This blog series on regulating digital asset platforms in Australia is produced in collaboration with Hamilton Locke, an award-winning team of lawyers advising forward-thinking businesses and innovators on their most pressing challenges. Special thanks to Michele Levine and Jaime Lumsden.

As discussed in the first blog in this series, “Will you be custodying digital assets?“, anyone who has factual control of digital assets will, under changes proposed by the Australian Treasury in the Regulating Digital Asset Platforms Consultation Paper, be providing a financial service and will be subject to requirements for a digital asset facility (DAF).

The current proposal is that DAFs will need to meet the minimum standards for asset holding.  There’s not much detail about the minimum standards but it appears they will include:

• A requirement to hold digital assets on trust

• A net tangible assets (NTA) requirement

• Other financial requirements including a solvency and positive net assets requirement and cash needs requirement

• Requirements relating to adequate organisation structure, staffing capabilities, and capacity and resources to perform core administrative activities.

What does it mean to hold digital assets on trust?

In a digital asset context, holding assets on trust essentially means that the DAF provider will hold the private key for the digital assets. By holding the private key, the DAF provider essentially holds legal title to the digital assets on behalf of its customers. Customers are beneficially entitled to those digital assets and this entitlement is reflected in the DAF provider’s records. These records are normally kept in ledgers which identify what digital assets are credited to a customer’s account. 

What is the NTA requirement?

Treasury’s Consultation Paper proposes that DAF providers will be required to hold NTA of at least:

• 0.5% of the value of the DAF (if using a sub custodian digital asset facility that has $5 million NTA); or

• $5 million (if performing the custody function itself). 

This requirement is broadly based on the NTA requirements for margin lending facilities. It is unclear why this approach was adopted, especially given that DAFs are more akin to platforms and schemes given the trust requirements that will apply.  

Net tangible assets is not defined in the Consultation Paper, but it is likely to have the same meaning as in ASIC RG 166, which sets out the financial requirements for AFS licensees. Net tangible assets are essentially all your unencumbered assets, less your liabilities, and there is a formula for determining this in ASIC RG 166.

We expect that at least some of the NTA must be held in cash or cash equivalents, with the remainder to be liquid assets. There isn’t much detail on this in the Consultation Paper, and presently RG c166 prescribes no cash equivalents or liquid assets rules for NTA for margin lending facilities, so we’ve had reference to these requirements in ASIC RG 166 for funds, IDPS operators, and custodians, who all have a cash equivalents and liquid assets rule. This means it is likely that the DAF NTA must be:

• held as:
  • at least 50% as cash or cash equivalents, such as:
    • cash on hand, demand deposits and money deposited with an Australian ADI that is available for immediate withdrawal; 
    •  short-term, highly liquid investments that are readily convertible to known amounts of cash that are subject to an insignificant risk of changes in value;
    • certain specific financial undertakings or commitments made by third parties and which are permitted by ASIC; and 
  • the balance of the NTA in assets where the market value can reasonably be expected to be realised within 6 months.

However, as no detail has been provided in the Consultation Paper, it is possible that Treasury or ASIC could propose different cash equivalent and liquid asset rules for DAFs. It will be interesting to see if stablecoins will be permitted and, if so, what requirements will apply.

The rationale for the NTA obligation is to:

• address the costs of an orderly wind-up in the event the DAF provider fails (i.e. to provide a financial buffer to decrease the risk of a disorderly or non-compliant wind-up); 

• balance the need to avoid concentration of digital assets among a small number of custodians with the need to ensure robust NTA; and

• ensure that as a facility expands, and the operational risk exposure of the platform provider grows, the provider will maintain a corresponding level of financial resources.  

 

Look out for part 3 in this series “Should you custody digital assets?”.

This blog series on regulating digital asset platforms in Australia is produced in collaboration with Hamilton Locke, an award-winning team of lawyers advising forward-thinking businesses and innovators on their most pressing challenges. Special thanks to Michele Levine and Jaime Lumsden.

This blog series on regulating digital asset platforms in Australia is produced in collaboration with Hamilton Locke, an award-winning team of lawyers advising forward-thinking businesses and innovators on their most pressing challenges. Special thanks to Michele Levine and Jaime Lumsden. 

Australia’s national Treasury’s recently released Regulating Digital Asset Platforms Consultation Paper proposes a framework for regulating digital assets that leverages the existing Australian financial services (AFS) licensing regime and introduces a new financial product called a digital asset facility (DAF). 

While it is possible the proposal may still change, at present, and importantly, a facility will be a DAF if it is an asset holding arrangement or if it performs any one or more “financialised functions”, being token trading, token staking, asset tokenisation and crowdfunding. It is likely that asset holding will remain the central theme and anchor point for regulation, notwithstanding any tweaks Treasury may make. This is because asset holders are the primary gateway to crypto products and services, as well as the function of asset holding presenting one of the largest risks a person trading digital assets can face i.e. loss of those assets. 

What is asset holding? 

The Consultation Paper recognises two types of asset holding arrangements: 

• DAFs that hold tokens; and 

• DAFs that hold real world assets that back tokens. 

DAFs that will hold tokens are part of Australia’s $21.6bn of Australia’s crypto industry and it is presently unknown the scale of asset holding that may be required in relation to real world assets. 

When it comes to tokens, it is proposed that a person will hold assets in custody where they have ‘factual control’. Factual control as a concept is broad and seeks to capture all cases where digital assets are at risk with providers. It is unclear whether factual control will require both positive control (can transact with the token e.g. use, disport or transfer) and negative control (excluding others from using the token). This is likely to be further considered and clarified as part of the legislative drafting process as there may be instances where a DAF has positive control but not negative control. 

Either way, it is safe to assume that you will be a DAF if you store customer tokens in a hot, warm or cold wallet owned and operated by you. If your wallet solution is provided by, or utilises, third party technology, this will not change the outcome. It also doesn’t matter if you hold the tokens in an omnibus wallet or segregated wallets. 

What digital assets are caught? 

When it comes to the custody rules for digitals assets, not all digital assets are equal. Currently we expect digital assets custody rules to apply as follows:

	All digital assets that are not financial products, including where held through a financial product structure e.g. BTC held by ETF
	Any digital assets that are financial products of themselves (e.g. a token that is a derivative)

It is possible this may change as part of the legislative drafting process. This is because it may make more sense for all digital assets to be subject to the same custody requirements given: 

• traditional custodians are not currently set up to provide custody solutions for digital assets and it is unclear whether or how quickly this will change; 

• any differential treatment may engender opportunities for regulatory arbitrage as businesses may decide to artificially design a product to fall inside or outside of traditional financial services; and 

• digital assets have a different risk profile to other traditional financial products. 

If you currently custody digital assets (that are not financial products) in Australia, we recommend you familiarise yourselves with the upcoming changes, as they may have significant impacts on your business and you may need to make decisions to prepare. Get in touch with our friendly Zodia Custody team in Australia if you’re considering delegating or outsourcing custody as a value-add to your clients, and we can have a chat about how we can help you keep their assets safe with a true, qualified custodian. 

Watch out for the second blog in this series “What are the digital asset custody requirements?” to further inform your decision-making. 

This blog series on regulating digital asset platforms in Australia is produced in collaboration with Hamilton Locke, an award-winning team of lawyers advising forward-thinking businesses and innovators on their most pressing challenges. Special thanks to Michele Levine and Jaime Lumsden.

The digital asset landscape is evolving rapidly, and institutional investors are seeking secure and efficient ways to participate in this dynamic market. As institutional adoption of digital assets surges, the need for even more secure and efficient settlement solutions becomes paramount. 

This is where Zodia Custody Interchange comes in: an off-venue settlement (OVS) solution designed to level up your institutional digital asset trading experience. 

Built upon the foundation of efficiency, trust, and security, Interchange represents the next step in institutional digital asset trading. It builds upon traditional exchange-based settlement and existing off-exchange settlement (OES) offerings, empowering institutions with greater control and confidence throughout their digital asset transactions. 

Level up: wider liquidity and flexibility with Interchange off-venue settlement

While off-venue settlement (OVS) shares some key principles with off-exchange settlement (OES), like being able to trade whilst assets are more securely held in cold storage, and reduced counterparty risk through secure custody, Interchange takes OVS a step further. It provides institutional investors with a broader network of trading venues, extending beyond traditional exchanges to encompass market makers and OTC desks. 

This expanded ecosystem, facilitated by Interchange as the secure bridge, unlocks a compelling array of benefits for institutional investors seeking to level up their digital asset trading experience: 

• Tap into diverse liquidity pools: Access a wider range of counterparties, potentially leading to better trade execution and minimised slippage. 
• Optimise trading strategies: With more venue choices, offering broader trading access, enhancing your overall trading performance. 
• Increase flexibility: The wider network allows you to choose counterparties that best suit your specific needs and risk profile. 

Streamlined OVS process with Interchange 

Interchange simplifies the OVS process, allowing you to trade digital assets without pre-funding exchange accounts. Here’s a breakdown of the streamlined process: 

1. Asset mirroring: Zodia Custody, acting as the custodian, mirrors the investor’s desired assets on a secure trading wallet held within our bank-grade custody infrastructure. This creates a virtual representation of the assets available for trading without physically moving them. 

2. Trade initiation: An investor initiates a trade with a participating venue (exchange, OTC desk, or market maker) through their usual trading platform. 

3. Trade execution: The trade is executed between the investor and the venue, with reference to the available mirrored assets. 

4. Settlement: Upon a successful trade and receipt of a qualified settlement instruction, the transfer of the underlying assets is completed directly between the investor and the venue. 

Interchange – the next step 

Off-venue settlement with Interchange unlocks the next level of institutional digital asset trading. By prioritising flexibility and efficiency, off-venue-settlement empowers investors to trade with greater confidence and unlock the full potential of the asset class – simply, safely, and securely – without compromising the security of their digital assets. 

On Monday 11^th March 24, the Financial Conduct Authority (FCA), announced they would ‘not object’ to issuers creating Bitcoin and Ethereum exchange traded products for professional investors.  

The FCA’s decision clears the path for UK-based, recognised investment exchanges, including the London Stock Exchange and CBOE UK, to accept applications from issuers seeking to list exchange-traded notes. This approval is contingent upon meeting existing listing requirements and specific criteria, such as the mandatory use of custodians, which are, for example, subject to anti-money laundering rules in the UK. 

First and foremost, this is another major developed market opening up institutional access to this digital asset class. We’ve seen the recent rapid success of the US Bitcoin Spot ETFs, with total Spot Bitcoin ETF AUM in excess of $56bn as at 20th March 2024. 

Fundamentally, these products reduce the barriers to entry, and mitigate risks, for institutions looking to invest in digital assets. This can be compared to buying gold exchange traded funds instead of physical gold. Trading a gold ETF is more convenient and less cumbersome than purchasing gold, where you get the exposure to the commodity without the additional costs around storage and insurance for example.   

Listed Digital Asset ETPs are subject to regulatory oversight, which provides investors with increased protection and transparency, compared to directly trading on largely unregulated cryptocurrency exchanges. Under listing requirements, they are also obliged to partner with reputable custodians like Zodia Custody, increasing benefits in the form of enhanced security, regulatory compliance, risk management, legal and fiduciary protection, as well as access to institutional services, all of which can result in enhanced confidence by investors who prioritise institutional grade services. 

Why the FCA announcing this is a positive step forward for the UK 

Ever since the privatisations of the 1980s, the UK, and more specifically the LSE, has been a symbol of the free market economy, with global giants such as Shell and HSBC deciding to list here. However, more recently, the UK has lost out on major IPOs and capital raising opportunities.  

Having banned crypto-related derivatives, which included exchange traded products, back in 2021, the FCA has revisited the decision on a total ban, most likely following the success of the US spot ETF. Having watched the UK equity markets lose their top position as the place to take a firm public, it’s encouraging to see the FCA move towards ensuring the UK becomes a go-to place to list digital asset products, particularly given UK Prime Mister, Rishi Sunak’s references to how he seeks for the UK to become an institutional crypto hub. 

ETNs vs ETFs – what’s in a name? 

It is interesting to note that the FCA has stopped short of approving ETFs, opting instead to signal no-objection to ETNs. 

While they both share many similarities – allowing investors to trade the underlying assets in a familiar, ‘securities like’ environment with transparency and liquidity – there are a couple of key differences that are worth highlighting: 

1. ETFs issuers have to buy and hold the underlying assets whereas ETNs are primarily debt instruments, akin to bonds, that do need to be backed by underlying assets. This means that while ETNs can generally track the referenced underlying asset more closely, they carry higher counterparty risk. 

2. European ETFs are subject to UCITS minimum diversification requirement. ETNs are free of such requirement. 

Why has the FCA gone down the ETN path? 

An ETF will likely need to have an underlying basket of crypto assets to be compliant with the UCITS diversification requirement whereas an ETN can be a spot product.  The UK regulator has been clear that any crypto ETNs (cETNs) will only be available to sophisticated institutional investors as it maintains it position on the inherent riskiness of crypto. When pitched at institutional investors the only assets for a spot ETN that are mature and liquid enough to be palatable are likely to be BTC and ETH which cleverly keeps the UK aligned with the US ETF landscape.  The London Stock Exchange (LSE) has in fact expressly stated that any admissible ETNs will need to have BTC or ETH as underlying digital assets. The guidance from the LSE goes further and requires the ETNs to be physically backed (i.e. non-leveraged) which brings them even closer in structure to US spot ETFs, giving UK based issuers and investors a fantastic opportunity to benefit from this exciting asset class. 

Choosing Zodia as your launch partner: 

Whilst the news is still fresh, listed product issuers are currently strategizing on their go-to market plans. Arguably, one of the most important decisions that an issuer can make is selecting the right custody provider – this directly impacts the success of the product.  

At Zodia we have a proven track record of delivering excellence as the trusted custodian for multiple ETP’s across Europe to a variety of tier 1 issuers. There are numerous reasons as to why multiple issuers have put their faith in Zodia and why we are extremely well positioned to lead as the primary custodian for UK ETP’s: 

1. Our custodial offering guarantees operational excellence allowing for efficient, compliant withdrawals in real-time from cold storage, eliminating the need for redemption batching.  

2. Evidenced robust and effective institutional grade controls providing bank-grade protection over the underlying crypto. 

3. Zodia goes above and beyond the strict requirements outlined by local regulators and exchange listing rules. 

4. Proactive and regulation-first approach in our service offering. Expertise and track record as a custodian of staked ETP products. 

5. We are more than just a custodial offering; we form strategic partnerships with issuers. Built by institutions, we utilise our heritage to widen distribution and attract institutional investors.  

Every issuer is provided with a dedicated relationship manager who specialises in ETPs, familiar with the operational flows and there to support from product inception to assist with strategic planning and ensure that products are launched smoothly and quickly. 

Choosing Zodia will help issuers fulfil the listing requirements! 

Should you wish to discuss further, get in touch with us here.  

Julian Sawyer, CEO, Zodia Custody, said:

“We are a company driven by the core values of good governance, transparency, and integrity. As such, we pride ourselves on working with like-minded entities who share this commitment to excellence.

“Over the last few days, a number of clients, exchanges and other market participants have spoken to us to share their concerns over the much-publicised event last week, initially reported by the Financial Times. We share these concerns. 

“We have today taken steps to ensure all our partners align with our values, respect and trust. This includes ceasing the partnership with Copper, effective immediately.

“Upholding the culture of the digital asset industry is a collective responsibility in which every market participant has a role to play. It is therefore our responsibility to withdraw from relationships where these mutual values are not practiced.”