CPD: Compliance primer – Crypto regulatory reform, consumer implications

01 Jul 2024

From AdviserVoice - this Regulatory Compliance and Consumer Protection CPD article is proudly brought to you by Russell Investments

Recent market and regulatory developments have brought digital assets – including crypto-based products – more into the financial mainstream.

Introduction

Still regarded with suspicion by many, cryptocurrencies have continued to grow in popularity in Australia. Despite losing value by more than 60% in 2022^[1], Bitcoin and other popular cryptocurrencies have proved remarkably resilient, to the extent that an estimated 5.6 million Australians^[2] – more than a quarter of the population – have either owned, or expressed an interest in owning, cryptocurrency over the last 12 months.

Increasingly then, financial advisers are finding their clients either already hold crypto, or are enquiring about it – questions which of course advisers are not currently licensed to advise on.

But while the inability to advise on crypto has seen most advisers give it scant attention historically, the first half of 2024 has seen a number of high-profile announcements splashed across the financial media, making the topic much harder to avoid. These announcements include the United States SEC approval of Bitcoin spot price ETFs in January 2024^[3], and more recently, the local launch of ‘Australia’s first spot Bitcoin ETF’ with direct Bitcoin holdings^[4] (a number of existing Bitcoin ETFs held Bitcoin indirectly).

More significant though, from a financial adviser perspective, is the regulatory reform of digital currency platforms currently underway, which is likely to utilise the existing AFSL framework, and is designed to significantly step-up protections for consumers and their digital assets.

To the extent that Australian financial regulation often takes a lead from developments in the US and UK, it seems inevitable that crypto-based products will eventually be regarded and regulated as mainstream offerings. High risk certainly, but arguably no more so than some existing classes of product.

Australian financial advisers should therefore be across developments in the crypto space for two main reasons:

a growing proportion of their clients already hold crypto or are interested in crypto, and
coming regulatory reforms are likely to expedite the process by which crypto and crypto-based products find their way onto APLs.

This article will revisit the current and proposed regulatory framework for cryptocurrencies, through a consumer protection lens, to help advisers understand the context already applicable to a small but growing percentage of their clients, and to prepare them for the almost inevitable entry of crypto-based products onto APLs around the country.

Current crypto context – through a consumer protection lens

When assessing current consumer risks and protections in the world of digital assets, Treasury’s four pillars of financial consumer protection⁵ can be a useful starting point:

product regulation
disclosure
financial literacy
financial advice.

Current product regulation and disclosure

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 (although this will change under proposed reforms), 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).

Some crypto-based instruments are already classed as financial products

While the currencies themselves (Bitcoin, Ethereum, etc) are not financial products (in the same way cash isn’t), some instruments based around crypto (such as crypto ETFs) ARE classed as financial products.

As far back as 2021 ASIC issued two Information Sheets relevant to crypto-based products – 225 (Crypto Assets)^[6], and 230 (Exchange traded products: Admission guidelines)^[7].

These Information Sheets 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.

Crypto-based ETFs

As already mentioned, a number of providers have been issuing crypto-based ETFs in Australia for a number of years now. These include offerings which indirectly hold crypto currencies, as well as those which tap into the companies operating in the broader crypto ecosystem, including companies building crypto mining equipment, crypto trading venues, and other key services that allow the crypto economy to thrive.

As Managed Investment Schemes, crypto-based ETFs are subject to 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.

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 requirements for crypto-based financial products

ASIC has also clarified^[8] the types of information it expects to see covered in the PDSs for crypto-based 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.

2024 proposed regulatory reform of digital assets (including crypto)

In October 2023, Treasury released a paper – Regulating Digital Asset Platforms (Proposal Paper) – seeking stakeholder feedback on proposals for a new framework to regulate entities providing access to cryptocurrencies and digital assets and holding them for Australians and Australian businesses^[9].

A number of changes are proposed by Treasury to achieve three main goals:

introduce a framework for the digital asset industry innovation and growth
provide certainty and clarity for the digital asset industry, and
protect consumers and their assets involved in the digital asset space.

One of the headline reforms proposed by Treasury is to extend the definition of financial product to include digital asset facilities. A ‘digital asset facility’ (DAF) is a facility for holding assets and assets backing digital assets.

The issuer of a DAF (or platform) would be the person or persons responsible for the obligations owed to customers under the terms of the asset holding arrangement.

This means a person carrying on a business of providing financial services in Australia in relation to a DAF will need to hold an AFS licence (and comply with all obligations that come with holding an AFS licence).

‘Financial services’ in this context include:

dealing in a financial product (applying for or acquiring, issuing, varying or disposing of a financial product)
making a market in a financial product
providing a custodial or depository service, and
providing financial product advice.

Given it is the DAFs that are financial products under the proposed regime – rather than the tokens themselves – an entity will only be providing financial product advice when the entity is giving advice about using a DAF and/or investing through it.

Treasury proposes that DAF advice would include advice in relation to acquiring, holding and disposing of digital assets (both financial product and non-financial products) through a digital asset platform.

From an adviser perspective, this nuance is significant, and reinforces the view that regulators are not putting advice providers on the hook for the fluctuating values of crypto assets, but rather for the due diligence around the DAF provider.

A salient example of why this may be more appropriate is the collapse of FTX, specifically referenced in the Treasury Proposals Paper:

“Recent failures of digital asset platforms have led to considerable consumer losses. For instance, the collapse of FTX alone affected approximately 50,000 Australian consumers. The common factors among these failures were: (i) significant loss of assets held on behalf of customers; (ii) ineffective management practices; (iii) inadequate governance structures; (iv) poor operational resilience; (v) instances of fraudulent activities; and (vi) widespread conflicts of interest.”^[10]

FTX was a crypto exchange (an example of a DAF), not a crypto currency, an important delineation!

It’s not about the digital assets, but the platforms on which they sit

A major implication of the proposals is that digital assets – including cryptocurrencies – will not generally be regulated as a financial product.

Rather, the focus of the reforms is on the risks created by intermediaries in the digital asset ecosystem, rather than the digital assets themselves.

To many observers, this is a significant change in direction compared to what may have been expected. (Earlier in 2023 the Government undertook an exercise called ‘Token Mapping, leading many to conclude that a token-based/technology-based approach was going underpin any regulatory framework.

The new approach is intended to create consistent regulatory outcomes regardless of the underlying token or technology. while focussing on where the potential harm might be.

Existing consumer law

Consumers are also provided a measure of protection under Australian Consumer Law (ACL) relating to the general offer of services or products (including crypto).

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 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 had previously indicated^[11]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.

ASIC in the courts over crypto

ASIC has been true to its word and has initiated a number of court cases, including recent ones involving Finder^[12], Block Earner^[13], and BPS Financial^[14]. In February 2024 they charged a Queensland based director with carrying on an unlicensed financial services business, after their investigation found he had encouraged clients to set up a self-managed superannuation fund (SMSF), transition their existing super into the fund and invest the funds into his own company which held cryptocurrency among other assets^[15]. In April they successfully seized the passport of the director of collapsed crypto exchange Blockchain Global^[16].

Financial advice and crypto

Financial advisers are of course the ultimate consumer protection, helping clients navigate complex and risky financial markets and products, through expert guidance that enables informed decision making.

But despite the recent developments bringing crypto more into the financial mainstream, advisers are currently hamstrung.

As FAAA CEO Sarah Abood told the Australian Financial Review, advisers are restrained from recommending digital currencies because of prohibitions by the companies that employ them or because their professional indemnity policy does not cover it.

“Most financial advisers would see these types of assets as speculation rather than investments, at this stage [and] very few would be willing to make a recommendation to a client to invest in them. Most advisers, and their licensees, will give them a wide berth at least until there’s a solid performance track record, and an ‘investment grade’ asset consultant rating,” Abood said^[17].

The current state of play undoubtedly leaves consumers at risk. In the words of Blockchain Australia^[18]:

“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 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.

Adviser knowledge gap

The proposed regulatory reform in the crypto sector, and its increasing acceptance as a legitimate investment, makes it inevitable that crypto will make its way into the realm of financial advice. However, when it does, a further barrier will present itself – in the form of subject matter expertise. According to Financial Adviser Cody Harmon of Cruz^[19], 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”.

Making it all the more important to be across developments in the sector, in order to better protect your clients now, and in the future.

Summary

Cryptocurrencies continue to grow in popularity in Australia, with research suggesting over one quarter of the population have shown interest in or owned cryptocurrency recently. Financial advisers will inevitably face increasing queries from clients about crypto, but current regulations prevent them from offering advice.

While market developments – including US SEC’s approval of Bitcoin spot price ETFs and launch of Australia’s first spot Bitcoin ETF will further integrate crypto into the mainstream financial system, the most significant development on the horizon is the proposed regulation of Digital Asset Facilities.

These changes – as proposed by the Treasury – aim to include digital asset facilities under the financial product category, ensuring entities holding or offering digital assets adhere to strict financial services regulations. This approach aims to mitigate risks associated with intermediaries rather than the assets.

Strengthening consumer protection is one of the core tenets of these reforms.

These market and regulatory developments mean it is increasingly inevitable that crypto-based offerings will find their way into the realm of financial advice, making it imperative that advisers prioritise an understanding of developments in the sector.