with legal personality or limited liability, and commented further:
Until such recognition, we are left with DAOs who do not operate as people within the eyes of the law. Currently, most Australian lawyers interpret DAOs as partnerships. These interpretations each lead to concerns that, amongst an organisation of potentially infinite parties, each individual party could be held personally liable for the debts of the organisation.
The current legal status of DAOs is analogous to the legal status of corporations prior to limited liability companies. Prior to limited liability companies, it was untenable for individual shareholders to have ‘moral culpability’ for the actions of corporations, as they lacked the power and control mechanisms to discipline errant management.
It is equally untenable for individual stakeholders of decentralised systems, such as decentralised financial applications, to have moral culpability for the actions of those decentralised systems, because the individuals lack the power and control mechanisms to discipline errant decision-making.
Mycelium argued that under current interpretations of the Corporations Act, multiple parties involved in the design and operation of DAOs are subject to legal uncertainty as to their responsibilities and potential liabilities.
Several submitters argued for the introduction of a DAO legal structure in Australia. The Digital Law Association argued that DAOs:
…will increasingly feature as a business model in the digital and decentralised economy and must be given legal recognition, the clear ability to hold property and contract, as well as limited liability.
The RMIT academics' submission recommended:
A new category of company should be created under the Corporations Act – a Limited Liability DAO (LLD). This would require legislative changes. However, existing mechanisms such as changing a type of company or replaceable rules could be adapted for the LLD.
Herbert Smith Freehills (HSF) suggested that the introduction of a DAO Limited entity in the Corporations Act would provide:
appropriate corporate oversight and guidance for a new business model manifesting in the digital economy, particularly in respect of digital asset transactions; and
clarity and recognition as to the cross over between Digital Assets and DAOs and how their integration into existing regulatory regimes should be facilitated with an eye to both functions. (For example, a constitution document set up as a smart legal contract could operate as both a DAO and a digital asset).
Introducing a new entity structure in the Corporations Act, regulated under the Treasury portfolio, would not be uncommon in Australian practice; for example, the Treasury has just finished a consultation process on draft legislation that would introduce a Collective Corporate Investment Vehicle structure in the Corporations Act.
Some jurisdictions internationally are starting to develop legal structures for DAOs, with Wyoming becoming the first US state to recognise DAOs as a legal entity in July 2021. Under the Wyoming model, a DAO is simply defined as a type of Wyoming limited liability company (LLC). In other words, the DAO Law clarifies that DAOs can use the LLC legal entity form as long as the DAO meets other requirements set out in the DAO Law (for example, requiring the DAO to maintain a registered agent in Wyoming, and requiring a publicly available identifier to be kept of any smart contract directly used to 'manage, facilitate or operate' the DAO).
The Coalition of Automated Legal Applications (COALA) has published a model law for DAOs which can be applied and adapted by different jurisdictions. The DAO Model Law developed by COALA is designed to 'provide answers to questions that have troubled those that have observed the growth of decentralised systems, such as: legal personality, liability, dispute resolution and taxation'. Proponents of a new DAO legal structure in Australia suggested that the COALA Model Law could be used as a starting point for developing a law in Australia (rather than being adopted directly).
DAOs based on the 'unincorporated joint venture' structure
Mr Chamberlain argued that while one possible solution to the issue of how to accommodate decentralised governance structures is enabling DAOs to incorporate, such as in the Wyoming model, in his view a 'better approach is to clarify circumstances in which a CCC or blockchain community are unincorporated joint ventures':
This model is similar to a partnership but involves no pooling of assets, sharing or profit, or joint and several liability. Instead, participants share outputs, not profit, retain ownership of the assets they contribute to the venture, and solely liable for their own conduct, and have no ability to bind other participants.
Mr Chamberlain expanded on this proposal in further information provided to the committee, putting forward a detailed model for how a DAO model based on the model of an unincorporated joint venture could work if creating a new corporate structure for DAOs under the Corporations Act is not a viable reform option. Mr Chamberlain summarised this proposal for a 'decentralised public network':
Properly structured, [unincorporated joint ventures] are not partnerships. Parties share the outputs (not profits) from their collaboration, bear their own costs, and tend to retain ownership of their inputs. While the joint venture tends to be co-ordinated through a management committee, the parties are severally liable to third parties for their own actions, pay their own tax, and retain their own insurance.
This proposal adopts the unincorporated joint venture model. It creates a special type of unincorporated joint venture – called a “decentralised public network”. Under this model, the code is the network’s rules, and the users have no liability to each other and limited liability to third parties for their participation in the decentralised public network, excluding crime and fraud. The overarching aim is to reinforce user’s reliance on their network’s code, and not the law.
Issues relating to digital asset infrastructure and cryptocurrency 'mining'
As noted in Chapter 2, cryptocurrencies and other digital assets are created and maintained using real-world infrastructure, predominantly data storage and computational power.
Blockchain Australia noted that because of the size and history of Bitcoin, a lot of the computation power required for crypto-assets has been used to 'mine' Bitcoin. The process of Bitcoin mining, whereby 'proof of work' computations are conducted to verify new Bitcoin transactions, is explained by the RBA as follows:
Bitcoin transactions are verified by other users of the network, and the process of compiling, verifying and confirming transactions is often referred to as ‘mining’. In particular, complex codes need to be solved to confirm transactions and make sure the system is not corrupted. The Bitcoin system increases the complexity of these codes as more computing power is used to solve them. A new block of transactions is compiled approximately every ten minutes. ‘Miners’ want to solve the codes and process transactions because they are rewarded with new bitcoins… The increase in competition between miners for new bitcoins has seen large increases in the amount of computing power and electricity required (which is often used for air conditioning to cool computer systems). While it is difficult to calculate with precision, some estimates suggest that the annual energy consumption of the Bitcoin system is similar to that of countries like Greece, Colombia or Switzerland.
The RBA noted in its submission that the very high use of energy involved in ‘mining’ cryptocurrencies, most notably Bitcoin, is 'attracting increasing attention from governments and policymakers'.
Dr John Hawkins submitted:
Another negative externality from cryptocurrencies is the large amount of greenhouse gases emitted in the process of creating them. These emissions have been estimated to bigger than those from entire countries. An appropriate carbon price should be imposed on cryptocurrency miners. If this is not possible, it strengthens the case for regulations that discourage their growth.
Mr Michael Tilley questioned whether the carbon impact of cryptocurrency mining is exaggerated, noting that the University of Cambridge Judge Business School found in a 2020 study that 76 per cent of the energy utilised globally by proof of work miners in 2019 was sourced from generators utilising renewable source material other than coal or gas.
The Climate Change Authority (CCA) noted that the biggest factor in determining the level of carbon emissions associated with cryptocurrency mining activity is the emissions intensity of the electricity used to power the necessary computer processing. The CCA commented further:
Cryptocurrency miners in Australia could directly address their emissions through purchasing renewable electricity. For example, large electricity users can enter into power purchase agreements for renewable electricity with an electricity generation company. An alternative would be to purchase large-scale generation certificates created under the Renewable Energy Target. While the electricity delivered to the customer is still from the grid, either approach ensures the customer’s power use is backed by renewable electricity generation and could be regarded as carbon neutral.
It would also be possible for the emissions from cryptocurrency transactions to be addressed through the purchase of carbon offsets, such as Australian Carbon Credit Units (ACCUs) which are issued by the Clean Energy Regulator under the Government’s Emissions Reduction Fund scheme. Other offsets are also available for purchase—the purchaser should undertake due diligence to satisfy themselves that offsets they are considering purchasing are of high integrity—that is, they represent genuine, additional abatement activities.
Blockchain Australia emphasised that the physical infrastructure required to support digital assets 'is becoming a new asset class', and commented further:
Many digital asset infrastructure providers are moving to the US. Unlike roads or “poles and wires”, digital asset infrastructure is relatively mobile. Because the biggest input cost is energy, companies are incentivised to move to countries where energy is abundant and cheap, including in remote areas. Increasingly, this energy is coming from renewable sources or capturing so-called “stranded” energy assets that cannot easily be put to productive use. Some instances of this include renewables curtailment (using excess renewables capacity such as hydroelectricity in the wet season or solar power in the middle of the day) and gas flaring (turning gas created as a by-product of resource extraction into a valuable commodity).
Given Australia’s significant potential solar capacity, there is an opportunity for a new economy to develop around digital asset infrastructure as part of a broader sustainable crypto-asset ecosystem.
The ATO noted in its submission that global markets 'are looking to capitalise on the regulatory policy settings in countries such as China, that has moved to ban Bitcoin mining altogether':
Large commercial Bitcoin miners operating in China are now looking for other countries to host their businesses. Mining relies on an abundance of affordable electricity and reliable internet connectivity and large institutional investors are looking for markets where they can mine bitcoins using renewable sources.
Submitters highlighted that the opportunity in digital assets infrastructure extends beyond cryptocurrency mining. For example, Distributed Storage Systems and Holon Global Investments both highlighted the revenue streams being derived by companies in Australia building cloud data storage infrastructure for the Filecoin ecosystem, a decentralised and distributed open data platform.