This the first part of our two-part series on 'Decrypting Crypto Regulation'. In this article, we explore the concept of token mapping and what is happening in Australia and overseas. We also examine how digital assets are often categorised and suggest the benefits of introducing a 'hybrid' category. In our next part, we will explore how the classification of tokens can and should shape the regulation of digital assets.

The current state of crypto regulation

Stablecoins were long touted as being separate and insulated from the wild price fluctuations and volatility long associated with cryptocurrencies. The belief was that they were a more secure investment, and therefore the digital asset of choice. However, this all changed in May 2022 when TerraUSD, an algorithmic stablecoin pegged to the US dollar, lost over $400 billion in market capitalisation. The loss occurred after it de-pegged from the US dollar and investors attempted to withdraw their money, triggering the start of the crypto winter.

Stablecoins have been on the radar for most regulators for some time. But the Terra crash has led to greater calls for more stringent consumer protection rules for stablecoins, token issuers and cryptocurrencies. Global regulators have also begun making broader moves to regulate the crypto ecosystem.

In July 2022, following almost two years of negotiations, the European Council and Parliament agreed on the Markets in Crypto-Assets (MiCA) proposal to regulate digital asset businesses. The proposal requires them to operate with a license and mandates that stablecoin issuers hold reserves like banks and provide immediate redemption rights to holders. MiCA also makes crypto service providers liable if they lose investors' assets. In addition, it makes them subject to European market-abuse regulations, including market manipulation and insider trading.

The United States is also expected to release federal legislation later this year in relation to stablecoins. This follows President Biden issuing an executive order calling for the regulation of crypto.

In the Asia-Pacific, Japan recently passed a law which regulates non-algorithmic stablecoins. That law restricts their stablecoin issuers to banks, licensed money transfer companies that have asset custody capabilities and trust companies. Intermediaries such as brokers must be registered under a new licensing system (which comes into force in a year's time).

Australia hasn't been far behind either. Following a review of the crypto landscape and payments ecosystem, the previous Australian government began consultation in March 2022 on licensing and custody requirements for crypto asset secondary service providers. Along with others, we responded to the issues raised by that Consultation Paper in our submission.

The federal election and a change of Government temporarily halted progress on the regulation front. However, crypto regulation does appear to be a key item on the agenda for the Labor Government. The key initiative the Government has announced is conducting a token mapping exercise to identify and characterise relevant digital assets. As the Government noted, this process may be ongoing given technology trends and emerging approaches taken by overseas jurisdictions, but the initial review is planned to be completed by the end of 2022.

What is token mapping?

Token mapping can be loosely described as the process by which digital assets are classified into broad categories. By differentiating between different types of assets – whether based on their differing 'uses' or 'functions', the different rights they offer, their characteristics at time of issue or otherwise – token mapping should guide regulators (and industry) by providing greater clarity and understanding about these assets. Token mapping should allow for implementation of a regulatory regime that captures the full range of existing assets, while maintaining flexibility for future assets that are yet be developed.

Do other jurisdictions do it?

There are a variety of approaches taken to classifying digital assets within different jurisdictions globally. The Cambridge Centre for Alternative Finance published a study in 2019 suggesting that 'regulatory guidance and legislative initiatives seem to be converging towards the three-category classification (payment, utility and security tokens).'

MiCA's draft puts forward a tripartite classification: asset-referenced tokens (stablecoins), tokens that function primarily as a means of payment (stabilise their value by referencing only one fiat currency), and utility tokens (tokens which are intended to provide access to a good or service, and are accepted only by their issuers). The UK has suggested adopting a similar classification: e-money tokens, payment services, and stablecoins.

We note that these categorisations are more focussed on stablecoins than digital assets in general. They do not include a hybrid category and therefore fail to recognise tokens with multiple functions.

By comparison, the European Securities and Markets Authority (ESMA) undertook a survey of member states in order to gain an understanding of the possible legal qualification of crypto-assets as financial instruments. The survey's classification of crypto-assets added a fourth category to the convergent three categories: payment-type digital assets, investment-type, utility-type and hybrids.

We believe this is a good approach, and the model we have proposed below adopts a similar form of classification to allow for new innovations in cryptocurrency or related technologies.

The Basel Committee (the Committee) has also recently released a consultation paper which proposes dividing digital assets into two groups.

• The first group includes tokenised traditional assets and digital assets with effective stabilisation mechanisms. The Committee suggests this group should have largely similar prudential treatment to traditional assets.
• The second group includes unbacked digital assets and stablecoins with ineffective stabilisation mechanisms. The Committee believes this group should be subject to conservative prudential treatment to reflect their higher risk status.

ASIC has indicated that they are considering the Committee's interpretation of digital assets. While a useful starting point, the Committee's risk-based assessment of digital assets is more focussed on prudential outcomes and is not be as useful for defining and categorising digital assets for the purpose of broader financial services regulation.

How should we classify digital assets?

The diagram below is an adaptation of the diagram by the Hong Kong Monetary Authority, based on the classification proposed by the Bank for International Settlements.

We suggest that the classification of crypto-assets should also include the 'Hybrid' category, which we have introduced below.

We believe the above categories are sufficiently broad to ensure that the full spectrum of existing digital assets are captured by regulation. At the same time, it should remain flexible enough to ensure that future innovations or technological developments can be encompassed within this method of classification. This is extremely important as it limits the need for constant legislative updates and provides clarity and certainty to the market. Most importantly, these proposed categories are intended to regulate the activities of the tokens, not the characteristics of the token at the time of issuance.

A brief explanation of each of the categories is below:

Means of exchange

Means of exchange tokens are those that are primarily used as a means of payment or value exchange.

We consider that means of exchange tokens can be divided into two further categories – stablecoins and non-stablecoins.

Stablecoins are payment tokens that can be further distinguished based on their stabilisation mechanisms. They are divided into:

• algorithmic stablecoins (e.g. TerraUSD), being stablecoins with a stable value supported by algorithmic stabilisation mechanisms, e.g. via protocols that provide for changes in supply of stablecoins in response to changes in demand;
• asset-linked (e.g. PAX Gold), being stablecoins being stablecoins pegged to multiple fiat currencies or commodities such as gold; or
• e-money tokens (e.g. Circle's USDC), being stablecoins pegged to a single fiat currency.

Non-stablecoins are means of exchange tokens where the value exchanged is not for 'payment'. Examples of non-stablecoins that fall under the 'means of exchange' category are:

• privacy tokens, which are cryptocurrencies that can be traded and obscure transactions on their blockchain, allowing the holder of the privacy token the ability to obscure transaction information on the token's blockchain.
• receipt tokens, which are often issued by DeFi protocols and represent the bundle of rights that are exchanged following the performance of an agreed upon action within a blockchain contract.

Utility

Utility tokens serve some form of specific purpose within a blockchain, for example by granting access to a current or prospective digital platform or service. These tokens are typically pre-mined and distributed in a manner chosen by the creator of the project. An example of a utility token is Brave's Basic Attention Token, which is used to tip content creators through the Brave browser, or Axie Infinity's Smooth Love Potion, which is a gaming token in the NFT game Axie Infinity.

Security

Security tokens are an investment instrument. They are essentially the digital form of traditional financial instruments like shares, debt instruments or units in a collective investment scheme, with ownership of these securities attached to a token that is hosted on a blockchain. An example of a security token is Aspen Coin, whereby holders of Aspen Coin hold shares in a real estate investment trust.

Hybrid

Hybrid tokens are tokens that move between, or span multiple categories of digital assets (payment, utility, security) simultaneously. A hybrid category is significant, as it recognises that tokens may move between different categories through their life cycle, and would be resistant to rigid classification. Hybrid tokens warrant particular attention and raise unique regulatory challenges to the extent that it may be unclear whether legal obligations associated with each function of a token ought to be considered cumulative or hierarchical.

Importantly, we have not included central bank digital currencies (CBDCs) in any of the classifications above. Unlike cryptocurrencies which are typically decentralised, CBDCs are centralised, and their unit of account is a fiat currency (such as AUD), making them a sovereign currency with legal tender status that is issued by a central bank. We also note that CBDCs are currently being considered separately from crypto-assets by governments and international organisations in terms of their regulatory treatment.

Final words and next steps

Although the technology of digital assets may be new, the underlying concepts are derived from existing longstanding financial products. The perception of the regulation of digital assets must change as the difficulties are often overstated. It is possible to apply existing regimes for regulating financial products to digital assets. It is crucial that regulators themselves understand digital assets. Token mapping is one of the methods to facilitate this.

As noted, the Government has indicated it will undertaking a token-mapping exercise is a priority and the first step towards identifying how crypto assets should be regulated. We look forward to the public consultation paper on token mapping that will be released shortly, which will seek input from stakeholders on a new framework for industry and regulators.

Stay tuned for Part 2 of 'Decrypting Crypto Regulation'. In the meantime, please contact our specialists below if you have any questions about our proposed classification for digital assets, or wish to stay in touch and track progress on regulation of the crypto sector. We have a strong commitment to working with regulators and the industry to establish a sensible regulatory framework for digital assets that is fit for purpose, innovative and consumer focused.