Innovations & regulation – the future of crypto
11/02/2022
As cryptocurrency moves beyond the periphery of financial services into the mainstream, most people now understand the basics of crypto, but its independence from regulated systems and the pace of its evolution remain problematic for governments.
Since the first transaction of bitcoin in 2009, new cryptocurrencies, networks, platforms and brokers have been established and continue to evolve. This new world of digital assets offers different ways for both providers and customers to think about investment opportunities.
There has been a significant uptake in institutional investment from well-established multinational companies such as JP Morgan, MicroStrategy, Mastercard, Microsoft, Tesla, Amazon, Facebook and many more. This institutional uptake of crypto assets has been attributed to an inflationary hedge, as well as a sign that diversified investments will ultimately include crypto.
Currently in Australia, there is no specific regulatory regime that caters for the various financial assets that have developed, and cryptocurrencies have specifically been classified as not being a foreign currency. Accordingly, any gain or loss from any disposal (including staking and wrapping) is subject to the capital gains tax provisions, the trading stock provision or ordinary income concepts, depending on the activities and circumstances of the investor.
Additionally, without it being classed as a financial product, in a lot of cases the Corporations Law will not apply to cryptocurrencies. In these instances, the application of cryptocurrencies as an investment asset will be outside of the jurisdiction of ASIC unless bundled up into a fund or a derivative.
Regulatory change is currently being explored. The resulting regime could mean that businesses investing, dealing or advising in relation digital or crypto assets may require some sort of financial licencing.
In this article, we look at both the origins and current trends for crypto and digital assets as Australian regulators will be considering how to manage these as part of the broader industry and payments landscape.
Crypto beginnings
The origins and development of the technology can be used to further understand the crypto market and its potential to revolutionise financial markets. Below we give a high-level overview of the developments, and the core ideological underpinnings that drive innovation in the crypto asset market.
Bitcoin (BTC) was the first decentralised cryptocurrency. BTC was created by Satoshi Nakamoto (the pseudonym give to the anonymous creator/ creators) as a means to operate an international payment system without the need to rely on financial intermediaries. Bitcoin was intended to function as money that did not rely on intermediaries to process and authorise transactions. Instead, Bitcoin relies on cryptographic hashing to generate proof of work to authorise transactions.
The second largest cryptocurrency network, Ethereum, was created by Vitalik Buterin in 2014. Ethereum introduced greater functionality by enabling smart contracts, which could facilitate the creation of decentralised applications (dApps), which ran off the Ethereum network. This increase in functionality spurred further innovation into significant new areas such as Decentralised Autonomous Organisations (DAOs), Non-Fungible Tokens (NFTs) and Decentralised Finance (DeFi).
DeFi, DAOs and NFTs are three of the most significant and innovative developments in the crypto-asset ecosystem. They pose a significant challenge to the way we think and interact with finance services, art and governance online.
DeFi
Decentralised finance (DeFi) is a financial technology that is used to undertake peer-to-peer transactions on distributed ledgers called blockchains. Rather than transactions being made through a centralized intermediary such as a cryptocurrency broker, securities exchange or a financial institution transactions are executed between participant directly which are verified through the programmed rules of the relevant blockchain
Because of this DeFi is a means of providing financial services without a financial intermediary. It is primarily used in crypto loans, decentralised exchanges, generating interest on tokens (known as yield) through staking, and play-to-earn gaming. DeFi applications rely on smart contracts to execute these functions. DeFi can be risky as the assets locked are an attractive target for hackers or nefarious actors who may want to defraud the DeFi platform.
DAOs
DAOs are Decentralised Autonomous Organisations, which are a new type of organisation structure. Participants of the DAOs can vote on decisions in accordance with the number of tokens or stake in the organisation. Voting power is often granted through governance tokens, which are allotted to users. DAOs can be used as investment vehicles, or other such dApps.
DAOs have attracted academic inquiry across the world as many jurisdictions struggle to define where the liability for a DAO will lie. Many DAOs are not yet fully decentralised, with key individuals holding the majority of governance tokens. Attributing liability in the case of fraud, or gross negligence in a truly decentralised organisation, will challenge existing company laws.
NFTs
Non-Fungible Tokens (NFTs) are by far the most popular and mainstream crypto asset outside of the major tokens such as Bitcoin and Ethereum.
NFTs are tokens that can be used to represent ownership of unique items. They allow things to be tokenised like art, collectibles, contracts, limited edition handbags and even real estate because each of these items are not interchangeable for other items because they have unique properties.
They can only have one official owner at a time, and no one can modify the record of ownership or copy/paste a new NFT into existence. Conversely, Fungible items, can be exchanged because their value defines them rather than their unique properties.
An NFT is essentially a unique token that can have metadata attached to it, for example an avatar picture. This metadata could contain anything (that fits within the limited storage capacity), and has been used most notably for art.
By attaching the metadata to the token, a public, immutable ledger of ownership is created on the blockchain. Ownership of art can be traced and authenticated to an individual wallet address, and therefore enables royalties to be earned in perpetuity. The use of NFTs in digital art demonstrates the growing importance and significance of the online world and digital identity.
NFTs have also been used for other purposes, such as certification of authenticity for pearls, and many foresee the use of NFTs to create digital identities and communities.
Australian Regulation
The crypto market capitalisation surpassed $3 trillion in January 2022 and while it dipped significantly afterwards, it is climbing back at a rapid rate. Despite this volatility, there is significant economic value in products and technological innovations using blockchain.
The rapid growth of digital assets and associated products have seen governments across the globe scramble to create new and suitable regulation. The Australian Government’s Blockchain Roadmap includes plans to update Australia’s payments system, with new regulation expected by the end of 2022. Three recent reviews on the topic, including the Senate Select Committee on Financial Technology and Regulatory Technology led by Senator Bragg in 2021, have issued a total of 41 recommendations to the government and regulators.
A particular focus of the reforms is to regulate buy now, pay later (BNPL) companies, digital wallets such as Apple Pay and Google Pay, and cryptocurrency. Treasurer Josh Frydenberg announcing this will be the largest legislative reform made to our payments systems in 25 years.
While there is tax guidance on how to treat digital assets by the ATO, fluctuating values of assets make it a more complex asset for accounting calculations. Furthermore, the difference between the protocols of cryptocurrencies make it extremely challenging for the ATO to make blanket interpretations across the universes of tokens.
Part of the reforms announced by Treasury include working with the ATO to create more specific guidance around current tax laws alongside a review of the current tax laws by the Board of Taxation. SW has reviewed these laws and can answer any questions you might have.
Where to from here?
Crypto experienced a breakthrough in 2021, with prices at all-time highs (followed by huge drops), multiple institutional buy-ins by major companies and explosive interest in crypto from payments companies to private and everyday investors. However, the industry is still in its infancy and continues to evolve.
While it’s difficult to predict the long-term trends, in the coming months, regulators and governments will be grappling with questions of long-term regulation that remains fit for purpose and institutional adoption of crypto payments.
How SW can help
Understanding the risks, rewards and potential legal implications of blockchain opportunities can assist in being more confident with how you choose to engage with any crypto assets.
If you have any questions, feel free to contact SWs Digital Assets team.
