Startup News & Analysis

Government considers new tax treatment and regulation for the ‘wild west’ of blockchain startups

Stephen Easton /

Josh Frydenberg

Treasurer Josh Frydenberg during Question Time in Canberra on Wednesday, December 5, 2018. Source: AAP/Mick Tsikas.

Do blockchain tokens have a place in a well-regulated economy as a way for startups to raise funds? Or are too many of these initial coin offerings turning out to be scams?

Is it possible for Australian financial rules and regulations to contain the risks and harness the benefits, and how would they need to change to do that?

A Treasury review is considering these sorts of questions, because the Commonwealth government is keen on fintech and imagines Australia becoming a “global leader” of the industry, according to the accompanying issues paper.

Bitcoin and similar cryptocurrencies were not devised to stimulate a wave of innovative new products, just to create a decentralised alternative to fiat currency. But there is considerable enthusiasm about other useful applications of the distributed ledger technology by companies that often sell their own virtual tokens as a way to raise capital.

There also remains a fair degree scepticism around just how transformative blockchain will prove to be, and governments have reacted to the financial and technological implications in a range of ways.

“A number of jurisdictions are actively competing to attract ICO activity and establish themselves as a hub for innovative technology companies that favour ICO fundraising,” observes Treasury.

“At the same time, regulators in many jurisdictions have expressed significant concerns over the potential risks posed by ICOs to consumers and investors. Reports of fraud and investor loss are numerous and there is also anecdotal evidence that many ICOs have been conducted based on an often incorrect assumption that existing financial regulations do not apply.”

The issues paper mentions the “wild west notoriety” of the ICO-funded sector, where borders are largely irrelevant and government regulations often ignored. However, it also notes “there are significant practical challenges in enforcing a complete ban, given the decentralised and global nature of digital tokens” and generally suggests this option is not on the table.

The review, led by financial systems division head James Kelly, is more concerned with how to manage the risks, define different kinds of tokens and regulate secondary trading of them — and the kinds of “socially and economically valuable” innovation legitimate ICOs might enable.

Aiming to stimulate discussion, the paper goes through opportunities and risks. There are potential benefits for startups who struggle to get other forms of finance, investors, and possibly for the nation if enough of them succeed.

Treasury tells us the government hopes the Australian fintech sector will grow into a significant part of the economy and make products that enhance the “efficiency and inclusiveness of the financial system” as well, but the proliferation of privately issued blockchain tokens presents a range of challenges from a regulatory perspective.

The opportunities

The section focused on the positives of ICOs is most convincing when listing some of the fairly obvious potential benefits to the startups selling the tokens — but the many uncertainties and risks also come through.

Opportunities for consumers and investors are not very concrete in a general sense; it really depends on the specific offer. The public servants behind the paper point out “industry and media reports indicate that a large number of digital tokens lose value after the ICO” in the same breath as noting they might hold their value, if you’re lucky.

The best Treasury comes up with here is the possibility that a certain kind of blockchain application called smart contracts can reduce investor risk, but again it depends on the specific business model:

“A smart contract is essentially an algorithm that executes an automatic transfer of digital assets, money, or utility between parties when pre-defined events occur, removing the need for an intermediary to ensure the parties’ rights under the contract are fairly executed.”

Getting the regulatory balance right is tricky but if it can be done, the department’s financial systems team suggests blockchain token sales could play a useful role in the local tech sector as a funding source:

“So long as the incentives faced by fundraisers and investors are sufficiently aligned, ICOs could help to improve the efficiency of capital allocation and contribute to economic growth.”

The opportunity for the national economy is tied into the dream of becoming a hub for startups and innovation, with various “ancillary services” riding on its coat-tails, including blockchain-specific ones like digital wallet providers and Australia’s first cryptocurrency exchanges.

These services also get a run in the section on risks, as they have suffered high-profile cyber attacks and failures on occasion, leading to devastating losses that are mathematically impossible to recover. In January, the founder of one big Canadian exchange died and, according to his wife, took a crucial password to the grave with him, leaving $190 million worth of digital tokens in limbo.

The risks

Te risks come through a lot more clearly in the discussion paper, it has to be said.

There are big challenges and lots of uncertainty in raising capital via an ICO, which has become harder over time. The large number of scams around severely undermine the credibility of more legitimate startups because it is very difficult to tell the difference.

On one estimate, the rate of success in 2017 was only about 7% and most of the gains went to investors who got in early in a special discounted presale or give-away. Treasury notes this arrangement can become a “pump and dump” scheme, where early investors build hype and cash out. Other offerings are outright con jobs:

“In addition to the traditional financial risks of investing in early-stage startups, retail investors in ICOs may find that the rights attached to digital tokens do not accord with their expectations or do not exist.

“‘White papers’ are the typical disclosure document where ICO issuers detail mission statements, employee biographies and the technical specifics of a project however, these documents often lack detailed, consistent information and some contain fraudulent claims or plagiarised language.

“Misrepresentations made by token issuers over the specific rights attached to the tokens, or the prospect of significant potential or guaranteed returns, is an area that has potential to be of significant harm to consumers.”

Investors must accept a risk of failed tech ventures based on big dreams that don’t come true. There is also extreme market volatility that could have profoundly negative effects on the economy if ICOs are encouraged and, Treasury explains, this could make macroeconomic management a more difficult and complicated task.

“Digital tokens, at least to date, have been subject to wide swings in value. Should individual and institutional investor exposure to digital tokens continue to grow, the financial stability implications of this volatility could become non-trivial.

“Further, much wider adoption of digital tokens as a means of payment could eventually present some challenges for monetary policy.”

The risks led the Chinese and South Korean governments to crack down on cryptocurrencies and initial coin offerings, although there are signs the latter might relent.

The paper notes ICOs started out as “a niche form of private fundraising within the technologically sophisticated developer community” but were soon being used to woo “mass retail investors” with vague promises, which attracted the attention of financial regulators. The Australian Securities and Investments Commission warned they were “high-risk speculative investments where you could lose some or all of your money if the project fails” two years ago.

In the early days, tech-savvy investors often understood the project they were funding and were familiar with the key people behind it, but like ASIC, Treasury observes they are often a gamble:

“As ICOs have become more popular, many newer investors do not or cannot undertake the due diligence required to have a full understanding of the risks involved with either the technology being used or the investment itself.”

The issues paper also summarises regulatory responses in Australia and elsewhere, which include: crackdowns; clarification of how existing laws apply; special new rules; exemptions from most financial regulations; efforts to urge caution among investors; and putting ICOs under closer scrutiny.

One task for regulators is to define different kinds of tokens using multiple categories that determine what rules apply, but Treasury observes that too much regulation can take away a lot of the attraction of ICOs as a fundraiser to tech startups, leading the blockchain-based tech firms to find a more accommodating home.

On the other hand, if the tokens are mostly unregulated, ICOs become more attractive to shonks and possibly less attractive to investors, shrinking the pool of funding available to more legitimate startups.

Is it a catch-22, or can policymakers find a happy medium?

Submissions are being accepted until February 28.

This article was first published on The Mandarin. Read the original article.

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Stephen Easton

Stephen Easton is a journalist at The Mandarin, based in Canberra. He's previously reported for Canberra CityNews and worked on industry titles for The Intermedia Group.