Token Mapping — A NotCentralised Response

The following is a copy of the Token Mapping response submitted by NotCentralised to Australian Commonwealth Treasury on 15th March (after pursuing an extension to the original submission date). The original Token Mapping Consultation Paper and questions can be seen here: https://treasury.gov.au/consultation/c2023-341659

Dear Director,

We appreciate the opportunity to provide feedback on the Token Mapping Consultation Paper (CP) — February 2023. Our response to this paper is broken up into three parts.

In part one, we offer a concise overview of NotCentralised and our diverse range of activities, which serves to provide context to our opinions. The second part proposes a public blockchain compliance solution being built by NotCentralised, while the third comprises our responses to the questions posed in the CP.

Overall, we would distinguish between two aspects of the Australian legal/regulatory framework. First, we believe that the current assessment rules are suitable for most cases involving digital assets, given their focus on actions and outcomes, rather than specific technology per se. Secondly, however, the enforcement and monitoring of these rules are not yet commensurate with the technology and workflows of digital assets. This “coal face” is where we believe there is the most potential for industry and government to work together on an effective system and we believe this is best done via more regular and ongoing engagement as well as the idea of using sandboxes for testing and problem-solving similar to the current RBA CBDC pilot project.

We are excited about the opportunity to advance the comprehension of crypto and web3 in Australia while highlighting their potential to enhance various industries. We look forward to playing our part in this effort and contributing to the growth and development of these technologies in the region.

We appreciate the opportunity to provide feedback on the Token Mapping Consultation Paper (CP) — February 2023. Our response to this paper is broken up into three parts.

Part One — About NotCentralised

NotCentralised is a venture studio that helps entrepreneurs bring their ideas to life through a unique blend of technology, capital, and business development expertise. We focus on product development, digital asset investment banking, and community building. NotCentralised has both created its own innovative solutions and helped others advance their businesses. Our team of experts, with diverse backgrounds in finance, technology, health and entrepreneurship, provide the necessary resources to help our portfolio companies succeed.

In terms of community building, we created the Australian DeFi Association and partnered with Stone & Chalk to create the Web3 Innovation Centre. Furthermore, we are leaders in the NSW Government Taskforce on Data, Digital and AI (DDAI). All of these projects are part of our efforts to build the blockchain ecosystem here in Australia.

In terms of our own projects, they include TradeFlows, our payments protocol which we’re using after being named to the recently announced RBA CBDC sandbox/pilot; and Layer-C, a token issuance platform for compliant development; and CryptoLulu, an NFT membership program for a prominent bar/restaurant in Sydney.

We are able to see the potential for blockchain innovation, and the need for regulation, through many lenses — those of developers, the community, corporates, VCs and even traditional financial institutions (given our backgrounds). We are also advocates for ongoing engagement in matters like this consultation across all corners of the community and we also encourage hands-on engagement such as in sandboxes to test ideas and potential outcomes. On the latter, we are doing this with the RBA as well as the NSW Government DDAI Task Force.

Part Two — Public Blockchain Compliance

Given that Token Mapping is a step towards bringing compliance and regulation to tokenised ecosystems, we believe it is important to mention an innovative platform NotCentralised is building, called Layer-C. This is a protocol built on blockchain, which can assist in providing effective financial regulation in non-traditional, tokenised systems. Layer-C is an example of how blockchain offers unique tools and processes that can improve financial governance and create a more accurate and transparent system. While the irony of blockchain needing regulation is not lost on us, Layer-C showcases the potential benefits of combining blockchain technology with effective regulation.

Layer-C is a piece of infrastructure for token issuers to comply with regulatory requirements while also preserving the privacy of user data. By “wrapping” an underlying token with a set of smart contract restrictions on its behaviour, Layer-C can force an object to behave as if it were a regulated “security”, for a given legal jurisdiction. This is achieved with a high level of security, bringing compliance down to the individual token level. This can help tokenised projects adhere to regulatory requirements while reducing the compliance costs associated with building in the web3 space. By utilising Layer-C, we encourage innovation within the blockchain space while complying with regulatory requirements, making financial products and services within web3 a part of the norm in an effectively governed financial system.

Additionally, Layer-C can provide safeguards for consumers interacting with digital assets. Firstly, it provides a secure, “whitelisted” environment for financial transactions by restricting participants to those who are KYC checked and comply with regulatory requirements. This can help to prevent fraud and other illegal activities that could harm consumers. Secondly, Layer-C can ensure that smart contracts are designed to protect consumers and their data. Specifically, the smart contract wrapper can be programmed to execute transactions only once certain conditions have been met, and allow only authorised parties to access certain data. Finally, Layer-C can provide a framework for resolving disputes between consumers and businesses by ensuring that smart contracts are designed with clear rules and procedures for dispute resolution. Overall, protocols such as Layer-C offer powerful tools for enhancing consumer protection in the blockchain and web3 space.

Part Three — Banking collapses highlight an opportunity for blockchain

In addition to our response we feel it pertinent to highlight that blockchain technology has the power to help out with problems in the tech and startup space. With the collapse of the crypto and technology-focused banks Silvergate (SI) and Silicon Valley Bank (SIVB), it appears both suffered due to inappropriate capital management or investment of funds. When these institutions offer banking services to concentrated groups of crypto or technology companies, the risks should be of concern to regulators. It isn’t just bad actors like Sam Bankman-Fried whose actions can lead to crypto customer pain, it can be bad business practices too.

Why is this problem worth addressing in our response? While safeguarding consumers is crucial for emerging crypto markets, protecting the working capital and workers in this innovative field is also important. Many startups rely on concentrated funding from a few banks and have limited credit provider options, leading them to work with whomever can provide banking or insurance services. However, we believe that blockchain technology can offer a solution.

Startups have limited choice of services

Technology startups have had to rely on specialised banks catering to particular industries, either due to lack of competition or as a result of pressure from their investors. This situation highlights the need for additional banking and insurance options for startups, or else problems with banks like SI/SIVB will persist.

Despite the potential returns from offering such services, many financial institutions may avoid doing so due to the regulatory ambiguity and perceived risks associated with this market. In addition, the nascent state of the technology makes exposure to these businesses more risky than larger, more established industries. However, ironically, with the advent of blockchain technology, these institutions could achieve greater transparency, control, and improved risk management when providing such risk-based services to tech and crypto startups

At present there are banks (and potentially other institutions) facing elevated concentration risk from a specific, narrow type of client base, instead of a robust competitive environment where more widely spread industry risk reduces the chances of this happening again.

Smarter lending, bailouts and grants

While discussing banking failures, we would also call out potential improvements to the way the government deploys funding into specific sectors of the economy. While a degree of government involvement in the private sector is warranted, funding alone is insufficient if we persist in supporting poor business practices. Funding becomes less effective without implementing technology to enhance the distribution and monitoring of those funds.

To address this issue, we envision controlled, transparent, and programmable payment methods, ensuring that investments occur only in specific ways. This could allow for micro-targeted funding, reduced risk for lenders, and ultimately result in better business models. With transparent and rule-based payment systems, funding would be allocated only based on what is outlined in smart contracts. Those providing funding, whether through loans or smart grants, would have real-time access to detailed risk information.

Blockchain technology would enable lenders to track how tokenised funds are being spent, ensuring capital is earmarked for specific project components. This is the power of smart contracts, which we will be demonstrating in the RBA CBDC pilot

Furthermore, traditional investors will gravitate to higher quality investments for a given return, and this trend is visible in the crypto space. Therefore, chains such as Hedera, Algorand and Polygon, which have been used, tested, and trusted by corporates and institutions, will become increasingly important for Government.

Flight to quality

In relation to Token Mapping, it’s essential to acknowledge that crypto businesses can only deliver value to consumers if they have the necessary tools and services to do so. One way to mitigate the risk involved in providing such services is to leverage the benefits of blockchain technology.

By using blockchain, businesses can offer more secure and efficient services, reducing the chances of fraud and errors. This not only benefits the businesses themselves but also the government and other service providers who work with them. With the use of blockchain, system risk is potentially reduced, which ultimately results in better outcomes for consumers.

Therefore, it’s imperative that the government and service providers work together to foster constructive innovation in the crypto industry, through the necessary infrastructure and support to leverage blockchain technology. By doing so, we can empower these businesses to deliver real-world outcomes, as showcased in our recent RBA CBDC pilot project in the construction industry.

Part Four — Responses to Token Mapping Questions

Question 1. What do you think the role of the Government should be in the regulation of the crypto ecosystem?

We believe that the government’s approach to regulating the crypto ecosystem should not be overly influenced by the technology used — i.e. it should be technology agnostic. Instead, the focus should be on regulating behaviour. Indeed, the government already regulates various activities regardless of the medium or technology involved. For instance, if a financial activity is regulated, ASIC would still need to oversee it, even if it is carried out on a blockchain as opposed to paper contracts.

Additionally, the role of Government should be the same as that taken with other emerging technologies that have both risks and rewards. Specifically, striking a balance between fostering innovation for the betterment of society on the one hand, and protection from malicious actors or accidents on the other.

It would be helpful for the many entrepreneurs in the digital assets space to have clarity from the Government with respect to the following regulatory or technical issues:

• Clarifying the status of common types of digital assets, for taxation, financial regulation, commerce and accounting purposes.
• Recognising digital property rights encoded for example in NFTs, in the same way as other property rights are reflected in the traditional world.
• Distinguishing between technologists that write code and scammers/criminals that intend to steal or do harm using code.

Given that blockchain and token technology is software, we argue the role of the Government is not to regulate software but to regulate businesses, activities and behaviours.

Businesses however are regulated, thus those working with digital assets should be too. Therefore, a business or individual that is defrauding customers, scamming investors or harming the public good should face the full force of legal repercussions. However, the technology it uses to do so is not at fault in this instance, it is neutral.

We also believe the role of government should be to foster further interaction with those in industry, especially with a nascent technology like blockchain driving further innovation across many industries. We commend the roundtables Commonwealth Treasury has engaged in, but we ask for more with other departments as well. This enables all stakeholders to learn about what the technology is capable of doing. We want to avoid situations where developers may only learn about what goes against regulations after they’ve had sanctions or enforcement handed down to them.

Finally, we believe that more emphasis should be put on the use of so-called sandboxes, whereby the government and industry build out new concepts or run POCs from ideas. This trial and error in a safe environment is important in setting regulation. We see this being done with the RBA CBDC pilot run by the DFCRC (Digital Finance Cooperative Research Centre) with use cases announced on 2nd March 2023. We also see a parallel with the NSW Government DDAI taskforce (mentioned in part one). These testing grounds allow for better understanding of the implications of regulation. They also enable the government to observe what this technology innovation means in practical use cases, helping craft better regulation in future.

Question 2. What are your views on potential safeguards for consumers and investors?

Safeguards can be positive if implemented effectively, in consultation with (i) the builders and users of this emerging technology, as well as (ii) those that are unaware of the technology but would be materially affected by it.

Having said that, the term “investors” should be expanded upon further for the purposes of legislative safeguards. If we contrast a large, sophisticated fund manager such as Airtree or Andreesen Horowitz (a16z), with a solo retail investor, there are clear differences with respect to the need or effectiveness of safeguards. This is the same as traditional asset classes such as equities, bonds and venture capital.

Capital markets pricing disciplines and risk/reward trade-offs are essential for the evolution of any technology. By imposing barriers in front of the sophisticated web3 investors, over and above those applied to other technologies they may invest in, Government would be stifling the iterative process which helps sectors evolve. Government is (arguably) not as well placed as the technical experts to determine which investments should or should not be made. The trial and error process of venture capital allocation must be allowed to operate in digital assets, as it would in other technology fields. Arbitrary barriers (“safeguards”) should not be applied to digital assets in a different way to other fields, for those technically qualified to appraise the risks.

Additionally, we can look to blockchain technology to provide safeguards for consumers and investors whether they are working with intermediaries or on public blockchains. One way is via the use of compliance protocols like Layer-C (see Part Two).

Another area to consider in providing safeguards for consumers and investors is better education. This could be done via the various associations and not-for-profits that are working to educate the community. Support that helps these organisations provide quality education against scams and hacks will also help in the fight against illicit activity. This could be government/industry endorsed educational campaigns or other activities, but such programs would add to the overall safeguards in this industry.

Question 3. Scams can be difficult for some consumers to identify.

3.a) Are there solutions (e.g. disclosure, code auditing or other requirements) that could be applied to safeguard consumers that choose to use crypto assets?

In the same way that private sector ratings agencies or researchers assess managed funds, ETFs, or superannuation products, there is room for such actors in the digital assets space. Highly regarded specialists such as Chainalysis, Dune Analytics or Arkham Intelligence have great potential to provide data or opinions with respect to products and services in the sector. Indeed, a specialist form of agency, perhaps with mixed ownership between the government and private sector, could be a way to disseminate risk warnings or ratings to digital asset users/investors. Clearly, well-credentialed specialists would be needed.

If Treasury and others wish to investigate this further, we recommend online “red flag” tools and services like RugDoc (https://rugdoc.io), DeFi Safety (https://www.defisafety.com/), or DeFi Watch (https://defiwatch.net/). These tools can create a framework that helps regulators, users and other counterparties keep an eye out for potential issues. Furthermore, we would credit highly reputable data analysis businesses such as Chainalysis (https://www.chainalysis.com/), which reports on the aftermath of illicit activity in the crypto space and helps investigate causes or trace transactions. We would also include the news site Rekt (https://rekt.news/) and on-chain investigators like ZachXBT (https://twitter.com/zachxbt).

Additionally, we recommend considering solutions such as the Layer-C protocol, that can be effective in safeguarding consumers of crypto assets (more details in Part Two).

Another solution could come from having better industry engagement with the various consumer action groups, such as ACCC, teaching them what factors to look out for and warn consumers against when it comes to scams and illicit activity. Identifying “red flags” can be driven by engagement with industry, developers, data analytics vendors, government departments like Treasury and ASIC and more. Moderate government funding for these ex ante initiatives will save taxpayer funds compared to ex post actions after scams.

3b) What policy or regulatory levers could be used to ensure crypto token exchanges do not offer scam tokens or more broadly, prevent consumers from being exposed to scams involving crypto assets?

First an obvious point — the definition of “scam” would likely differ between participants in the digital assets space, versus the general public, versus the Government. It is reasonable to expect centralised exchanges, or those facing retail investors, to conduct some form of minimum due diligence on the tokens they list on their platforms. Some CEX platforms do this routinely, and as a result, have a narrow range of tokens available to trade. Others are concerned solely with boosting trade volumes and fee revenue, and thus permit almost any token to be listed. What would be involved with such due diligence standards is a further discussion that should involve industry.

One approach is to enforce wallet classifications between sophisticated and unsophisticated participants, akin to wholesale versus retail in traditional finance. The unsophisticated could potentially be prevented from interacting with exchanges that do not vet the tokens listed. Indeed, NotCentralised is building a token issuance platform called Layer-C (see Part Two, above) which would systematically prevent unsophisticated participants (or any wallet that is not whitelisted) from transacting in certain tokens.

Furthermore, there should be minimum viable criteria for what “vetting” actually means in practice. The government can work with industry to figure out what vetting is reasonable in order to (i) protect the vulnerable, and (ii) avoid stifling innovation in the crypto ecosystem (e.g. informed by subject matter experts such as Chainalysis and NotCentralised).

Question 4. The concept of ‘exclusive use or control’ of public data is a key distinguishing feature between crypto tokens/crypto networks and other data records.

4a) How do you think the concepts could be used in a general definition of crypto token and crypto network for the purposes of future legislation?

A crypto system is a system where executing entities uniquely identify themselves through cryptographic keys and can exclusively execute code to perform a function. The code can only be executed from outside of the crypto system, and these executing entities are mostly legal persons, irrespective of their potential anonymity.

Applying this concept to a token only could limit the ability to describe a crypto system, where that system uses concepts that are difficult to describe as being “exclusively used or controlled” by a person. An example is a multi-signature (multi-sig) wallet, that requires multiple persons to cryptographically agree in order to execute code. In such a scenario, the concept of exclusivity by a person could be difficult to map, as all wallet signatories are necessary for execution, but each is a “person”.

Furthermore, the concept of “use or control” lacks a general description and requires a case-by-case definition. An example is that persons that own an allocation of (say) USDC tokens don’t have total control over their allocation because, at any point in time, the USDC could be seized if there were breaches of sanctions rules. Recent examples of such impacts can be seen in the OFAC sanctions of Tornado Cash, where ‘innocent’ wallets are ‘dusted’ by sanctioned tokens.

Another example is that one cannot code all the terms and conditions of a product such as an NFT project into a smart contract. Here we mean terms such as codifying the rights to “commercially exploit” the image. This is a natural language term that can’t be digitally expressed because it is subject to interpretation.

The limitations mentioned above could be addressed via ongoing consultation with the industry, especially as blockchain technology is evolving. Coming up with regulatory solutions for all areas of a still-nascent technology will be impossible so some room for change needs to be considered.

4b) What are the benefits and disadvantages of adopting this approach to define crypto tokens and crypto networks?

As above, we flag that the use of the ‘exclusive control’ concept may limit the ability to describe certain concepts or functions in a crypto system, such as multi-sig wallets; and the concept of control requires a case-by-case definition. Similarly, certain terms and conditions of token projects cannot be digitally expressed in a smart contract, as they rely on natural language and interpretation. It may be necessary to seek better solutions and industry consultation to address these outliers in the future.

5. This paper sets out some reasons for why a bespoke ‘crypto asset’ taxonomy may have minimal regulatory value.

5a) What are additional supporting reasons or alternative views on the value of a bespoke taxonomy?

It is important to recognise that the digital assets space is still evolving and that the functions, applications, and behaviours of different token types are constantly changing. Therefore, attempting to create a comprehensive taxonomy of all digital assets would be premature, potentially leading to regulatory confusion and inefficiencies.

Instead, a more flexible regulatory approach that focuses on the resulting functions, outcomes and risks associated with different token types (rather than their precise technical specifications) may be more appropriate. This approach would allow regulators to adapt to changing market conditions and ensure that regulation is focused on protecting investors and promoting market integrity, without imposing unnecessary restrictions or stifling innovation.

Overall, while the classification of digital assets is important for regulatory purposes (and taxation and accounting), it is equally important to recognise the limitations of taxonomies and ensure that regulatory frameworks remain flexible and adaptable to changing market conditions.

Given that different token types have different functions, users, applications and behaviours, it is logical to distinguish at least some of them for the purposes of regulation. To draw an obvious parallel, regulation distinguishes between listed equities, private debt, ETFs and currency derivatives. They share some underlying features but are different instruments. A term deposit is not treated identically to a government bond or a private debt instrument. It is risky to imply, by avoiding token mapping altogether, that all digital assets are the same.

We would encourage the approach Treasury seems to be taking where first, tokens are assessed that are similar in functional outcome/purpose to existing financial assets. Those could simply slot under existing rules and regulations. Then distinctions would be needed for the new and unique crypto assets that are, currently, difficult to map to the existing financial regulatory system or products.

For those working in the crypto space who advocate for no regulation at all (whether it’s for intermediary or public-type tokens), we question what the motivations are for this position. This stance would allow some bad actors to take actions that have no consequences. Additionally, it would stifle further adoption from non-crypto businesses and users.

Regulation of non-intermediated systems will require regulators to work with those from the world of crypto and blockchain and we encourage regular conversation between developers and Government. Unfortunately, this happens now in limited situations like consultation-based roundtables, or worse when industry participants are disciplined. Ongoing engagement would provide educational and awareness benefits to both government and industry. It would avoid having regulation that stifles innovation or confuses developers and others in industry about their regulatory environment.

In conclusion, we suggest initiatives aimed at providing blockchain and token developers with a better understanding of the existing legal landscape, as it applies to crypto. This can be achieved through the implementation of systems that assist developers in avoiding inadvertent violations of the law.

5b) What are your views on the creation of a standalone regulatory framework that relies on a bespoke taxonomy?

As far as possible, we believe that digital assets should be treated under the same regulations as apply to other forms of product, service, asset or investment, such as managed investment schemes or savings products. An entire set of distinct regulations is neither necessary nor practical, and would delay or stifle adoption of the technology for the betterment of society as a whole.

5c) In the absence of a bespoke taxonomy, what are your views on how to provide regulatory certainty to individuals and businesses using crypto networks and crypto assets in a non‑financial manner?

Certainty would come from a better and more constructive dialogue with the enforcement arm of ASIC.

Question 6. Some intermediated crypto assets are ‘backed’ by existing items, goods, or assets. These crypto assets can be broadly described as ‘wrapped’ real-world assets.

6a) Are reforms necessary to ensure a wrapped real-world asset gets the same regulatory treatment as that of the asset backing it? Why? What reforms are needed?

We feel this question is best answered comprehensively by legal professionals. Rather than argue if existing law is sufficient or not, we would suggest ensuring that any existing property rights can be implemented through new and innovative technology. We do not propose to opine on whether existing property laws are effective enough. We would simply encourage lawmakers to ensure that new technological methods of expressing existing property rights, can be effectively enforced.

There are precedents here in the use of derivatives in financial markets. In some cases, such derivatives are contracts that insist upon physical delivery of an underlying asset, or instead provide for cash settlement based on a change in value of that underlying physical asset.

Question 7. It can be difficult to identify the arrangements that constitute an intermediated token system.

7a) Should crypto asset service providers be required to ensure their users are able to access information that allows them to identify arrangements underpinning crypto tokens? How might this be achieved?

Please see our comments above with respect to methods of “rating” or “vetting” tokens listed by exchanges.

Crypto asset service providers should be required to ensure that their users have access to information that allows them to identify arrangements underpinning crypto tokens, including all risks associated with them. This information should be made available by the facility from which the user buys the token and the description of the token itself written by the token issuer. We highlight an example of such a use case below.

As part of the RBA CBDC pilot, (using a NotCentralised protocol called TradeFlows), eAUD is used as a proof of reserve (PoR) that backs a stablecoin used to facilitate payments in that particular token system. This enables enhanced transparency and trust within the use case to ensure counterparties in these transactions know that the digital escrow is backed by actual dollars.

A proof of reserve feature shows users of intermediated systems the “arrangements” (i.e. collateral) underpinning their tokens. Users can trace their funds down to source collateral and check they are not being tampered with. Such features add trust to the crypto ecosystem, not just for intermediated but also for public token systems too.

To roll out such PoR features across all locally operating, intermediated crypto asset providers, would need legislation in Australia. Leaving it to intermediary choice is suboptimal, because whilst having a PoR may be seen as a competitive advantage for intermediaries, optionality allows for loopholes.

There is a potential role to play here for regulation wrapping functions like those envisaged in Layer-C (see Part Two). Specifically, whitelisted/KYC’d wallets could have different information and execution rights when dealing with token types that cannot be sold to retail investors.

7b) What are some other initiatives that crypto asset service providers could take to promote good consumer outcomes?

Regardless of regulatory requirements, crypto asset service providers should consider utilising systems that promote transparency regarding potential risks, overall usability and minimum standards. Whether they provide this themselves or utilise protocols like Layer-C (see Part Two), they will be increasing the level of trust for consumers of crypto services, potentially ahead of that seen in traditional financial markets.

Question 10. Intermediated crypto assets involve crypto tokens linked to intangible property or other arrangements. Should there be limits, restrictions or frictions on the investment by consumers in relation to any arrangements not covered already by the financial services framework? Why?

If an asset is not covered by the current financial services framework, it is presumably not a financial asset. In that instance, we do not feel the role of government should be restricting consumer investment. In the same way that acquiring multiple vintage cars or artwork is not restricted for consumers. Should the government, for example, restrict a consumer’s investment in NFT gaming “skins” on platforms such as The Sandbox?

Having said this, it is instructive when considering this answer, to compare digital assets with equities, ETFs or forex investments today, for retail investors. Equity investments are subject to risk, ultimately reflecting the value of both tangible and intangible assets, and the expectation of future (uncertain) cash flows. Forex trading reflects the relative value between sets of fiat currencies. We should acknowledge that fiat currency is a somewhat nebulous concept, built on promises and a social construct.

Retail investors are free to open equity brokerage accounts, forex trading accounts, obtain margin loans etc and trade as much as they like with listed equities or ETFs. In many instances, the retail investor has little to no idea of any intrinsic value for the assets in question. Therefore, current regulations already allow for risky activities in financial markets.

Question 11. Some jurisdictions have implemented regulatory frameworks that address the marketing and promotion of products within the crypto ecosystem (including network tokens and public smart contracts). Would a similar solution be suitable for Australia? If so, how might this be implemented?

As with any product or service marketed by its creator or sponsor, it should be “fit for purpose”. Again, existing legislation around scams and false or misleading advertising applies to digital assets just as it does to, say, financial services or items sold on eBay and Etsy for example. It would be sensible to ask why existing legislation does NOT apply, or is NOT effective, prior to drafting new legislation specifically for the marketing and promotion of digital assets.

Having said this, referring back to question 8a, if a digital asset can easily be classified according to current financial regulation, then the same restrictions on marketing and promotion should apply.

Question 12. Smart contracts are commonly developed as ‘free open source software’. They are often published and republished by entities other than their original authors.

12a) What are the regulatory and policy levers available to encourage the development of smart contracts that comply with existing regulatory frameworks?

We argue that there should be encouragement of rules ensuring that smart contracts that in effect provide financial services to Australian users, comply with existing regulatory requirements. If this were the case, providers would need to either amend their smart contracts and showcase how they are compliant with the regulation, or utilise services that do this on their behalf such as the token-issuance platform, Layer-C (mentioned in Part Two).

Furthermore, there are several regulatory and policy levers that can be used, including:

Regulatory guidance: Regulators can issue guidance on how existing regulations apply to smart contracts. This can help developers to better understand their legal obligations and design smart contracts that comply with existing regulations.

Legal clarity: Governments can pass laws that clarify the legal status of smart contracts and provide a legal framework for their use. This can help to reduce legal uncertainty and encourage the development of smart contracts that comply with existing regulations.

Certification programs: Certification programs can be developed to ensure that smart contracts meet certain regulatory requirements. Developers can voluntarily submit their smart contracts for certification, and those that meet the requirements can be certified as compliant.

Industry standards: Industry groups can develop standards for smart contracts that address regulatory compliance issues. This can help to ensure that smart contracts are designed in a way that meets regulatory requirements.

Sandbox programs: Regulators can create sandbox programs that allow developers to test their smart contracts in a controlled environment. This can help to identify potential compliance issues and enable regulators to provide guidance on how to address them.

Question 13. Some smart contract applications assist users to connect to smart contracts that implement a pawnbroker style of collateralised lending (i.e. only recourse in the event of default is the collateral).

13a) What are the key risk differences between smart contract and conventional pawn broker lending?

We would respectfully suggest that using the pawnbroker analogy has an unintended pejorative implication. There are many other lending activities in commercial finance which have single asset security, rather than full recourse to the obligor.

Pawnbroking requires full trust on the lending service providing the liquidity to hold the collateral over the period of time specified under agreement. In contrast, smart contract based DeFi lending uses self-custody escrow type mechanisms that cannot be corrupted by human error.

13b) Is there quantifiable data on the consumer outcomes in conventional pawn broker lending compared with user outcomes for analogous services provided through smart contract applications?

Given pawn-broking is governed by state-based legislation (e.g. NSW Fair Trading) and ASIC, the data should exist that would allow for quantifiable comparisons. If this were to be done, it could be via a range of factors including interest rates, repayment terms, default rates, collateral requirements, the level of consumer protections and more.

Question 14. Some smart contract applications assist users to connect to automated market makers (AMM).

14a) What are the key differences in risk between using an AMM and using the services of a crypto asset exchange?

For the sake of clarity, we will distinguish between the risks of an AMM and a crypto asset exchange that is fully or partially managed by human intervention (CEX). An AMM, as per its name, is fully governed by the smart contracts and the tokenomics that incentivise the provision of liquidity. In contrast, a CEX exposes users to both human error and fraud.

AMMs expose users to liquidity dynamics driven by supply and demand of token buyers / sellers and liquidity providers. This is fully akin to market dynamics / risks. CEXs are able to be more dynamic during the provision of liquidity, which is a major reason to their widespread adoption, but apart from exposing users to the market risks, they also expose users to custody, human and fraud risks

14b) Is there quantifiable data on consumer outcomes in trading on conventional crypto asset exchanges compared with user outcomes in trading on AMMs?

We suggest this question is best directed at the high quality, on-chain data providers such as Chainalysis, Dune Analytics or Arkham Intelligence.