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17.11.2021

News

Good practice guidelines for REs of Crypto Schemes

At last, ASIC has released information for product issuers and market operators about how they can meet their regulatory obligations in relation to crypto-assets. Partner Elliott Stumm outlines the new guidance provided by ASIC.


What is a crypto-asset?

Among other things, the information released covers ASIC’s introduction of a new ‘crypto-asset’ category in the licensing space. Going forward, responsible entities (REs) intending to set up a fund that invests in crypto-assets will need to be authorised to operate a scheme of this kind. For these purposes, ASIC defines a ‘crypto-asset’ as—

a digital representation of value or rights (including rights to property), the ownership of which is evidenced cryptographically and that is held and transferred electronically by:

    • a type of distributed ledger technology; or
    • another distributed cryptographically verifiable data structure.

This definition is intended to be broad and captures a range of crypto-assets, including ‘coins’, ‘stablecoins’ and ‘tokens’.

When seeking to register a crypto fund, REs will need to consider whether the investments of the fund (including the crypto-assets to be invested in) require the RE to obtain authorisation to operate the scheme as a ‘financial asset’ or ‘derivative’ scheme as well.

The AFS licensing regime has always accommodated schemes being registered that will hold ‘novel assets’ (including those that do not neatly fall within the definition of ‘financial asset’, for example). However, the creation of a defined asset-kind signals applications to seek authorisation to operate crypto-asset schemes will become ‘less novel’ over time, which will hopefully result in reduced assessment times.


Good practices

ASIC has published ‘good practices’ which are set out in two new information sheets:

  • Information Sheet 225 Crypto-assets (INFO 225)
  • Information Sheet 230 Exchange traded products: Admission guidelines (INFO 230).

ASIC’s guidance sets out some of the key matters REs must consider when setting up funds that will invest in crypto-assets.


Custody

Holders of scheme property – whether the RE or a third-party custodian – are subject to minimum standards or requirements. In meeting these requirements with respect to holding crypto-assets, ASIC says it is good practice that, among other things—

  • the asset holder has specialist expertise and infrastructure relating to crypto-asset custody, including robust cyber and physical security practices
  • the crypto-assets are segregated on the blockchain by having unique public and private keys so that scheme assets are not intermingled with other holdings
  • the private keys used to access the crypto-assets are generated and stored in a way that minimises the risk of loss and unauthorised access.

ASIC has emphasised the security of private keys is of critical importance, because if they are compromised, unauthorised parties can use them to transfer the scheme’s crypto-assets to addresses (and parties) outside the control of the RE.

There are a range of ways a holder of cryptocurrency can store their asset, including by using online wallets (‘hot wallets’) and offline wallets (‘cold wallets’). Offline wallets are generally the most secure way to store cryptocurrency, and typically take the form of a USB drive that stores private keys. Custodians often store crypto-assets in offline wallets, which are physically stored in safes or lock boxes, to minimise risk of loss and unauthorised access.


Risk management

In terms of managing risks in relation to crypto-assets, ASIC considers it is good practice for REs to carefully consider the crypto-asset trading platforms used by them or their service providers to access crypto-assets. In particular, ASIC says an RE should be satisfied any crypto-asset trading platform it relies on is registered with AUSTRAC (or by an equivalent regulator in another Financial Action Task Force country), and implements risk-based systems and controls supervised or monitored by a body that can enforce the customer due diligence and record-keeping obligations.


Disclosure

Where an RE is to offer investment in a crypto fund to retail clients, the RE will need to issue a compliant PDS. One of the challenges that will be faced by an RE (given the technical nature of crypto-assets) is the need to ensure the PDS is worded and presented in a clear, concise and effective manner. ASIC has emphasised the need for PDSs for crypto funds to ensure sufficient information about the characteristics and risks of crypto-assets are set out in the PDS, as well as information about how the product is intended to operate and generate a return.

In relation to the characteristics of crypto-assets, ASIC considers some of the information that may be relevant includes the technologies underpinning the crypto-assets (such as blockchains), how they are created, transferred and destroyed, and how they are valued, held and traded.

In relation to the risks of crypto-assets, ASIC considers some of the risks that may be relevant include the following:

  1. Market risk—given their highly volatile nature, there is risk they could have little or no value in the future.
  2. Political, regulatory and legal risk—the regulation of crypto-assets, both in Australia and globally, is the subject of ongoing discussion, so crypto-assets are likely more susceptible to this sort of risk than other asset classes. In this context, the Select Committee on Australia as a Technology and Financial Centre tabled its final report on 20 October 2021, which contained a number of recommendations for reforms.
  3. Custody risk—given the private keys may be lost or compromised, there is a risk crypto-assets may become inaccessible or accessed by third parties without authorisation. In this context, there is also risk associated with unauthorised transfers not being able to be reversed.
  4. Cyber risk—given their nature, crypto-assets are generally more susceptible to cyber risks than other asset classes.

Takeaway

While the information released by ASIC provides some guidance to REs as to how they can meet their obligations in relation to crypto-assets, it is important REs are familiar with the nature of crypto-assets before they launch funds to enable their investor base to gain exposure to this increasingly visible asset class. It is also important REs ensure they have the processes, procedures and infrastructure in place to ensure they meet their obligations before launching a fund.

We can help you understand the requirements and regulatory obligations in relation to crypto-assets in the funds management space. Contact our team for more information.


Authors

Elliott Stumm

Elliott Stumm

Partner

Contact McMahon Clarke

Brisbane
T +61 7 3239 2900
A Level 7, 100 Creek Street, Brisbane Qld 4000

Melbourne
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