Crypto – a regulatory and consumer protection primer for advisers
Crypto offerings have rapidly evolving regulatory and consumer protection frameworks.
Suspicious minds
It is a normal human trait to be suspicious of things we don’t understand, which is why so many people still regard cryptocurrency as something of a fringe concept.
And whilst the news may be increasingly filled with stories like the large, respected institution who allowed its 16,000 advisers to access crypto for clients[1] (Morgan Stanley), or the platforms who now accept bitcoin as a payment type[2] (PayPal and Zip), or the entire US State that implemented a crypto dedicated banking charter[3] (Wyoming), these things have all happened afar, making it easier for us to remain detached from their ramifications. Even the news that famous crypto sceptic Warren Buffet had just invested $1 billion in a crypto bank[4], or that crypto exchange Coinbase had listed on the NASDAQ[5], left us unmoved.
Until now.
The times are a changing
2021 saw two local announcements that may ultimately prove seismic in shifting the worlds of cryptocurrency and financial advice closer together in this country.
Firstly, in October, the Senate Committee chaired by Senator Andrew Bragg handed down its final report, ‘Australia as a Technology and Financial Centre[6] (ATFC), making 12 recommendations (Figure 1, below) designed to make Australia a world crypto leader, luring blockchain developers and entrepreneurs here by offering the regulatory clarity and certainty that other developed nations such as Britain, the US, and Singapore, are still grappling with.
That was followed shortly afterwards by arguably the biggest signal yet that crypto has gone mainstream in Australia, when CBA announced[7] it would allow the 6.5 million users of its retail banking app to buy and sell 10 different crypto currencies, including Bitcoin, Ether, and Litecoin. (An announcement which, it seems fair to say, caught many off guard, including its biggest competitors).
Yes, crypto is here to stay, and it’s growing, with both EY and finder estimate that close to 30% of Australians will soon participate in the sector currently valued globally at over $3 trillion[8].
From a financial adviser perspective, that means an ever-increasing likelihood of clients wanting to talk about digital assets and the opportunities.
And whilst you may be unable to provide your clients with advice on crypto, or NFTs, or the blockchain (because they are not classed as financial products), it is critical that you understand the regulatory and consumer protection framework around crypto as it currently exists, in order to help your clients appreciate the undoubted risks that exist in this area.
A consumer protection perspective
When assessing the consumer risks and protections in the world of digital assets, Treasury’s four pillars of financial consumer protection[9] can be a useful starting point:
- Product Regulation
- Disclosure
- Financial Literacy
- Financial Advice
Crypto product regulation and disclosure
Type crypto into a news search and you are almost certain to encounter the phrase ‘unregulated wild west’ pretty early. But whilst it is true that the regulatory framework is embryonic (hence the work of the Bragg Committee), it is not accurate to describe the sector as completely unregulated. ASIC and others have already started to inroads into this space, and more change is clearly on the short-term horizon.
Adequate regulation will clearly be crucial for increasing consumer confidence in the sector.
As it currently stands, crypto currency and other digital assets are not themselves classed as financial products under Corporations law, putting them beyond the scope of many regulatory requirements and associated consumer protections.
The issuers of such offerings are not required to be licensed, they aren’t required to act in the best interests of investors, they aren’t subject to any capital requirements, and they aren’t required to be a member of an External Dispute Resolution Body or the Compensation Scheme of last resort (CSLR).
As such, if you invest in a cryptocurrency and it becomes worthless, you are on your own.
But some instruments based around crypto CAN be classed as financial products, as clarified by ASIC recently[10], meaning consumers can at least gain some confidence in the legitimacy of the company taking their money (it doesn’t mean they still can’t lose it all).
Following extensive consultation around their CP 343 paper, in November 2021 ASIC released two new Information Sheets, 225 (Crypto Assets[11] and 230 (Exchange traded products: Admission guidelines)[12]. These materials work alongside Information Sheet 219 which deals with the blockchain and other similar technologies[13].
Information Sheets 225 and 230 address the circumstances where a crypto offering could be classed as a financial product, and then provide more detailed guidance about matters the issuers of such products needed to address, including institutional support of the crypto asset, service providers willing to support the use of the crypto asset, maturity of the spot market for the crypto asset, regulation of derivatives linked to the crypto asset, and the availability of robust and transparent pricing mechanisms for the crypto asset. ASIC also offers suggestions on good practices in relation to custody, disclosure, and risk management.
Crypto based ETFs
The Information Sheets set out specific guidance on crypto-based derivatives, securities, payment facilities, and Managed Investment Schemes. In the case of the latter category (which includes ETFs), they published a simple test to determine if an offering meets the definition of a financial product, as shown in Figure 2 below:
If an issuer of a crypto asset IS deemed to be operating a managed investment scheme offered to retail investors, they will need to comply with the strict guidelines applying to other retail financial products, including:
- registering the scheme with ASIC
- establishing a constitution and compliance plan
- obtaining an AFS licence to act as a responsible entity, and
- preparing and issuing a compliant product disclosure statement (PDS) and comply with other disclosure obligations.
ASIC notes that ‘Responsible entities (REs) and managed investment schemes are regulated under Chapter 5C of the Corporations Act. They are entrusted with the funds of their investors and must comply with their legal obligations as REs, including to act in the best interests of members of the scheme’.
Disclosure
Financial products and services are complex and costly and fraught with risks. Australia’s financial disclosure regime, which manifests through vehicles such as the PDS, FSG and SOA, has long been the bedrock of our financial consumer protection framework.
Whilst many cryptocurrencies themselves are not classified as financial products, and therefore avoid such requirements, a growing number of crypto-based offerings will be classed as financial products, and in this context, ASIC has also clarified[15] the types of information it expects to see covered in the PDSs for such offerings:
- in relation to the characteristics of crypto assets:
- the technologies that underpin crypto assets, such as blockchains, distributed ledger technology, cryptography and others
- how crypto assets are created, transferred, and destroyed
- how crypto assets are valued and traded, and
- how crypto assets are held in custody
- in relation to the risks of the crypto assets:
- market risk – historically, crypto-assets have demonstrated that their investment performance can be highly volatile
- pricing risk – it may be difficult to value some crypto-assets accurately
- immutability – most crypto-assets are built on immutable blockchains, meaning that an incorrect or unauthorised transfer cannot be reversed
- political, regulatory, and legal risk – government and/or regulatory action may affect the value of crypto-assets held by the scheme
- custody risk – the private keys may be lost or compromised,
- cyber risk – the nature of crypto-assets may mean they are more susceptible to cyber risks than other asset classes, and
- environmental impact –some crypto-assets have a large environmental impact because of the energy consumed when mining them
Another layer of risk – crypto exchanges
Cryptocurrencies are purchased through crypto exchanges, digital marketplaces which allow users to convert fiat currency (traditional money) into a range of crypto currencies, and then trade those currencies.
Whilst most of the 455 Digital Currency Exchanges (DCEs) currently operating in Australia[16] are NOT regarded as financial products, since 2018, DCE providers have been required to register and enrol with AUSTRAC, under Australia’s AML/CTF regulatory framework[17].
Registered exchanges are required to implement know-your-customer processes to adequately verify the identity of their customers, with ongoing reporting obligations such as annual compliance reporting and the requirement to monitor and report suspicious and large transactions. Exchange operators are also required to keep certain records relating to customer identification and transactions for up to seven years. DCE providers are required to renew their registration every three years.
It should be noted however, that registration with AUSTRAC does not involve any policing by ASIC, nor any requirement around capital adequacy. As the December 2021 collapse[18] of MyCryptoWallet – an Australian DCE – proved, the consumer risk isn’t just limited to the underlying digital currencies, the exchange you use can be just as risky.
Some exchanges are members of AFCA
That said, the more established Australian exchanges have a good reputation, and share a genuine interest in cleaning the sector up. Many subscribe to the Australian Digital Currency Industry Code of Conduct[19], a voluntary code formulated by Blockchain Australia, the peak industry body for businesses in this sector. Under the code, Blockchain Australia Certified Digital Currency Businesses must maintain membership and comply with the terms of references of an External Dispute Resolution Scheme to facilitate fair resolution of customer complaints and disputes. In order to meet this requirement, a number of members have chosen to become members of AFCA[20].
Consumer law
Even if a crypto offering is not regulated under the Corporations Act, it may still be subject to other regulation and laws, including the Australian Consumer Law (ACL) relating to the general offer of services or products to Australian consumers.
This law prohibits misleading or deceptive conduct in a range of contexts, including marketing and advertising. Promoters of sellers of any product or service (including crypto offerings) must take care to ensure buyers are not misled or deceived and that any promotional material they use does not contain false information. Furthermore, they are prohibited from engaging in unconscionable conduct and must ensure that the products they are offering are fit for their intended purpose.
Using powers delegated by the ACCC, ASIC has indicated[21] that it will take action if it detects misleading or deceptive conduct in the following contexts relating to crypto offerings:
- the use of social media to create a sense of inflated public interest
- creating the appearance of greater levels of buying and selling activity for a crypto asset by engaging in certain trading strategies
- failing to disclose appropriate information about the asset; or
- suggesting that the crypto asset is a regulated product when it is not.
Financial literacy
One of the most powerful protections consumers have from negative financial outcomes is knowledge. Financial products and services tend to be complex and risky, and the more a user understands the nature of a product, the more they are likely to use that product in an appropriate manner. Even a basic knowledge can be enough to prevent the all too familiar stories of people losing their life savings. But achieving these basic levels of knowledge on a widespread scale has thus far proved elusive, and countless government and corporate financial literacy initiatives have, to date, failed to move the dial.
Crypto takes the literacy challenge to a whole new, scarier, level.
Firstly, crypto is fundamentally a difficult subject to even comprehend, let alone understand in detail. We can’t see or touch crypto, and it emanates from faceless sources all over the world, not some central issuer. There is no bitcoin customer service line.
Secondly, the processes procedures and protocols surrounding crypto assets can be full of traps for the unwary.
Choosing a crypto currency in itself is probably half the battle, Bitcoin may be the biggest player but it’s not the only one. And not all coins are the same. Some, called stable coins, aim to be far less volatile. Some are ‘pegged’, meaning their value is linked to an external reference point, such as the USD exchange rate. Some are backed by assets.
Users pay fees, sometimes hundreds of dollars, to buy into, and exchange between, cryptocurrencies.
And then there is the matter of security.
Crypto owners are responsible for looking after their unique “private keys”, which operate like passwords and allow users to buy and sell crypto assets. If you lose your private key, there is no way to recover it, so the cryptocurrency holding is lost for ever. Even the most regulated exchanges, such as Coinbase, do not cover investors who lose their password.
Blockchain data firm Chainalysis estimates[22] 20 per cent of the supply of bitcoins has been lost – forever – in this way!
Financial Advice
Financial advisers may themselves be the ultimate consumer protection, helping clients navigate complex and risky financial markets and products, through expert guidance that enables informed decision making.
But as we have already seen, and in the words of Blockchain Australia[23], “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.”
Whilst the inability to access financial advice about crypto (because it is not regarded as a financial product) remains a hurdle for many retail investors, the sector is too tempting for many to ignore, leaving the door open for them to fall victim to the unlicensed scammers and finfluencers.
Even if crypto were classified as a financial product, the advice community itself seems divided on the merits of crypto. Many are happy to avoid the area altogether, whilst others, including Cody Harmon of Hardline Wealth[24], believe cryptocurrencies should play a role in diversified portfolios and investors would benefit from professional advice.
Of course, when crypto does make its way into the realm of financial advice (as seems inevitable), a further barrier will present itself in the form of subject matter expertise. According to Harmon, many advisers currently lack the requisite knowledge, pointing out that “retail investors – and particularly younger ones – know much more [about cryptocurrencies] than the advisers themselves and regulators”.
Which gets us back to our starting point. The growing consumer demand for crypto makes it inevitable that your clients will want to discuss the sector with you. And even if you can’t provide advice in this space, you should at the very least be able to broadly explain the features and risks of such an investment. That, in itself, is a measure of protection.
Summary
Growing interest levels in, and demand for, crypto assets make it inevitable that clients will want to engage with their adviser on this topic. The inability to provide advice on crypto should not be a barrier to such engagement. Far from being a lawless frontier, there are already many regulations in place designed to protect the interests of consumers, with more undoubtedly on the way, and Advisers should keep abreast of this regulatory framework as it continues to evolve. By being able to broadly explain to clients the features and risks of crypto offerings, (which can be done outside the context of ‘advice’) advisers can provide a crucial additional layer of consumer protection, augmenting that already provided through regulatory means.
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