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Recent development of Japanese financial regulations concerning cryptoassets and initial coin offerings

In 2019, the Payment Services Act (the "PSA") of Japan (Act No. 59 of 2009) and the Financial Instruments and Exchange Act (the "FIEA") of Japan (Act No. 28 of 1948) were amended in connection with, among other things, virtual currencies (cryptoassets) and initial coin offerings. This article briefly explains these amendments. The PSA and the FIEA so amended are respectively referred to as the "2019 amended PSA" and the "2019 amended FIEA"; furthermore, the PSA and the FIEA before these amendments are respectively referred to as the "pre-2019 amended PSA" and the "pre-2019 amended FIEA".

Intensified Regulation of cryptoassets (formerly known as virtual currencies)

The pre-2019 amended PSA provided for the regulatory framework for bitcoin and other virtual currencies with the aim of sound development of virtual currency transactions. Under that regulatory framework, a company may engage in "Virtual Currency Exchange Services"1 if it is registered with the Financial Services Agency of Japan (the "FSA").

However, various problems have subsequently surfaced. For example, some virtual currencies are anonymously traded and could be used for improper purposes. Furthermore, some virtual currency traders have had poor and inappropriate internal control systems. In addition, some traders have had security problems, and they have had virtual currencies in their custody stolen by someone who had breached their computer system.

The 2019 amended PSA (which came into effect in May 2020) is intended to address the above-mentioned problems.

(1)Renaming Virtual Currency as Cryptocurrency

Under the 2019 amended PSA, the defined term "Virtual Currency" has been renamed "Cryptoasset" in order to avoid confusion with legal currency.2 The definition of Cryptoasset substantially remains unchanged from the former definition;3 however, any cryptoasset that also falls under the definition of an "Electronically Recorded Transferable Right" (as mentioned below in relation to an ICO) shall be excluded from the definition of a Cryptoasset.

(2)Custody Business for Cryptoassets

Under the pre-2019 amended PSA, a company that engages only in custody of Virtual Currencies (now renamed Cryptoassets) but does not engage in the sale, purchase, exchange or brokerage thereof was able to do so without the need to register with the FSA.

However, under the 2019 amended PSA, engaging only in custody of Cryptoassets is included in the Cryptoasset Exchange Services. This means that a person engaging in such activities must be registered with the FSA. If any person holds secret keys for Cryptoassets owned by other persons and is able to transfer the Cryptoassets without involving those other persons, he is deemed to be in custody of the Cryptoassets and must be so registered. In this regard, if a securities firm receives Cryptoassets from its customer to secure the customer's obligations under the futures trading positions, it is deemed to be effectively engaged in custody business.

Borrowing Cryptoassets from the owner pursuant to a loan transaction does not require FSA registration. This is because the borrower taking delivery of Cryptoassets under the loan is not deemed to be in custody of them. However, if the lender is able to demand at any time the return of the Cryptoassets from the borrower under the loan agreement, the borrower is deemed to be effectively engaging in custody business.

(3) Response to Problematic Cryptoassets

There are many types of Cryptoassets. Some Cryptoassets do not publicize any transfer records and could be used for money laundering purposes. Other Cryptoassets have a fragile system for the maintenance and renewal of the transfer records. Under the 2019 amended PSA, if a CES Provider intends to newly deal with any type of Cryptoasset, it must file a prior notification thereof with the FSA. This is to ensure that CES Providers will not deal with problematic Cryptoassets. If the proposed Cryptoasset is deemed to have questionable features, then in cooperation with the self-regulating industry association, it is expected that the FSA would adequately respond to the situation.

(4) Management of Clients' Assets

The 2019 amended PSA ensures that a CES Provider shall properly manage clients' assets. First, a CES Provider must entrust money deposited by its clients to a trust company. Secondly, a CES Provider must keep Cryptoassets deposited by its clients in a cold wallet; provided, however, that it may keep up to 5% of such Cryptoassets in a hot wallet so that it may timely respond to clients' requests for withdrawal or transfer. In the case of the proviso, the CES Provider must maintain (in a segregated cold wallet) its proprietary Cryptoassets in an amount equal to the clients' assets kept in the hot wallet.

(5) Regulation under the FIEA

In concurrence with the above-mentioned amendment of the PSA, the 2019 amended FIEA prohibits unfair practices, spread of rumors, and market manipulation in relation to the trading of Cryptoassets.

Derivative transactions of cryptoassets

Most Cryptoasset transactions in Japan relate to margin transactions, which had not been subject to financial regulation. Under the 2019 amended FIEA, Cryptoassets are included in the definition of "Financial Instruments". This means that engaging in margin and other derivative transactions in Cryptoassets requires registration as a Financial Instruments Business Operator. Accordingly, various regulations (including delivery of disclosure documents, and prohibition of false information, conclusive judgment or unwelcome solicitation) apply to derivative transactions in Cryptoassets. Also, the maximum leverage limit is stipulated for margin transactions of Cryptoassets.

Regulation on initial coin offering

Initial coin offering ("ICO") means raising legal currencies or Cryptoassets in consideration for electronically-issued tokens. Under the pre-2019 amended FIEA, it was unclear whether and to what extent an ICO would be subject to regulation, although some tokens of a similar nature to a collective investment scheme could be deemed to constitute "Securities" for the purposes of the FIEA. As some overseas ICOs were said to have been conducted fraudulently, it is considered necessary to have ICOs properly regulated.

Under the pre-2019 amended FIEA, all types of interests (other than shares in a corporation or securities investment trust) in a collective investment scheme were categorized as "Paragraph II Securities",4 which are exempted from the disclosure requirements under the FIEA (unless that scheme invests mainly in securities) and which may be handled by Type II Financial Instruments Business Operators.5 This is because such interests would unlikely be circulated among the general public. However, if such interests are recorded on the blockchain technology, they could easily be circulated among many unspecified persons.

Under the 2019 amended FIEA, a new regulatory regime was introduced to deal with a collective investment scheme that takes the form of electronically-issued tokens. A new term "Electronically Recorded Transferable Right" is defined to mean an interest in a collective investment scheme that is electronically recorded and transferable by using a computer, which typically includes such interest recorded by using the blockchain technology. Electronically Recorded Transferable Rights are categorized as Paragraph I Securities, rather than as Paragraph II Securities. This categorization means that dealing or brokerage of Electronically Recorded Transferable Rights may be handled only by Type I Financial Instruments Business Operators.6

Also, any public offering of Electronically Recorded Transferable Rights is subject to the extensive disclosure requirements applicable to Paragraph I Securities under the FIEA. If an ICO is implemented, matters relating to the distributed ledger technology for the offered Electronically Recorded Transferable Rights should be disclosed, in addition to the terms and conditions of the offering.

1. Under the pre-2019 amended PSA, "Virtual Currency Exchange Services" was defined to mean (i) sale, purchase, exchange or brokerage of virtual currency; or (ii) custody of users' money or virtual currency in connection with item (i) above. A registrant of Virtual Currency Exchange Services was referred to as a "Virtual Currency Exchange Service Provider".

2. The terms "Virtual Currency Exchange Services" and "Virtual Currency Exchange Service Provider" have accordingly been renamed "Cryptoasset Exchange Services" and "Cryptoasset Exchange Service Provider", respectively. In this article, a Cryptoasset Exchange Service Provider is briefly referred to as a "CES Provider".

3. The pre-2019 amended PSA defined "Virtual Currency" as:

(i) asset value (limited to the one that is electronically recorded and excluding Japanese and other foreign currencies and currency-denominated assets) that may be used to pay the purchase price of any goods or services to unspecified persons and may be sold to or purchased from unspecified persons and that may be transferred electronically (on a computer system); or

(ii) asset value that is exchangeable for the asset value referred to item (i) above with unspecified persons and that may be transferred electronically (on a computer system).

4. Under the FIEA, "Paragraph II Securities" are less heavily regulated than "Paragraph I Securities" (such as stock in corporations, debt instruments, and units in securities or real-estate investment corporations).

5. Type II Financial Instruments Business Operators are less heavily regulated than Type I Financial Instruments Business Operators (such as securities firms dealing with Paragraph I Securities).

6. However, offering of Electronically Recorded Transferable Rights by the issuer itself may be conducted if the issuer is registered as a Type II Financial Instruments Business Operator.