The Japanese Financial Services Agency (“FSA”), Japan’s primary financial regulator, announced on March 15, 2019, that it was submitting a bill to the Diet to amend both the Payment Services Act (the “PSA”) and the Financial Instruments and Exchange Act (the “FIEA”) relating to how the purchase and sale of cryptocurrencies is regulated in Japan (the “Proposed Amendment”).
In Japan, the current regulations governing businesses that purchase or sell cryptocurrencies, intermediate the purchase or sale of cryptocurrencies, or provide exchange services for cryptocurrencies (collectively, “Virtual Currency Exchange Services”) were introduced via an amendment to the PSA in 2016, which came into effect on April 1, 2017. Under the PSA, companies providing Virtual Currency Exchange Services on a “business basis” are generally required to register with the FSA in advance.
As of March 25, 2019, there were 19 registered providers of Virtual Currency Exchange Services (“Virtual Currency Exchange Service Providers”) in Japan, and it has been reported that there are many others waiting in line for their licenses to be issued. However, the FSA delayed processing pending applications after a series of sanctions were imposed on several Virtual Currency Exchange Service Providers (and other entities grandfathered in to operate such services under the 2017 amendment to the PSA) over the past year due to issues, such as the insufficient management of their operations, failure to comply with applicable regulations, and losses of a significant quantity of cryptocurrencies as a result of security breaches and computer hacks. As a result of these events, the FSA raised its standards for granting new licenses (essentially temporarily suspending the process) while simultaneously preparing the amendments to the PSA that were recently proposed.
Prior to drafting the Proposed Amendment, the FSA set up a Study Group on Virtual Currency Exchange Services in March 2018, which published a report regarding its recommendations on December 21, 2018. The Proposed Amendment is generally in line with the recommendations set forth in the report.
Current Regulatory Regime
Under the current regulatory regime, any person or entity engaged in providing Virtual Currency Exchange Services in Japan must be licensed by the FSA in accordance with the PSA. To apply for registration, the applicant must be either a Japanese kabushiki kaisha (a corporation limited by stocks) or a foreign corporation having a license or registration equivalent to that granted under the PSA in another jurisdiction and a registered branch office (with sufficient minimum stated capital) and resident representative in Japan.
Applicants for registration as a Virtual Currency Exchange Service Provider must also be an organization deemed by the FSA as sufficient to operate the Virtual Currency Exchange Services “properly and with certainty” and to comply with the provisions of the PSA. The criteria for determining the sufficiency of an organization are not specified in detail in the PSA or related regulations. However, an 86-page questionnaire revised by the FSA in October 2018 provides guidance on the level of organizational integrity currently required of applicants by the FSA.
In addition, Virtual Currency Exchange Service Providers must also meet several other criteria, including:
- Segregating customer assets held in custody in connection with its Virtual Currency Exchange Services from the Virtual Currency Exchange Service Provider’s own assets and conducting regular audits (by a CPA or an accounting firm) to confirm the same;
- Complying with various other obligations, including maintaining accurate books, filing an annual business report with the FSA, having arrangements for the resolution of disputes with customers, properly supervising third parties to which part of any Virtual Currency Exchange Services may be outsourced, etc.; and
- Complying with AML/CFT regulations, including KYC verification requirements under the Act on Prevention of Transfer of Criminal Proceeds.
Foreign providers of Virtual Currency Exchange Services not licensed to provide such services under the PSA are prohibited from conducting solicitations for such services addressed to persons in the territory of Japan.
Currently, there are no statutory or regulatory provisions in Japan specifically addressing initial coin offerings (“ICOs”), although the FSA previously issued a statement warning that an ICO may constitute an offering of securities that is subject to provisions of the FIEA or the sale of cryptocurrencies, which requires registration under the PSA as a Virtual Currency Exchange Service Provider. Similarly, there are no current regulations expressly regulating cash-settled cryptocurrency derivatives or margin transactions.
As part of the FSA’s efforts to strengthen protections for investors, introduce restrictions on improper market practices, and further clarify how Japanese regulations will apply with respect to the purchase and sale of cryptocurrencies in Japan (including with respect to ICOs) and the provision of services similar to Virtual Currency Exchange Services, the Proposed Amendment contemplates the following changes to the PSA:
1. Changing the defined term assigned to cryptocurrencies from “Virtual Currency” to “Crypto Asset.” This change is not substantive, as the FSA had previously used the term “Virtual Currency” to refer to cryptocurrencies in general, but now the FSA understands that “crypto” is more widely used and views the term “currency” as potentially misleading in the context of referring to all cryptocurrencies.
2. Certain types of cryptocurrencies (or “tokens”) would constitute “securities” for purposes of Japanese securities regulations, and such cryptocurrencies would be exclusively regulated by the FIEA and excluded from the definition of “Crypto Assets” under the PSA.
3. The provision of “custody services” regarding Crypto Assets (i.e., the holding or management of Crypto Assets other than as part of services relating to the direct or intermediation of the sale or purchase of Crypto Assets) would become subject to the PSA and require entities providing such services to register as a “Crypto Asset Exchange Service Provider” (which is how the Proposed Amendment refers to Virtual Currency Exchange Service Providers).
4. Adopting changes to certain requirements regarding the safe keeping of customer Crypto Assets by Crypto Asset Exchange Service Providers: First, Crypto Assets would need to be maintained in the method to be designated in the regulations under the PSA, which is expected to be off-line “cold” wallets or similar methods (the “Designated Method”), other than that portion of Crypto Assets that needs to be kept on-line to satisfy daily customer demand (subject to further conditions to be further clarified in the revised regulations). Second, with respect to those customer Crypto Assets not maintained in the Designated Method, Crypto Asset Exchange Service Providers would be required to hold their own Crypto Assets (of the same type and quantity as such customer Crypto Assets) in the Designated Method, segregated from the Crypto Asset Exchange Service Provider’s other assets which are not subject to this requirement. Lastly, customers who have deposited Crypto Assets with the Crypto Asset Exchange Service Provider would be entitled to satisfy claims for the return/delivery of their Crypto Assets from such segregated assets with priority over claims of other creditors.
5. Crypto Asset Exchange Service Providers would be required to notify the FSA prior to conducting transactions with respect to each particular Crypto Asset (i.e., in advance of buying/selling/exchanging any Crypto Asset or introducing any new Crypto Assets into its existing services or business). Relatedly, the Proposed Amendment also prohibits conduct that the PSA designates as presenting unacceptable risks of harm to customers or the proper operations of the Crypto Asset Exchange Services, and it is expected that transactions involving certain categories of Crypto Assets (e.g., Crypto Assets that are difficult to trace when the FSA views such ability as important to investigate illegal activities) would be designated as one type of such prohibited conduct.
6. Advertisements or solicitations inducing “speculative investments” with respect to Crypto Assets would be prohibited, and other regulations regarding solicitations/advertisements for Crypto Asset Exchange Services would be introduced.
7. Crypto Asset Exchange Service Providers would be required to implement internal rules and regulations substantially consistent with the rules adopted by the Designated Association of Crypto Asset Exchange Service Providers, a self-regulatory body authorized under the PSA. Currently, the Japan Virtual Currency Exchange Association (“JVCEA”) is designated as such designated association.
The JVCEA published a series of revised and/or newly introduced rules and guidelines between July and October 2018. These rules appear to have been prepared in anticipation of the regulations to be strengthened by the Proposed Amendment but may be further amended or supplemented to reflect the amended PSA and regulations under the PSA. The areas covered by the JVCEA’s proposed rules are quite extensive and include:
- the types of Crypto Assets that may be dealt with by its members (e.g., Crypto Assets that are more likely to be used for illegal activities, including money laundering, or which are difficult to keep safe or to trace the flow of in circulation, may not be tradable);
- procedures that its members should follow when determining whether to deal with Crypto Assets (e.g., risk factors, such as vulnerability to computer hacking, credit, or liquidity risks, etc.);
- requirements concerning solicitation and advertisements;
- customer account administration requirements, including KYC procedures for new customers, restrictions on trading with minors or elderly people, principles of suitability, restrictions on trading exposures, methods of permitted trading (i.e., bilateral sale and purchase, use of intermediaries, competitive bid and offer, market making, or OTC), requirements to deliver certain information on risks of trading in writing, and delivery of confirmation and statements on transactions;
- AML/CFT requirements;
- regulations on the administration of customer assets, including segregation from the member’s own assets, segregating personnel handling transactions for customers from those responsible for verification of trades and safekeeping of Crypto Assets, and related bookkeeping requirements;
- required internal systems and procedures for taking orders and detecting inappropriate trades, including segregating functions in charge of accepting and executing Crypto Asset orders from those in charge of monitoring inappropriate trades, rules related to treatment of trade slips and other records, screening for excessively large volume orders or orders executed at prices materially deviating from market prices, criteria for suspending trades when prices are rapidly fluctuating, and prohibitions on inappropriate trades;
- requirements for the administration of non-public material information;
- requirements for the treatment of customer claims;
- rules for managing computer/information systems risks;
- establishment of a contingency plan in case of emergency and data security protection requirements;
- employee disciplinary rules/training; and
- accounting risk controls.
Based on the breadth of the foregoing, under the JVCEA’s proposed rules, applicants seeking to register as a Crypto Asset Exchange Service Provider would be required to implement internal rules and monitoring/compliance/audit systems similar to those required of securities broker/dealers under the FIEA.
8. Where the Crypto Asset Exchange Service Provider extends credit to customers in connection with the customer’s acquisition of Crypto Assets, the Crypto Asset Exchange Service Provider would be required to take steps (to be further set forth in the regulations implementing the Proposed Amendment) to protect the customer. It is expected that margin trading regulations similar to those applicable to foreign exchange transactions will be introduced by regulations under the amended PSA as well.
9. Through amendments to the FIEA, Crypto Assets would be designated as “Financial Instruments” under the FIEA. One of the results of this amendment would be that the OTC derivatives transactions involving Crypto Assets would be regulated by the FIEA, and a person engaged in the business of derivatives transactions involving or referring to Crypto Assets would be required to register as a Type I Financial Instrument Business Operator and be subject to stringent rules under the FIEA, including the capital adequacy test.
10. Any rights in “collective investment schemes” (as defined by the FIEA) that are transferrable electronically (including on a blockchain) would be designated as “securities” under the FIEA. As a result, the offering and trading of “securities token”-type assets (which typically accompanies a sharing of profits and losses of a certain business or project) would be subject to regulation under the FIEA applicable to securities, including those related to public offering and disclosure and using a licensed broker/dealer in connection with providing relevant services. A related amendment is also being made to the FIEA to clarify that where contributions to a collective investment scheme are made by delivery of Crypto Assets, the rights in the collective investment scheme would also be deemed as securities (whereas, under the current text of the FIEA, contributions to a collective investment scheme must be made in cash for related rights therein to be deemed as securities).
11. Implementing a set of provisions in the FIEA prohibiting unfair trading and price manipulation involving Crypto Assets, similar to those applicable to unfair trading concerning securities.
The current session of the Diet ends on June 28, 2019, and a schedule for the discussions on the Proposed Amendment is as yet unknown. However, it would be prudent to expect that the bill will likely be passed by the Diet without substantial changes in the next several months absent unexpected circumstances, given the widespread support in the market now for enhancing regulation of cryptocurrencies. The FSA will not release a draft of the revised regulations for public comment until several months after the Diet has passed the bill. Once amendments to the PSA and FIEA are adopted, they will likely come into force within one year.
Although public debate over the Proposed Amendment has yet to take place and the proposed amendments may be modified as the PSA and FIEA are amended, it is clear that the FSA is seeking to further regulate the purchase, sale, and trading of Crypto Assets in Japan. Assuming that the Proposed Amendment is adopted largely in the form currently proposed, the key implications are as follows:
For Crypto Asset Exchanges:
- Registration with the FSA as a licensed Crypto Asset Exchange Service Provider is required to offer services related to the purchase, sale, and exchange of Crypto Assets to Japanese residents, and the license would also become required under the amended PSA for Crypto Asset custody services without accompanying exchange/intermediary services;
- An extensive set of internal procedures and safeguards – including heighted KYC and AML procedures, as well as the adoption of data security protocols and customer protections – would need to be adopted in a manner compliant with the revised PSA and the rules of the JVCEA;
- FSA oversight/approval would be a prerequisite with respect to each Crypto Asset that is listed and traded on any regulated Crypto Asset exchange, and some of the Crypto Assets traded outside Japan may not be approved by the FSA; and
- To engage in Crypto Asset-related derivatives transactions in Japan, a license for the derivatives business would become required (regardless of whether the settlement is made in cash or for other Crypto Assets).
For Companies Offering Tokens:
- The offering of tokens for purchase by Japanese individuals and companies, whether in the form of an ICO or otherwise and when conducted “on a business basis” in Japan, would be a regulated activity subject to the requirements of the PSA or FIEA (as applicable);
- Private companies would either need to be registered as a licensed Crypto Asset Exchange Service Provider, or work through an already licensed Crypto Asset Exchange Service Provider, to offer new Crypto Assets in Japan;
- It may become increasingly difficult to obtain FSA approval for trading (or to find a licensed Crypto Asset Exchange Service Provider willing to trade) new Crypto Assets with limited trade volumes; and
- Depending upon the nature of the particular tokens, applicable regulations under the FIEA may apply requiring companies to work with a licensed dealer/broker under the FIEA and comply with disclosure and similar requirements under applicable Japanese securities laws.
Given that these regulations are changing so rapidly, any market participant seeking to operate a business relating to Crypto Assets in Japan should seek legal guidance in advance. Morrison & Foerster and Ito & Mitomi are continuing to follow the development of these regulations and can assist any entity seeking to engage in such activities in Japan.