Spearheading Regulatory Framework
Japan is well-known for being supportive and pro-blockchain projects. Beginning with being home to Mt. Gox, the largest cryptocurrency exchange at one point, to more recently having multiple exchanges and associations, Japan has always been on the map of crypto world. In contrast to countries where they have outright banned ICOs or any cryptocurrency trading like China and South Korea, and unlike countries, such as Malta, which are technically safe havens for all crypto projects, along with Singapore and Australia, Japan has favored growth of blockchain projects and adoption of cryptocurrencies. In April 2017, virtual currency exchanges were given legal status, while virtual currencies were defined to prescribe the virtual exchange services by law.
But where Japan really sets itself apart is with spearheading the campaign to put in place a regulatory framework using which players in the crypto market can operate. Regulations are usually not seen as positive actions, possibly due to instinctive reactions of humans. And this is reflected in the negative price reaction of cryptocurrencies when each related news of regulation is released. Moving past the instinctive thoughts and circumstantial evidence of price reactions, regulations are in fact a positive move for encouraging blockchain adoption, supporting quality projects and providing protection for retail investors.
Necessity for Regulations, But Neutrality in Treatment
When rightly structured, regulations provide legitimacy, acknowledgement and recognition for cryptocurrencies and blockchain projects. Regulations can also provide a breeding ground for the right projects to grow – projects with the right group of people with the right intentions, while filtering out bad actors. And primarily, retail investors are likely to be better protected through regulations.
Still, there is no denying that there is a fine line between regulation and stifling-innovations. And how authorities go about putting the framework down has a huge influence on the eventual market. Whether it inhibits innovation or encourages adoption of quality projects depends on the authorities’ approach. Overstepping the line could mean the end of blockchain revolution and many great open-source projects. Falling short from the line could mean bad players causing more harm to the general public. And more often than not, governments would rather err on the side of caution than being sorry.
But if blockchain and cryptocurrencies are to be properly regulated in a healthy manner, one important feature of governments’ approach should be neutrality. Japan’s regulatory body, the FSA (Financial Services Agency), embodies this feature – neutrality towards the cryptocurrency market. They did not outright do a blanket ban on blockchain projects, cryptocurrencies and exchanges. Rather they require a registration process and conduct a filtering of players in the market, while remaining neutral to the technology and its possibilities.
After the theft of the infamous Mt. Gox exchange, when 850,000 Bitcoins were alleged to have been stolen, a study group and working group within the FSA was formed, which led to a few insights. The highlights of the outcome were: (i) necessity for cryptocurrency exchanges to register with the FSA, (ii) for cryptocurrency transactions to comply with anti-money laundering (AML) laws, and (iii) for investors to be protected were highlighted.
And naturally so; no government can condone people profiting from illegal activities. Nor would they want their citizens to be swindled or financially hurt due to speculative activities that hurt their livelihood and threaten their survival. Hence, regulating the exchanges to achieve these two goals became a priority. But that was just the beginning, and regardless of how quickly and efficiently they would prefer to sort everything out, the task is neither easy nor straightforward.
Cryptocurrencies and blockchain projects are a new field and unfamiliar to majority of the world. The ranges of types of tokens that have come to life complicate matters for the worse. There are payment tokens (cryptocurrencies), utility tokens, and security tokens (asset tokens), which is the most troublesome of all, regulation-wise. Payment tokens are means of purchasing, selling or making any financial transactions similar to how cash or gold would be used, designed to work pretty much the same way the US dollar or Japanese yen would work but without backing from the government or any organization. Utility tokens of a project are designed to be used for the products and services and any other derived benefits on a network. Security tokens work similar to stocks, bonds or derivatives, representing stake in the underlying company/project and/or entitlement to interests or dividends.
The FSA faces challenges in determining the regulatory boundaries of utility tokens and security tokens mainly because these have not been considered before when drafting their financial laws and they do not fall within any jurisdiction of any constituted law or acts. As far as cryptocurrencies are concerned, considering them as means of payment allows the FSA to leverage on the Payment Services Act, which was established in June 2009. The Payment Services Act was amended in 2016 to include the scope of cryptocurrencies and exchanges, with the amendments taking effect since April 2017.
|2016||Payment Services Act was amended in 2016 to include the scope of cryptocurrencies and exchanges.|
|April 2017||Virtual currency exchanges were given legal status, while virtual currencies were defined to prescribe the virtual exchange services by law.|
|December 2017||The National Tax Agency ruled that gains on cryptocurrencies should be categorized as ‘miscellaneous income’ and investors taxed at rates of 15%-55%.|
|July 2018||Privacy coins such as Monero are blacklisted to prevent money laundering and other illegal activities|
|August 2018||Cryptocurrency classified as financial product due to the need for protection against hacks and security breaches.|
As per the amended Act:
- Exchanges are required to register with competent local Finance Bureau in order to legally operate in Japan.
- The firm should be either a stock company or a “foreign cryptocurrency exchange business” that is a company, has a Japanese resident as representative and an office in Japan. By “foreign cryptocurrency exchange business”, the Act refers to a cryptocurrency exchange that is registered in a foreign country with that foreign government, subject to a law that requires a registration system equivalent to the system under the Japanese Payment Services Act.
- Additionally, exchanges are required to establish security systems to protect data and funds.
- If the exchange engages any contractor to run part of its operations, then sufficient measures need to be taken to ensure that operations are appropriately conducted.
- The Act also stipulates that exchanges should provide information regarding fees and other contract terms to their customers.
- Exchanges must separately manage customers’ funds (money and/or cryptocurrency) and their own. Exchanges have to undergo review by certified public accountants or accounting firms.
- If a designated dispute resolution center with expertise in cryptocurrency exchanges exists, then exchanges must have a contract with such designated center. Otherwise the exchange must establish its own system to deal with dispute matters and complaints from customers.
- Registered exchanges are required to keep accounting records of transactions and submit annual reports to the FSA.
- On top of being able to order exchanges to submit reports and other relevant materials, the FSA also has the right to send officials for inspection of exchanges to ensure proper operating protocols. Failure to comply or pass inspection tests can lead to being suspended or having the registration rescinded.
The above list is not exhaustive but a basic guideline for all exchanges wishing to operate within Japan.
But even with such measures and efforts taken, earlier this year in January 2018, Coincheck, which was one of the biggest exchanges in Japan lost more than US$500 million, mostly by theft of more than 500 million NEM tokens. The shocking magnitude of the theft triggered inspection checks of all exchanges and review of operating protocols. The leaders of the existing operating exchanges then decided to form the JVCEA – a self-regulating body consisting of 16 exchanges.
JVCEA (Japan Virtual Currency Exchange Association)
The Japan Virtual Currency Exchange Association (JVCEA) is a coalition of registered exchanges that came about to improve the operations of the industry. Having obtained approval recently from the FSA to self-regulate, the JVCEA can now decide on rules for the following: operational protocols, consumer protection, prevention of money laundering and employee ethics. The association now has the power to enforce compliance among its members.
Joining the JVCEA is not mandatory for every registered exchange. However, through the coalition and self-regulation they hope to reform the industry. After the Coincheck incident and another hack and theft of about US$60 million from the Zaif exchange in September 2018, the FSA introduced further stringent requirements and screening process for registration of new exchanges as well as review and inspection of existing ones. Meanwhile, consumer confidence has taken a hit too, especially considering that the hacks occurred to registered exchanges, which supposedly should have been properly monitored and passed FSA’s requirements. Hence, regaining trust is one of the top objectives of the JVCEA.
As to how effective self-regulation will be remains to be seen. One advantage of self-regulation is that the rules and measures would be designed by people who are more familiar with cryptocurrency exchange operations and the markets. In a sense, the JVCEA committee would be experts relative to the government, who are still trying to understand cryptocurrencies and its implications. But the downside would be that the JVCEA is still made up of for-profit corporations with different privatized agendas. Hence, our opinion is that while self-regulation is good, continued oversight and monitoring from the FSA on all operators would be ideal. The double-layer regulation might work better in keeping bad players out, ensuring high standards of operational protocols and protecting investors.
Representatives from 15 of the original 16 members of the Japan Virtual Currency Exchange Association, formed in April 2018.
Similarly, the listing of tokens on exchanges is also scrutinized and follows a stringent selection process. Exchanges are required to prepare extensive documentation on each token that they wish to list in accordance with the format and details required by the FSA. It is understood that part of the application process involves submitting details to a sixty-part questionnaire pertaining to the token. However, the JVCEA is supposedly negotiating the terms of token listing process to lighten the burden on its members.
Being part of the JVCEA does not entitle exchanges to list coins across the board. Meaning, for example, if Coincheck obtains permission to list the ELA or BCH token, it does not mean that BitFlyer or Quoine can list the tokens as well. Each exchange has to individually apply for the tokens they wish to list. This is most likely seen as a cumbersome process not just for exchanges but also for projects wishing to list on Japanese exchanges.
It is the result of the FSA focusing on protecting investors from tokens with manipulative nature in trading activities due to the fact that many coins have gotten listed on exchanges with just monetary influence rather than qualitative advantages. And often the tokens have highly volatile trading activity that results in profits for exchanges through transaction fees but results in uneducated retail investors often being on the wrong side of the trades, buying at the highs and being forced to sell at the lows to exit trades.
While that has been the way retail investors were affected by listed tokens, the other way was through the now-infamous parade of ICO fund raises in the past 12 to 18 months. Majority of retail investors have poured their hard-earned lifesavings and salaries into ICOs expecting huge profits based on the promises and charades made by founders and teams of countless projects. Some projects were doomed to fail from the start without the right intentions or relevant people working on them, other projects lost value through improper execution or their inability to survive market volatility.
But the group that always suffers no matter which project fails was the retail investors. After all, it was and still is a highly speculative endeavor. As of now, ICOs are not allowed in Japan, but not outright banned forever. Deregulation of the ICO ban would most likely occur once the necessary framework and requirements have been put in place.
While regulations related to cryptocurrencies and exchanges were derived from the Payment Services Act, the same could not be done for utility tokens and security tokens. There is no precedence for any activities related to ICOs. The lack of precedence and unfamiliarity with the matter provides the biggest challenge in drafting a regulatory framework. With regards to this, the FSA will refer to the Financial Instruments and Exchanges Act. However, when this Act was drafted in June 2006, it did not provide room for interpretation of completely new instrument types such as utility and security tokens, nor for financial activities such as ICOs.
The FSA’s crypto study group holds meetings to discuss on regulation matters with experts on the matter. The last meeting held by the group on November 1, 2018 focused on details surrounding ICOs especially. This would kick-start the regulatory framework on ICOs to start forming its shape, with people in the industry expecting ICOs to be finally allowed within 6-9months. This would be good news for projects that have been unable to conduct ICOs in Japan, for foreign projects that are looking to tap into the Japanese market and for Japanese investors who have been banned from participating in ICOs.
The ICO Business Research Group is a government-backed study group
Quite obviously, one of the main issues to tackle would be defining what kind of tokens would constitute a utility token vs what factors would qualify a token as security token. With the demand in security token offerings (STO) expected to rise, especially with the entrance of mainstream institutions in the blockchain space, the need for clear definitions increases. The Securities Exchange Committee (SEC) in the U.S. uses the Howey Test to determine if a financial instrument, in this case crypto tokens, is a security.
Asking crypto projects which are mostly start-ups, to declare and provide information on the level that mainstream institutions are required to by financial regulators and stock exchanges would probably be too much of a demand. At the same time, regulators need to know enough about the project to determine its legitimacy and determine the nature of the underlying token. Striking a balance on requirements would then be a tricky challenge. How the FSA would determine if a token is a security is not yet clear, but it is quite possible that they would include a framework similar to the Howey Test, and that the Financial Instruments and Exchanges Act would be amended to include security, and potentially utility tokens.
One other remaining issue the regulators are grappling with is the problem of margin trading. One of the reasons why it is a point of concern is due to the volume of margin trading – almost 80 percent of total cryptocurrency trading has been attributed to margin trading. Another reason for concern is the high margin ratios; some exchanges offer as much as 25 times leverage options. This enables traders to effectively borrow cryptocurrencies worth 25 times their deposit at the exchange. While that would reap high returns for even a slight rise, the opposite is also true – a 4 percent drop in the holdings would wipe out the original deposit that is their entire capital.
Derivatives were originally a tool that was invented for investors to hedge their bets against risks in the equity and debt markets. However, it is now being used with much more speculation through margin trading. Out of the 16 exchanges that are registered with the FSA, 7 of them offer margin trading. The JVCEA with FSA’s backing has set the leverage cap at a low multiple of 4, but even that they believe is too high. Like others, they question if margin trades are healthy for the cryptocurrency market at all.
The short answer is probably no. Margin trades worsen what is already bad – speculation. Traders in mainstream capital markets of stocks, bonds and other financial instruments base their trading activities on technical analysis or fundamentals or news events or a combination of sorts. And even then, they have risk management measures in place to counter the speculative risk involved in their trades. But most of the current traders in the cryptocurrency markets have no such basis nor risk management measures. Not to mention the inherent speculative nature of cryptocurrencies valuations since they are mostly startups. And technical analysis does not apply to almost all cryptocurrencies yet due to lack of volume and distribution.
Excessive speculation would only hurt the cryptocurrency market in the medium to long run. Regulatory authorities are considering amending the regulations regarding margin trading further for investor protection. We could potentially see a lower leverage cap or even a ban on margin trading at least for the short term, in order to remove speculative elements in the market. Furthermore, traders/trading accounts that wish to conduct margin trading might be required to obtain additional levels of approval to ensure their financial knowledge and standing.
Word for Projects New to Japan
Despite the early beginnings of cryptocurrencies in Japan, very few projects have actually attempted to enter the market, start up or set up base there. Quite possibly regulations have kept most of them at bay. But in our view, regulations are exactly why projects should explore the Japanese market.
As mentioned earlier, the FSA is quite neutral towards cryptocurrencies and blockchain projects. They do not judge but they understand their responsibility to ensure it is a fair game for all participants. In our view, we feel they are even slightly positively-skewed. Investor protection is at the core of the FSA’s attempt to regulate the crypto space. Hence, they are more concerned with how to better protect retail investors than other reasons. As far as investor protection is concerned, we believe there are two other ways the FSA and other regulatory bodies can achieve their aims: investor education and regulating crypto funds.
Educating investors on staying wary of poor-quality projects and identifying better quality projects for investments could prove to be a valuable tool in protecting investors from losing their savings. Rather than protecting them from external organizations, this approach enables investors to protect themselves. At Visionz Capital we share our reports on projects and market topics to raise awareness in the community, hoping to cultivate a more informed and educated market of investors. Akin to that, regulatory bodies could disseminate information to those who wish to invest in crypto projects. This would aid in achieving a mature market of investors, which is better for sustainability of crypto markets.
The other approach of protecting retail investors would be by regulating crypto funds. Most of the existing crypto funds are nothing like mainstream hedge funds or asset management firms. Being mostly free to operate in whichever way they please in a market with low liquidity, these “funds” have more influence on trading activity of tokens than what would be perceived of them. They can drive prices up at will, tempting gullible retail investors to join in and buy at the high; just in time for the funds to exit the trades leaving them with profits while retail investors receive the short end of the stick.
The regulatory framework in Japan has come quite a distance but it is far from done. Proper regulation in itself is good for nations, blockchain projects, investors and the overall crypto market. Having regulations removes most of the legal and operational uncertainties for projects. Rather than being on one’s toes when authorities are going to land the blow, crypto firms can operate with full confidence and support of the government.
Regulation provides acknowledgement, recognition and legitimacy to the firms that operate in observance. The FSA is doing the right thing by taking the approach of treating this unfamiliar space with neutrality. Achieving the balance between protecting investors and stifling innovation is critical and could mean the difference between providing a breeding ground for revolutionary projects versus being seen as an unfavorable place for crypto projects.
Japan is amongst the forerunners in the race to provide regulatory framework for crypto markets, and it could very well win it and be a future blockchain hub. The exchange operators and other crypto companies within Japan understand this very well and are optimistic about the whole situation. And they are patiently waiting for two things – one, for regulations to completely fall in place, and two, for the next wave of investors to enter the market.