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Virtual currencies: regulators make their move

Izuru Goto, Yasuyuki Kuribayashi and Takashi Saito of City-Yuwa Partners introduce Japan’s new regulatory regime for virtual currencies, which is due to be in place by about April 2020

Izuru Goto, Yasuyuki Kuribayashi and Takashi Saito of City-Yuwa Partners introduce Japan’s new regulatory regime for virtual currencies, which is due to be in place by about April 2020

www.city-yuwa.com/english/

The current regulatory framework for virtual currencies in Japan was implemented by amendments to the Payment Services Act (PSA) and the Act on Prevention of Transfer of Criminal Proceeds (APTCP) in June 2016. These came into force on April 1 2017. The regulations were enacted because Japan needed to implement anti-money laundering/countering the financing of terrorism (AML/CFT) regulations relating to virtual currencies, as pointed out in reports published by the Financial Action Task Force (FATF); and to boost the level of customer protection as a result of weaknesses highlighted by the insolvency of MT Gox in February 2014 (one of the world's largest bitcoin exchanges at the time).

Current regulations on virtual currencies include the regulations under the PSA and the relevant cabinet office ordinance and guidelines and a new set of regulations on virtual currencies in Japan.

The Payment Services Act and the Act on Prevention of Transfer of Criminal Proceeds

The regulations under the PSA establish, among other things: (i) the definitions of a virtual currency, a virtual currency exchange business and a virtual currency exchange provider; (ii) registration procedures for virtual currency exchange providers; (iii) restrictions against virtual currency exchange providers; and (iv) authorities' supervision over virtual currency exchange providers. The details of these regulations are stipulated in the relevant cabinet office ordinance and the guidelines adopted by the Financial Services Agency of Japan (FSA) (Guidelines).

The registration procedure for virtual currency exchange providers applies to business operators that conduct a "virtual currency exchange business" in Japan. A virtual currency exchange business means: (i) the sale or purchase of virtual currencies or exchange of a virtual currency for another virtual currency; (ii) intermediary, brokerage or agency services for the activities mentioned in (i); and (iii) the management of customers' money or virtual currency in connection with the activities mentioned in (i) and (ii). These activities must be registered with the Prime Minister of Japan as a virtual currency exchange provider.

The applicant must file an Application for Registration to a local finance bureau in Japan and will be registered as virtual currency exchange provider once the local finance bureau and FSA review the application and confirm that there are no "grounds to refuse the registration", as listed in the PSA. The main grounds for refusal are as follows:

  • The business operator is not a Japanese stock company or a foreign company with a business office in Japan and it conducts a virtual currency exchange business in a foreign country with an equivalent registration from the authority of the foreign country (ie it is a foreign virtual currency exchange provider);
  • The foreign virtual currency exchange provider does not appoint a representative in Japan (who has an address in Japan);
  • The business operator does not have capital of at least ¥10 million (approximately $92,000) or a positive net worth;
  • The business operator has not established or maintained an internal structure that ensures the proper performance of a virtual currency exchange business and compliance with the PSA; and
  • The business operator's director, company auditor or accounting advisor falls under any of the grounds for disqualification prescribed in the PSA.

The main part of the authority's review process, when checking whether any of the grounds for refusing registration exist, is verifying whether the business operator's internal structure, as mentioned in above, has been established and maintained. The notable points on the authority's verification of the applicant's internal structure are detailed in the Guidelines. The Guidelines prescribe the notable points in detail regarding, among other things: the development and maintenance of the internal structure as regards compliance with the laws and regulations, timely and appropriate provision of information to customers and implementation of system risk management, etc; and verification of the appropriateness and suitability of the virtual currencies dealt by registration applicant.


In October 2018, the Japan Virtual Currency Exchange Association was authorised by the FSA as a self-regulatory organisation


The PSA also imposes various restrictions on virtual currency exchange providers. The main restrictions include four aspects. First is the obligation to take necessary measures for security management over the information relating to the virtual currency exchange business. Second is the obligation to take necessary measures to protect customers, which includes providing customers with information relating to the contents of contracts. Third is the obligation to segregate customers' assets from the virtual currency exchange provider's own assets and to conduct periodic audits on the status of the segregated management. Lastly, there is the obligation to implement measures to handle customer complaints and to resolve disputes relating to virtual currency exchange business.

The APTCP is the law that lays out AML/CFT regulations in Japan and imposes on financial institutions, or other business operators prescribed in the APTCP, obligations to verify the identity of customers upon conducting certain transactions; prepare and record customer identity verifications and transactions with customers; report suspicious transactions to authorities; and develop and maintain an appropriate internal structure.

The amendment to the APTCP in June 2016 extended the above obligations on virtual currency exchange providers.

New market called for new regulations

Towards the end of 2017 (and after the implementation of the virtual currency exchange business regulations based on the amendments to the PSA and APTCP on April 1 2017), the virtual currency market became active. However, most customers acquired virtual currencies as an investment rather than as a means of settlement. Consequently, the market for speculative transactions involving virtual currencies using margin trading became very active and the need to protect customers conducting virtual currency transactions as investments became a public issue. Another aspect that received public attention was the market for initial coin offerings (ICOs), which are a type of financing used by start-up companies to raise funds by providing investors with electronic tokens with various benefits in exchange for invested funds. In connection with this, fraud cases involving ICOs became a cause for concern.

In January 2018, large amounts of virtual currency held by one of the largest virtual currency exchange providers in Japan were stolen after a cyberattack on its network. As a result of on-site inspections conducted by the FSA, it became clear that the internal structures for system security in many of the active virtual currency exchange providers were insufficient.

In the case described above, a research committee was established in the FSA which began discussions over and reviews of the regulations for virtual currency exchange providers, to strengthen customer protection and cater for new transactions that use virtual currencies. The committee issued its final report in December 2018. It should be noted that in October 2018, the Japan Virtual Currency Exchange Association was authorised by the FSA as a self-regulatory organisation for virtual currency exchange businesses.

On March 15 2019, the series of amendment bills, including the amendments to the PSA and the Financial Instruments and Exchange Act of Japan (FIEA), which reflected the proposals in the final report, were submitted to the National Diet of Japan. The amendments to the PSA and FIEA were enacted on May 31 2019.

Major new regulations under the amended PSA

The major new regulations under the amended PSA include five key aspects. The first is that under the amended PSA, the term "virtual currency" will replaced by "cryptoasset", to be in line with the example used in the recent international conference. The amended PSA excludes from the definition of a "cryptoasset" a cryptoasset representing "electronically recorded transferable rights" (denshi-kiroku-iten-kenri), as defined in the amended FIEA (explained below), in order to avoid an overlapping of regulations under the PSA and FIEA. Except for this exclusion, the definition of a cryptoasset will not change from the definition of a virtual currency under the current PSA.


The amendments to the PSA and FIEA […] are scheduled to come into force around April 2020


The amended PSA also adds the custody of customers' cryptoassets as a type of cryptoasset exchange business. Due to such an amendment, the cryptoasset custody business, which does not involve the sale or purchase of cryptoassets, etc, will also be included as a cryptoasset exchange business and therefore, any operators of such a business will have to register with the Prime Minister of Japan as a cryptoasset exchange provider.

A third aspect is that the amended PSA prohibits cryptoasset exchange providers and their directors and employees from making false representations, misleading representations concerning the characteristics of the cryptoassets and representations that encourage speculative transactions upon the execution of contract, solicitations and advertisement concerning cryptoasset exchange businesses.

The amended PSA also strengthens the obligation to safeguard customers' assets. This is achieved firstly by segregating customers' money, as under the amended PSA, cryptoasset exchange providers are required to segregate customers' money from their own money by entrusting the customer's money to a trust company; and secondly by segregating customers' cryptoassets, as under the amended PSA, cryptoasset exchange providers are required to segregate the customer's cryptoassets from their own cryptoassets by using the method that will be prescribed under the relevant cabinet office ordinance. This method is less likely to result in insufficient protection for customers (the "cold-wallet" is expected to be the method that the cabinet office ordinance will prescribe in the future) and it excludes cryptoassets "to be specified under the relevant cabinet office ordinance as being necessary for ensuring customers' convenience and smooth performance of [a] cryptoasset exchange business".

With regard to cryptoassets that are necessary for ensuring convenience, as mentioned above, cryptoasset exchange providers are required to own the same kind and same amount of cryptoassets as cryptoassets necessary for ensuring convenience ("cryptoasset necessary for performance" – rikou-hoshou-angou-shisan) and segregate the cryptoasset necessary for performance from a cryptoasset exchange provider's other cryptoassets by using the method that will be prescribed under the relevant cabinet office ordinance, which will be less likely to result in insufficient protection of customers.

A fifth and final key aspect in the amended PSA is the customer's right to receive preferential payment in relation to a claim for a return of cryptoassets. Under the amended PSA, cryptoasset exchange providers' customers have the right to receive preferential payment from their cryptoassets segregated by the cryptoasset exchange provider and cryptoassets necessary for performance concerning their claim against the cryptoasset exchange provider for a return of cryptoassets.

The amended Financial Instruments and Exchange Act of Japan

Under the amended FIEA, cryptoassets will fall under the definition of "financial instruments". Therefore, derivative transactions in which cryptoassets are the underlying asset or an index on cryptoassets is the reference index (cryptoasset derivative transactions), will fall under the definition of "derivative transactions" under the FIEA. Accordingly, the OTC derivative transactions business on cryptoassets or intermediary, brokerage or agency services for OTC derivative transactions on cryptoassets will fall under the definition of "Type I Financial Instruments Business" under the FIEA. The business operator of OTC derivative transactions on cryptoassets or intermediary services, etc, thereof will have to register with the Prime Minister of Japan as a Type I Financial Instruments Business Operator.

Under the amended FIEA, the rights prescribed in Article 2, Paragraph 2 of the FIEA, such as trust beneficiary interests and rights on collective investment schemes, which are represented by a property value that is limited to the property value that is electronically recorded on electronic device and which is transferable by using electronic data processing systems (an "electronically recorded transferable right" – denshi-kiroku-iten-kenri), will generally be treated as a "Paragraph I Security". This is a security described in Article 2, Paragraph 1 of the FIEA which includes share certificates and corporate bond certificates.

Due to the amendment, in principle, the electronically recorded transferable right will become subject to the FIEA's disclosure requirements. Business operators that conduct sale or purchase transactions of electronically recorded transferable rights and intermediary, brokerage or agency services for such sale or purchase, or that deal in public offerings or private placements of these rights, will be required to register with the Prime Minister of Japan as a Type I Financial Instruments Business Operator.

The amended FIEA prohibits any person from: conducting unfair trading; spreading rumours; using fraudulent means; engaging in violence or intimidation; or conducting market manipulation concerning the sale, purchase or other transactions involving cryptoasset or cryptoasset derivative transactions.

Looking ahead

As mentioned above, the amendments to the PSA and FIEA were enacted on May 31 2019. The relevant cabinet office ordinance and the Guidelines will be amended hereafter, and the amendments to the PSA and FIEA together with the amended cabinet office ordinance and Guidelines are scheduled to come into force around April 2020.

About the author

Izuru Goto
Partner, City-Yuwa Partners

Tokyo, Japan
T: +81 3 6212 5507
E: izuru.goto@city-yuwa.com
W: www.city-yuwa.com/english/

Izuru Goto's main practice area is banking and finance, including structured finance, project finance and trust schemes. Recently, Izuru has also been actively providing opinions on issues concerning virtual currency through articles and other publications. His main relevant articles include "Commentary on virtual currency law (partial amendment to payment services law)" (in "Framework and practice of the virtual currency law", Nihon Kajo Shuppan, 2018); "Discussion on legal analysis on Bitcoin transactions" (in "Future civil practice and legal theory", Minjihokenkyukai, 2018); and "Cryptocurrency and Trust" (in "Trust Forum Vol. 10", Nihon Kajo Shuppan, 2018). He was also a guest speaker at a seminar held by the Japan Cryptocurrency Business Association in January 2019 which conducted a legal analysis of various virtual currency transactions.


About the author

Takashi Saito
Partner, City-Yuwa Partners

Tokyo, Japan
T: +81 3 6212 5500
E: takashi.saito@city-yuwa.com
W: www.city-yuwa.com/english/

Takashi Saito is a partner in City-Yuwa Partners. He has extensive experience in the banking, finance, investment funds, derivative transactions, securities lending transactions and Japanese financial regulations. He currently advises a major Japanese bank on its euro MTN programme. He also advises and represents Japanese and offshore investment funds, hedge funds and venture funds and investment managers with regards to fund formation, operations and ongoing regulatory compliance. In the area of securities lending transactions, he has advised a major Japanese securities finance company in connection with many offshore transactions. He represents offshore high-frequency-trading operators with regards to registration with Japanese authorities and ongoing regulatory compliance. He previously worked as deputy director of the Financial Services Agency of Japan. He received his LLB from Waseda University and LLM from Duke University School of Law.


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