Overview of Japan Blockchain Regulations

This article is not intended to be legal advice. Individual legal and factual circumstances should be taken into consideration in consultation with professional counsel prior to taking any action related to the subject matter of this article.

Overview

Japan was once one of the centers of Bitcoin communities and then experienced in February 2014 bankruptcy of Mt. Gox which was one of the biggest incidents then, and in January 2018 hacking of NEM coins which amounts to around 58 billion JPY. To prevent such incidents from happening again, the Japanese government and industry have introduced and tightened regulations over cryptocurrency.

As a result, Japan has become one of the jurisdictions with the longest history in regulating cryptocurrencies. Through the accumulation of deliberations, Japan has developed one of the most explicit cryptocurrency regulatory frameworks in comparison to other countries, albeit still evolving.

Furthermore, the Japanese government shifted its focus towards promoting Web3 as an industrial policy. Correspondingly, an increasing number of traditional large Japanese corporations are entering the Web3/blockchain sector. Under the government's policy of advancing Web3, regulatory relaxation is being cautiously implemented while considering potential drawbacks. This article will explore Japan's cryptocurrency landscape, delving into governmental, legal, and regulatory aspects, followed by a detailed legal overview for each business category.

Government Policy

The Liberal Democratic Party, the Japanese ruling party, published a paper titled “NFT White Paper (Japan’s NFT Strategy for the Web 3.0 Era)” in April 2022. The paper discusses measures to create an ecosystem to help NFT businesses develop in a healthy and legally compliant way.

Japanese government stated in its Basic Policy on Economic and Fiscal Management and Reform 2022, which is one of the most fundamental yearly national economic policy, that “We will also consider improving the environment for the implementation of Web3 such as the use of NFT and DAO based on blockchain technology.

Web3 Whitepaper

The whitepaper addresses key issues and recommendations for advancing web3 in Japan. It suggests modifications to accounting audits for crypto companies, legal frameworks for DAOs, and improvements in token screening processes. The paper also discusses promoting stablecoin and security token circulation, addressing the concern of NFTs without the IP holders’ permission, consumer protection, enabling financial institutions' entry into web3, and legal aspects of NFTs in the content industry. Each point aims to update legislative and regulatory frameworks to support Japan's evolving web3 landscape.

Ministries and Agencies involved in Policy Making

Financial Services Agency

With the aim of promoting private innovation while simultaneously ensuring appropriate protection for users, the Study Group on Approaches to Digital and Decentralized Finance was established in July 2021 to examine the approaches to digitalization of remittance methods, security products, and similar areas. This study group met intermittently, convening a total of 12 times up until the end of 2023.

Digital Agency

In October 2022, Japan's Digital Agency established the Web3.0 Research Group, which later published a report titled "Web3.0 Research Group's Report — Toward Sound Development of Web3.0". The report focuses on the development of Web3.0 in Japan, covering aspects such as digital assets, decentralized autonomous organizations (DAOs), decentralized identity (DID), the metaverse, and user protection and law enforcement. It discusses the potential benefits and risks associated with these technologies, the need for regulation and user protection, and the importance of innovation and technological development.

Ministry of Economy, Trade and Industry

In July 2022, Japan's Ministry of Economy, Trade and Industry established the Web3.0 Policy Office within the Minister's Secretariat. This office aims to strengthen the examination of business environment issues related to Web3.0. The office collaborates with relevant ministries, including the Digital Agency, and integrates departments responsible for funding, tax systems, business entities (vehicles), and sectors such as content, sports, fashion, and art.

The Office published a document titled "Approach to Improving Web3.0 Business Environment" which provides an in-depth analysis of the Web3.0 landscape. It discusses the transition from Web1.0 and Web2.0 to Web3.0, emphasizing the shift towards decentralized and token-based economies and the potential foundation of Society 5.0. The report includes insights from various professionals and covers topics like blockchain technology, public and private chains, the emergence of Bitcoin and Ethereum, token economics, and the social impact of Web3.0.

Legal Nature Of Crypto Tokens]

Traditional legal frameworks categorize "things" as tangible (corporeal) objects. However, cryptocurrencies, being intangible and existing primarily as digital records on a blockchain, challenge this classification.

A court case, referred to as the Tokyo District Court case of August 5, 2015, specifically dealt with the classification of Bitcoin in the context of property law. The court found that Bitcoin lacks the physical tangibility and exclusive control that are typically required for something to be considered a "thing" in the legal sense.

It should be duly noted that the case in question represents a judgment rendered by a court of first instance. Consequently, this judgment does not establish a definitive resolution regarding the legal characterization of cryptocurrencies within the Japanese legal framework.

In May 2023, the Study Group on Approaches to Digital and Decentralized Finance in the Financial Services Agency hosted Professor Ignacio Tirado, Secretary-General of UNIDROIT, to discuss the UNIDROIT Principles on Digital Assets and Private Law. This discussion may indicate that there is a possibility of future legal developments concerning the private law nature of cryptocurrencies.

Key Statutes

Payment Services Act

The Payment Services Act aims to ensure the appropriate provision of payment services, protect users, and promote service provision, thereby enhancing the safety, efficiency, and convenience of payment and settlement systems.

Under the Act, cryptoasset exchange services must be registered with the prime minister. The services include purchasing and selling cryptoassets, exchanging them with other cryptoassets, intermediary, brokerage or agency services related to such transactions, management of users' money in connection with these transactions, and managing cryptoassets on behalf of another person, except when such management is specifically governed by other acts.

Under the Payment Service Act in Japan, "cryptoassets" are defined as follows:

Type 1 Cryptoassets: These are values represented as property, recorded electronically and used for transactions with unspecified persons for buying goods or services. They exclude Japanese currency, foreign currencies, and currency-denominated assets. Tokens regarded as securities (see below) are also excluded. These include BTC, ETH, governance tokens, and other fungible tokens whether or not they have utility functions.

Type 2 Cryptoassets: These are also property values that can be exchanged with Type 1 cryptoassets, with similar transferability through electronic systems.

Regarding Non-Fungible Tokens (NFTs), the Japanese Financial Services Agency has publicly stated that trading cards, game items, and similar items are generally not considered to have economic functions like payments. Therefore, they are not categorized as Type 2 cryptoassets. In this context, NFTs are not regarded as Type 1 cryptoassets either. In 2023, it was clarified by public comments that NFTs can be sold without being classified as cryptoassets if certain conditions are met: (i) NFT operators must specify in their terms that NFTs are not to be used as a payment method, including in secondary markets; (ii) NFTs should be issued and sold within specified limits (no more than 1 million indivisible units and priced 1000 JPY or above each); (iii) Operators must ensure that NFTs are not used as payment methods, taking reasonable actions such as warnings if such usage is found.

Financial Instruments and Exchange Act

Cryptoassets, NFTs, or any digital tokens become subject to regulations under the Financial Instruments and Exchange Act as "interests in a collective investment scheme" when they meet the following conditions:

1. the rights holders (investors) contribute or invest money or other assets;
2. these contributions or investments are utilized in a business venture (investment target business); and
3. the investors have the right to receive dividends or distributions from the profits generated by the investment target business.

In addtion, even if the above conditions are met, certain rights are excluded from the definition of interests in a collective investment scheme by cabinet orders and ordinances when they are considered typologically low in the necessity for investor protection. These include: (a) rights where all investors are actively involved in the investment target business, and (b) rights where investors do not receive dividends or distributions exceeding the amount they contributed or invested.

Tokens classified as collective investment schemes, as well as those with characteristics of corporate bonds and investment trusts etc., are also categorized as securities. These security tokens are regulated under the Financial Instruments and Exchange Act as "electronically recorded transferable rights".

LPS Act

Currently, the Limited Partnership for Investment (LPS) entities used by many venture capitals cannot directly hold cryptoassets. They are only permitted to engage in activities enumerated by the Act, and investment in crypto assets is not listed among these permitted activities. Though Japanese venture capitals using LPS can indirectly include crypto assets in their portfolios by having the LPS own a company etc. that holds cryptoassets. This approach introduces unnecessary costs and complexity. According to news, the government plans to submit an amendment to relax these regulations, potentially within 2024.

Regulatory Overview by Business Type

Centralized Exchange

To operate a cryptoasset spot exchange in Japan, registration as a Cryptoasset Exchange Service Provider (CAESP) under the Payment Service Act is mandatory. As of December 1, 2023, there are 29 registered CAESPs. For operating a derivatives exchange related to cryptoassets, a separate license under the Financial Instruments and Exchange Act is required.

Key requirements and regulations for CAESPs include:

1. Crypto Asset Storage: More than 95% of the crypto assets deposited by users must be stored in cold wallets, which have never been connected to the Internet, ensuring high security.

2. Performance-Guarantee cryptoassets:: In addition to the previously mentioned requirements, CAESPs are required to maintain cryptoassets, referred to as "Performance-Guarantee cryptoassets". These assets must be of a greater value than the users' cryptoassets stored in hot wallets. Furthermore, these Performance-Guarantee cryptoassets must be stored in cold wallets.

3. User Cash Management: Users' cash deposits must be separated from the CAESP’s funds through a trust arrangement. Users are the beneficiaries of this arrangement, which must be managed by a licensed trust bank or trust corporation.

4. Audits and Compliance: Periodic audits by certified public accountants are mandatory. CAESPs must adhere to KYC/AML requirements and join an association like the Japan Virtual and Crypto assets Exchange Association (JVCEA), following its rules.

5. Operational Restrictions: CAESPs are restricted in their advertising and are obliged to provide clear information to users. Provisions prohibiting market manipulation and spreading rumors apply to both spot and derivative trading of cryptoassets.

6. Leverage Limits for Derivatives: For individual traders, the maximum leverage allowed in derivative/margin trading is 2x. For corporations, leverage must be based on historical volatility or otherwise set at 2x.

Cryptoasset Public Sales

The involvement of a CAESP may enable the conduct of an Initial Exchange Offering (IEO), contingent on several requirements, including adherence to the Japan Virtual and Crypto assets Exchange Association (JVCEA) guidelines for new crypto asset sales. This was exemplified in May 2021 when Coincheck, a licensed cryptocurrency exchange, spearheaded Japan's first IEO. Following this, various IEOs have been launched under different licensed crypto exchanges.

Stablecoins

Japan's new stablecoin regulations were made effective from June 2023. These regulations classify stablecoins similar to digital money, which are pegged to fiat currencies, as electronic payment methods. They distinguish these from other types of stablecoins, such as algorithmic ones, regulated as "cryptoassets" or "securities". Additionally, these regulations incorporate AML/CFT/CPF measures as per FATF recommendations and extend regulatory oversight to intermediaries involved in electronic payment transactions, including banks, credit cooperatives, and credit unions. The regulations also align with international economic sanctions under the Foreign Exchange and Foreign Trade Act.

DeFi

There are no specific regulations applied to decentralized finance. However, it should be noted that regulations generally over finance activities may apply to DeFi as well. Discussions about regulations are far from reaching consensus in Japan. A case-by-case analysis is required especially in the field of DeFi.

At the "Meeting on Approaches to Digital and Decentralized Finance" held on November 13, 2023, discussions were conducted on international regulatory trends for crypto-related finance. Key topics included IMF-FSB's comprehensive policy framework, FSB's high-level recommendations on cryptoassets and global stablecoins, and IOSCO's proposals on cryptoassets and decentralized finance (DeFi). The meeting also examined crypto regulation in various jurisdictions, including the U.S., Europe, the U.K., Singapore, and Hong Kong, focusing on recent legal developments, court cases, and regulatory updates.

DAO

The Web3 whitepaper mentioned above discusses the need for a legal framework specifically for DAOs (Decentralized Autonomous Organizations), emphasizing their increasing role in areas like regional revitalization and social issue resolution. The paper highlights the lack of a clear legal structure for DAOs in Japan, particularly regarding limited liability for members and an organizational form that aligns with the agile nature of DAOs.

The recommendation is to consider the establishment of special laws for LLC-type DAOs. An LLC (Limited Liability Company) is seen as compatible with DAOs due to its unified ownership and management structure and the autonomy it offers. Proposed changes include amending the relevant act and the Financial Instruments and Exchange Act to better suit DAO operations.

NFT

Several reports have been published from study groups organized by industry associations, which included participation from lawyers and scholars, on the legal issues of NFTs.

"Guidelines for NFT Business" issued in March 2023 by Japan Cryptoasset Business Association, provides comprehensive guidelines for businesses involved in NFTs. It covers various aspects, including NFT use cases, legal nature, considerations for gambling laws, user privacy, security, and user protection.

"Guidelines on Package Sales of NFTs Using Sports Content and Establishment of Secondary Market" published in Sep 2022 by the Council for Sports Ecosystem Promotion (C-SEP) discusses the challenges and legal considerations of utilizing sports content for NFTs in Japan. It addresses concerns about gambling laws in the context of NFT package sales and secondary market operations.

"Guidelines for Random Type Sales of NFTs" published in October 2022 jointly by various Japanese blockchain and cryptocurrency associations, focuses on providing guidelines for NFT random sales. The guidelines suggest that random sales should avoid scenarios where a buyer might lose out on value, thus avoiding gambling accusations. It also includes recommendations for consumer protection, such as proper information disclosure and consideration for minors.

Mining

In the realm of cryptoasset mining, current regulations do not specifically target the mining activities themselves. However, mining pools may come under the scope of the Financial Instruments and Exchange Act as they could be considered collective investment schemes.

Custody

Only entities registered as CAESPs under the Payment Services Act or trust corporations licensed under the Trust Business Act are authorized to manage cryptoassets owned by others. This includes providing custodial services or wallets for cryptoassets, as well as businesses that incorporate such custodial functions.

Staking

A business model of staking can be varied. If a private key for customers’ cryptoassets are held by an operator and such operator can move such cryptoassets at its own decision, such status may be regarded as “management of cryptoassets on behalf of another person”. In such a case, the operator shall be registered as a CAESP.

Lending

A business where a customer lends their cryptoassets to an operator is basically not regulated. However, if a customer can withdraw at any time upon their request, such business may be regarded as substantially accepting deposit and conduct “management of cryptoassets on behalf of another person”. In such a case, registration as a CAESP may be required, but it depends on circumstances.

Payment

While individuals are not prohibited from using cryptoassets for payments, providing payment-related services as business may require a registration or license, depending on the specifics of their activities.

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