An extract from The Virtual Currency Regulation Review, 3rd Edition
Introduction to the legal and regulatory framework
Virtual currencies and services related to virtual currencies in New Zealand are regulated by existing, technology neutral legislation. Given that the rights and functions created in respect of virtual currencies are flexible, each virtual currency or service associated with virtual currencies will be regulated according to its specific properties.
For the purposes of this chapter, the term virtual currencies includes all digital tokens that are recorded on a blockchain ledger.
Securities and investment laws
The Financial Markets Authority (FMA) has responsibility for the regulation of financial products in New Zealand, and the Financial Markets Conduct Act 2013 (FMCA) is the principal piece of legislation that regulates financial products. The primary purposes of the FMCA are to promote the confident and informed participation of businesses, investors and consumers in New Zealand's financial markets, and to promote and facilitate the development of fair, efficient and transparent financial markets.
Offers of financial products in New Zealand are regulated by the FMCA and regulations made under the FMCA (the Regulations). The FMCA and the Regulations:
- impose fair dealing obligations on conduct in both the retail and wholesale financial markets;
- set out the disclosure requirements for offers of financial products;
- set out a regime of exclusions and wholesale investor categories in connection with the disclosure requirements;
- set out the governance rules that apply to financial products; and
- impose licensing regimes.
In general under the FMCA, issuers of financial products must comply with various fair dealing obligations and certain disclosure, governance and operational obligations (subject to certain exceptions). The fair dealing provisions are concerned with misleading or deceptive conduct, and false, misleading or unsubstantiated representations. Failure to comply with the appropriate obligations may result in criminal or civil liability, or both, under the FMCA, and may result in material financial penalties, imprisonment, or both.
At a high level (and subject to the detail below), the disclosure and governance provisions of the FMCA will only apply to the offer of a virtual currency if:
- it is offered in New Zealand;
- it is made under a regulated offer; and
- the relevant virtual currency falls within one of the categories of financial product in the FMCA, or is otherwise designated as a financial product by the FMA.
The obligations imposed under the FMCA apply to offers of financial products in New Zealand, regardless of where the issue occurs or where the issuer is based. An offer is deemed to have been offered in New Zealand if it is received by a person in New Zealand (including electronically), unless the issuer can demonstrate that it has taken all reasonable steps to ensure that persons in New Zealand to whom disclosure would otherwise be required under the FMCA may not accept the offer.ii Regulated offers
An offer of financial products that requires disclosure under the FMCA is a regulated offer. An offer of financial products for issue requires disclosure to investors unless an exclusion applies to all persons to whom the offer is made. Certain specified offers of financial products for sale will also require disclosure to investors. The form and content of the disclosure required in relation to each financial product is set out in the Regulations and is tailored according to the characteristics of the particular financial product being offered.
The FMCA provides that a person must not make a regulated offer unless the issuer has prepared a product disclosure statement (PDS) for the offer, has lodged that PDS with the Registrar of Financial Service Providers (the Registrar) and has prepared an online register with the prescribed information.
An offer that is not a regulated offer will still be subject to the fair dealing provisions in the FMCA. As noted above, these provisions prevent people from making false or misleading statements or unsubstantiated representations. Similar obligations are imposed under the Fair Trading Act 1986.iii Types of financial product
There are four categories of financial products under the FMCA: debt securities, equity securities, managed investment products and derivatives.
Virtual currencies are regulated by the FMCA only to the extent that a particular virtual currency meets the definition of one these categories of financial product. The FMCA sets out a hierarchy of financial products, such that a virtual currency that would prima facie satisfy the definition of more than one category of financial product will default into only one category.Debt securities
A debt security is defined as a right to be repaid money, or paid interest on money, where that money is deposited, lent to or otherwise owing by any person. Importantly, for the purposes of the definition of debt security, money does not include money's worth. Several prominent virtual currencies, such as Bitcoin and Ether, do not constitute debt securities because there is not a right to be repaid money or to be paid interest by the issuer, or anyone else.Equity securities
An equity security is narrowly defined in the FMCA as a share in a company, an industrial and provident society, or a building society, but does not include a debt security.
While a blockchain could mimic a traditional share register (with each unit of the virtual currency representing a single share, and shareholders being able to represent trades in those shares by trading in those units), the virtual currency itself would not constitute a share in a company, an industrial and provident society, or a building society. As such, a virtual currency could not be an equity security as defined in the FMCA. This is the case even where a virtual currency gives holders rights traditionally associated with equity (such as certain profit and governance rights).Managed investment products
A managed investment product refers to an interest in a managed investment scheme, which is broadly defined to include any scheme:
- the purpose or effect of which is to enable participating investors to contribute money to the scheme to acquire an interest in the scheme;
- where the interests are rights to participate in or receive financial benefits produced principally by the efforts of others; and
- where participating investors do not have day-to-day control over the operation of the scheme.
If a product is classified as a debt security or an equity security it would not be a managed investment product.
If a virtual currency is classified as a managed investment product, the FMCA imposes significant disclosure and governance requirements on the underlying managed investment scheme. These requirements include registering the scheme with the Registrar; complying with reporting and governance requirements; and requiring the appointment of a licensed manager and licensed independent supervisor, each of which owe statutory duties of care to investors.
In practice, the nature of a virtual currency may make it impractical or impossible to fully comply with these additional requirements. For example, one of the functions of the manager of a managed investment scheme is to manage the scheme property and investments. This requirement is not compatible with a decentralised blockchain where the scheme property is held in (for example) an Ethereum account associated with a smart contract. If there were a manager who had overall control over this account, the decentralised nature of the blockchain and the autonomous nature of the smart contract would be undermined.
By way of example, the DAO and DAO tokens, which were the subject of a report in 2017 by the United States' Securities and Exchange Commission, could have been characterised as a managed investment scheme and managed investment products (respectively) under the FMCA.2Derivatives
A derivative is defined as an agreement under which consideration is, or may be, payable to another person at some future time and the amount of the consideration is ultimately determined, is derived from or varies by reference to (in whole or in part) the value or amount of something else (including an asset, interest rate, exchange rate, index or commodity). A derivative does not include, inter alia, a debt security, equity security or managed investment product. Certain virtual currencies that are tied to the value of fiat currencies, or that are tied to commodities such as gold (stablecoins), could constitute a derivative under the FMCA.iv FMA designation and exemption powers
The FMA has certain designation powers under the FMCA, including the power to designate:
- that a security that would not otherwise be a financial product is a financial product of a particular kind. A security is an arrangement or facility that has, or is intended to have, the effect of a person making an investment or managing a financial risk. The FMA has expressed the view that all digital tokens issued in an initial coin offering (ICO) will constitute a security for the purposes of the FMCA; or
- that a financial product is, or is to become, a financial product of a particular kind. For example, if a virtual currency fell within the definition of managed investment product, the FMA could designate such interests as equity securities. In that case, the issuer would still be required to provide disclosure to investors, but would not be subject to the prescriptive governance obligations described above.
Alternatively, the FMA has the power to exempt any person or class of persons, or any transaction or class of transactions, from compliance with certain obligations imposed under the FMCA. For example, the FMA could exempt an issuer of a virtual currency classified as a managed investment product from some of the provisions that would otherwise apply to the issuer.
Banking and money transmission
The Reserve Bank of New Zealand (RBNZ) has responsibility for the prudential regulation of registered banks, non-bank deposit takers and insurers in New Zealand. The RBNZ does not directly regulate virtual currencies. However, as New Zealand's central bank, the RBNZ is responsible for promoting the maintenance of a sound and efficient financial system.
Money transmission services in New Zealand are regulated separately by the Financial Service Providers (Registration and Dispute Resolution) Act 2008 (the FSP Act) and the Anti-Money Laundering and Countering Financing of Terrorism Act 2009 (the AML/CFT Act). As the anti-money laundering regime is discussed in Section IV, this section is limited to the FSP Act.
Subject to certain limited exceptions, the FSP Act applies to any person who carries on the business of providing a financial service (a financial service provider) and:
- is ordinarily resident in New Zealand or has a place of business in New Zealand;
- is required to be a licensed provider under a licensing enactment (which includes registered banks, authorised financial advisers, licensed insurers and certain licensed supervisors); or
- is required to be registered under the FSP Act by any other enactment.
The term financial service includes, inter alia, operating a money or value transfer service, operating a financial product market, and issuing and managing means of payment.
The core requirement of the FSP Act is that financial service providers must be registered for the relevant financial service on the Financial Service Providers Register (FSPR). Financial service providers that provide financial services to retail clients must also join an approved dispute resolution scheme, subject to certain limited exceptions.
The Financial Services Legislation Amendment Act 2019 (FSLAA) will, inter alia, change the scope of persons to whom the FSP Act registration requirements apply. In particular, under the FSLAA persons will be subject to the FSP Act if they provide financial services to persons in New Zealand or if they are a reporting entity to which the AML/CFT Act applies. This extended scope is subject to subsequent provisions that exclude persons whose financial services are merely accessible by persons in New Zealand, persons who do not have a place of business in New Zealand and who do not provide financial services to retail clients in New Zealand and persons providing financial services that do not meet any prescribed threshold requirement. Notably, persons who do not have a place of business in New Zealand but provide financial services to New Zealand retail clients may be subject to the extended FSP Act registration requirements under the FSLAA. The FSLAA was scheduled to come into force on 29 June 2020; however, owing to the covid-19 pandemic, the government has delayed the start date for the new regime until early 2021.
The FMA has issued guidance (the Guidance) stating that in the context of virtual currency services, exchanges, wallets, deposits, broking and ICOs may be considered financial services under the FSP Act.3 By way of example, exchanges allowing virtual currency trading will, according to the Guidance, be operating a value transfer service under the FSP Act. Similarly, the Guidance states, a wallet provider that stores virtual currency or money on behalf of others and facilitates exchanges between virtual currencies or between money and virtual currencies will also be operating a value transfer service. The Guidance also points out that trading of virtual currencies that are financial products may trigger the need for a licence to operate a financial product market under the FMCA.
Enforcing the provisions of the FSP Act in relation to public blockchains is somewhat difficult in practice. The primary issue is that a public blockchain may not be managed by one particular entity, but instead may be managed by the relevant blockchain community. The core requirement of the FSP Act, that financial service providers are registered, may prove to be difficult when there is not one person or organisation that is able to register.