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Australia’s Treasury has published a new consultation that seeks feedback on proposals to regulate the crypto industry using existing financial service frameworks, and based on a division of tokens, token systems and their associated functions.

Entitled , the Treasury said the consultation will inform policy development ahead of the publication of a proposed crypto licensing and custody regime in mid-2023. It may also contribute to potential reform of existing financial service frameworks.

Open for feedback until March 3, the consultation aims to assist industry, regulators and consumers in navigating the crypto ecosystem and its interaction with financial services laws.

Drawing on Australia’s 2001 Corporations Act, the Treasury proposes that the crypto ecosystem should be regulated based on the “function” of its individual products and services.

This differs from approaches taken by other jurisdictions, where crypto is regulated based on the type of activity or the type of risk it presents, with new products and services added to predetermined categories over time.

As noted by the Treasury, the consultation also draws on the 1996 Wallis Inquiry and the 2014 Financial System Inquiry, both of which concluded that “functionally-equivalent” products should be treated equivalently by regulators.

In theory, this principle ensures that financial regulation remains “technology-neutral”, giving entrepreneurs room to innovate and giving regulators the flexibility to address novel products and services without the need for additional legislation.

Mapping the crypto universe

The Treasury’s use of the token mapping framework is designed to help conceptualise how crypto products might fit within future regulatory frameworks.

In August last year, when the Treasury its token mapping plans, Treasurer Jim Chalmers said the crypto industry is mostly an uncharted territory for Australian regulators.

“As it stands, the crypto sector is largely unregulated, and we need to do some work to get the balance right so we can embrace new and innovative technologies while safeguarding consumers,” he said.

“Our government is ready to start consultation with stakeholders on a framework for industry and regulators, which allows consumers to participate in the market while also better protecting them.”

The Treasury also noted that, in January this year, the Bank for International Settlements (BIS) published a on token mapping, which concluded that it will be a necessary part of crypto regulation building.

In Australia’s Treasury consultation, the token mapping framework defines the concepts of “tokens”, “token systems” and “functions”.

Tokens, such as bitcoin, are digital units of information that have a role in a token system; a token system is a collection of steps involved in performing a function; and a function can be any benefit ensured or facilitated by the token system to the token holder (i.e., end user).

“It is important to identify the function because it is the key link to our existing financial services regulatory framework,” said the Treasury.

“In the context of crypto, the relevant ‘function’ is the target of the assessment in the same way as any non-crypto product.”

An example of this formula would be the use of bitcoin (a token) leveraged as collateral at a crypto exchange (token system) as part of an agreement to take out a stablecoin loan (function).

Intermediated and public token systems

The Treasury further proposes that a “high-level taxonomy” be used to divide token systems into those that are “intermediated” and those that are “public”.

Intermediated token systems would typically involve a promise or an arrangement for functions to be performed by intermediaries or agents, as outlined in its terms of service.

As noted by the Treasury, one of the “unique” roles that can only be performed by an intermediated token system is the creation of links between the crypto ecosystem and the traditional financial system.

This includes facilitating trades between crypto tokens and fiat money; the issuance and use of crypto asset-linked debit and credit cards; and the creation of crypto tokens that represent conventional financial instruments.

The heightened importance of these roles must be given due consideration in future regulations, the Treasury argued.

Moreover, the Treasury said that the vast majority of crypto businesses fit the description of an intermediated token system and the vast majority of individuals who engage with the crypto ecosystem will do so through one such platform.

At the same time, however, the vast majority of customer harm seen over the past year has been due to the failure of these centralised entities, such as Celsius, FTX and BlockFi, to fulfil their obligations as custodians of customer funds.

“Accordingly, there is a strong need for consumer protection to be addressed in the context of crypto-asset services,” said the Treasury.

Public, open-source platforms

In contrast, public token systems allow crypto-asset holders to interact with each other and to perform financial functions without the need for an agent or intermediary.

For example, many of the decentralised finance (defi) applications built on the ethereum network, such as Aave, Maker and Compound, allow users to lend and borrow from each other via smart contracts, without ever knowing the identity of their counterparty.

Defi applications may, therefore, reduce counterparty risk, but may also expose users to heightened risks in other areas such as platform risk due to source code errors, or compliance risk due to blacklisted applications.

“While traditional policy and regulatory levers are available for a large portion of the crypto ecosystem (i.e. intermediated token systems), in the pockets of the ecosystem where functions are truly being ensured by public, self-service software, a fundamentally different approach may be required,” the Treasury notes.

Unlike in the UK or the EU, where an entirely new framework for crypto-asset has been proposed and approved respectively, Australia appears to be willing to revise existing financial service legislation insofar as it can accommodate crypto products and services without prejudice to their underlying technologies.