The regulatory environment in Japan for cryptoasset derivative transactions and cryptoasset custody services has been significantly changed as a result of amendments to the Financial Instruments and Exchange Act (FIEA) and the Payment Services Act (PSA), which came into force on May 1 2020. The changes have impacted foreign business operators engaging in cryptoasset derivative transactions and custody services.
Cryptoasset derivative services in Japan
Prior to its most recent amendment, the FIEA did not regulate cryptoasset derivative transactions, although Japan was hosting a significant volume of cryptoasset derivative transactions mainly in the form of contracts for difference (CFDs) on margin at Japanese cryptoasset exchanges. To protect users and ensure that only appropriate transactions are conducted, however, the FIEA was amended to regulate cryptoasset derivative transactions by including cryptoassets, along with their prices, interest rates, etc. on the list of assets underlying derivative transactions that are subject to regulation.
The FIEA uses "derivative transactions" as a general term to encompass market derivative transactions, over-the-counter (OTC) derivative transactions and foreign market derivative transactions. Each of these is then further classified into sub-categories (such as futures transactions, CFD transactions, option transactions and swap transactions) with references to either "financial instrument" or "financial indicator".
As a consequence of the inclusion of "cryptoassets" and standardised instruments of cryptoassets created by financial instruments exchanges within the definition of "financial instruments", and the inclusion of cryptoasset prices, interest rates, etc. within the definition of the "financial indicators", respectively, cryptoasset derivative transactions will now be subject to the provisions of the FIEA, regardless of the type of derivative transaction involved. Derivative transactions involving the exchange of cryptoassets for other cryptoassets will also covered by the FIEA.
Regulatory requirements and exemptions differ depending on the type of derivative transaction in question. In this connection, the Financial Services Agency (FSA) published a statement – in response to public comments regarding amendments to subordinate legislation in respect of the FIEA and PSA – to the effect that the provision of a trading platform with an order book indicating buy and sell orders of cryptoasset derivative transactions would be deemed "OTC cryptoassets derivative transactions", as defined in the FIEA, unless the trading platform is operated by a financial instruments exchange licensed under the FIEA or an overseas counterpart.
Based on this statement, it is generally believed that most cryptoasset derivative transactions conducted in Japan (or involving Japanese residents) will likely be deemed OTC cryptoasset derivative transactions.
Foreign cryptoasset derivative businesses
Handling OTC cryptoasset derivative transactions or acting as an intermediary, broker or agent in relation such transactions constitutes a Type I financial instruments business (Type I business), as defined by the FIEA. Accordingly, a company engaging in such transactions will have to register as a Type I financial instruments business operator (Type I operator).
Any entity looking to be a financial instruments business operator and to engage in the Type I business must establish a domestic sales or business office and meet certain asset requirements, including having a stated capital of at least JPY50 million approximately ($466,000); net assets of at least JPY50 million; and a capital-to-risk ratio of at least 120%.
Notwithstanding the above, a foreign cryptoasset derivative business operator that is permitted to conduct OTC cryptoasset derivatives transactions under the laws and regulations of its home jurisdiction is exempt from such registration requirements if it conducts such transactions with certain professional entities in Japan, including and limited to:
1. The Japanese government or the Bank of Japan.
2. Financial instruments business operators and financial institutions that engage in OTC cryptoasset derivative transactions in the course of their business.
3. Financial institutions, domestic trust companies (excluding domestic custodial trust companies) or foreign trust companies (excluding foreign custodial trust companies), provided that they conduct OTC cryptoasset derivative transactions for investment purposes or for the account of trustors under trust agreements.
4. Financial instruments business operators that engage in investment management business, provided that such entities conduct activities relating to investment management business.
It is noteworthy that no conventional exemption for non-securities related derivative transactions provided to certain professional customers (including qualified institutional investors and companies with capital amounts of JPY1 billion or more) is available under the FIEA to OTC cryptoasset derivative transactions, in light of the high-risk nature of these transactions.
Although OTC cryptoasset derivative transactions may include the physical exchange or delivery of cryptoassets, this physical exchange or delivery of cryptoassets is exempt from the regulations applicable to cryptoasset exchange services under the PSA, unless they involve the management of customers' cryptoassets, as explained in more detail below (Cryptoasset custody services).
Rules of conduct
Under the FIEA, financial instruments business operators that provide customers with OTC derivative transactions are subject to various rules of conduct.
Loss-cutting rules generally refer to a mechanism through which an open position will be compulsorily liquidated by an offsetting transaction to prevent any further losses, if the appraised loss reaches a certain level. The Cabinet Office Order on Financial Instruments Business, etc. (Cabinet Office Order) imposes an obligation on financial instruments business operators to establish and observe loss-cutting rules in connection with their OTC cryptoasset derivative transactions with individual customers.
Leverage regulations generally mean regulations obligating business operators to require their customers to deposit margin exceeding a certain ratio of the transaction amount (i.e., the notional principal). If a financial instrument business operator engages in cryptoasset derivative transactions, it will be prohibited from entering into transactions with customers without requiring their customers to deposit the necessary amount of margin; and continuing in transactions with customers without requiring their customers to deposit margin to make up any shortfall in the required deposit, at a certain time every business day.
The amount of margin required to be deposited by a customer differs depending on whether the customer is an individual or a corporation. Customers that are individuals are required to deposit a margin equivalent to 50% of the value of the customers' cryptoasset derivative transactions (i.e., a leverage ratio of up to two times). Corporate customers, on the other hand, are required to deposit a margin equivalent to the value of the customers' cryptoasset derivative transactions, multiplied by either (a) 50% or (b) the cryptoasset risk assumption ratio, as calculated using historical volatilities specified in the public notice of the FSA's commissioner.
These leverage regulations will come into force on May 1 2021. It should be noted, however, that the rules of the Japan Virtual and Cryptoassets Exchange Association (JVCEA), which are in effect, limit leverage ratio to no more than four times; except that a Type I operator may choose to use the aforementioned cryptoasset risk assumption ratio.
The JVCEA is a self-regulatory association certified by the FSA in respect of both cryptoasset exchange services and cryptoasset derivative transactions. Although a Type I operator is not obliged to join the JVCEA, it is generally understood that the rules of the JVCEA are virtually applicable to and binding on all Type I operators. This is because the FSA, in practice, requires all Type I operators to establish internal controls that are comparable to those required under the rules of the JVCEA.
The FIEA also imposes the obligation on a financial instruments business operator to entrust its customers' funds to a trust company or a trust bank to ensure that such funds are refundable to customers, even in the event of the insolvency of the operator.
Countering risk
Type I operators are required to calculate their capital-to-risk ratio, and to report such ratio at the end of every month to the FSA or relevant local finance bureau, as well as when such ratio falls below 140%. Type I operators whose capital-to-risk ratio falls below 120% will be subject to a business improvement order. Where their capital-to-risk ratio falls below 100%, they will be subject to an order for suspension of business or rescission of registration.
For this purpose, the capital-to-risk ratio means the percentage derived by dividing the total value of a business operator's stated capital, reserve fund and other items as prescribed in the Cabinet Officer Order – after deducing the total value of its fixed assets and other items as prescribed in the Cabinet Office Order – by the total value of its market risk, counterparty risk and basic risk. The specific method of calculating a business operator's capital-to-risk ratio is prescribed in the relevant public notice.
The value of a business operator's market risk is calculated by either a standardised approach or an internal control model. Under the standardised approach, a business operator's market risk is calculated by the aggregation of values equivalent to equity risk, interest rate risk, foreign currency risk, commodity risk and cryptoasset risk. The value of cryptoasset risk in turn is calculated under the assumption that the market risk of cryptoassets and cryptoasset derivative transactions holds a risk weightage of 100%. Under the internal control model, on the other hand, the value of a business operator's market risk is calculable using value-at-risk, with the FSA commissioner's approval.
The value of counterparty risk is equal to the aggregate exposure of a business operator to its counterparties (less the collaterals received), multiplied by a certain risk weightage as specified in the relevant public notice. The risk weightage for transactions relating to cryptoassets falls within the category with the highest percentages.
Type I operators that hold cryptoassets will have to include within the value of their basic risk the total market value of its cryptoassets that are not managed with cold wallets or other equivalent means.
Additionally, a Type I operator that deposits cryptoassets with a third party will assume credit risk vis-à-vis such third party in relation to the right to claim the return of such crypto assets. Furthermore, if the third party does not manage, or if it is indeterminable whether such third party is managing the deposited cryptoassets with cold wallets or other equivalent means, the Type I operator will be required to take the deposited cryptoassets into account when calculating the value of its counterparty risk and basic risk, respectively.
Cryptoasset custody services
Before the PSA's amendment, it was generally understood that the mere management of users' cryptoasset and the transfer of such cryptoassets to an address designated by users does not meet the PSA's definition of a cryptoasset exchange service. This is because the PSA had previously only provided that the management of users' funds or cryptoasset in connection with the sale or purchase of a cryptoasset or the exchange of a crypto asset for another crypto asset; or any intermediary, brokerage or agency service, constitute provision of a cryptoasset exchange service.
To address concerns that cryptoasset custody services share common risks with existing cryptoasset exchange services, including risks associated with leakage of users' cryptoassets, bankruptcy of service providers, and money-laundering and terrorism-financing, the amended PSA now designates the "management of cryptoassets for the benefit of another person" (cryptoasset custody services) as an additional type of cryptoasset exchange service. Consequently, managing cryptoassets, regardless of whether any sale and purchase is involved, now constitutes provision of cryptoasset exchange service. A person engaging in a cryptoasset custody service will have to register as a cryptoasset exchange service provider (CAESP). It should be noted that there is no professional investor exemption for this registration requirement under the PSA.
In this context, the Revised Guidelines on Crypto Asset explains what constitutes the management of cryptoassets for the benefit of another person: "although whether a service constitutes management of cryptoassets should be determined based on the actual circumstances, a service will constitute the management of cryptoassets if the service provider is in a position in which it may transfer its users' cryptoassets (such as, for example, if the service provider owns a private key with which it may transfer its users' cryptoassets solely or jointly with its related parties, without the users' involvement)."
Accordingly, it is understood that if a service provider merely provides its users with a cryptoasset wallet application (i.e., a non-custodial wallet) and the users manage private keys by themselves, this service would not constitute a cryptoasset custody service. On the other hand, if the provider of a trading platform for cryptoasset derivative transactions accept deposits of users' cryptoassets as margins in a wallet managed by it, it would constitute the provision of a cryptoasset custody service.
A CAESP must not only meet requirements relating to the assets, personnel, corporate organisation and establishment of internal regulations, but also manage customers' funds separately from its own, and entrust customers' funds to a trust company or any other similar entity. A CAESP must also manage its customers' cryptoassets (the entrusted cryptoassets) separately from its own cryptoassets. Furthermore, a CAESP must manage 95% or more of the value of its total entrusted cryptoassets with fully-offline wallets or by other technical means that have the equivalent safety levels of fully-offline wallets.
Shunsuke Aoki
Partner, Anderson Mori & Tomotsune
Tokyo, Japan
Tel: +81 3 6775 1173
Shunsuke Aoki advises primarily on financial regulatory matters with a particular focus on fintech regulations and corporate finance transactions, including equity and debt offerings in both the domestic and international capital markets. Shunsuke also regularly assists overseas clients in the cryptocurrency and crypto derivatives industries, on their entry into or exit from the Japanese market. Capitalising on his two-year stint with one of Japan's leading securities houses, Shunsuke also acts for domestic financial institutions in their structuring of various financial instruments using innovative technologies such as blockchain. Additionally, Shunsuke has considerable experience in matters relating to security tokens.
Shunsuke serves as a member of a research group, established by one of Japan's leading securities houses, that is looking at the use of blockchain technology in the financial markets. Members of the research group include experts from industry and academia.
Ken Kawai
Partner, Anderson Mori & Tomotsune
Tokyo, Japan
Tel: +81 3 6775 1205
Ken Kawai has extensive experience advising financial institutions, fintech start-ups, investors and corporate clients on complex finance and financial regulatory matters. Ken focuses primarily on the fintech industry, and regularly advises fintech companies, financial institutions, international organisations and industry organisations on legal issues surrounding fintech, including the complex legal framework governing cryptocurrencies, and blockchain.
Ken also specialises in derivatives, and has counselled global banks, broker-dealers and investors on regulatory matters and best practices in respect of derivatives and related products. He derives his deep and practical knowledge in this area from his 17 year career at MUFG Bank, where he was involved in derivatives trading and marketing.
Ken's practice also involves cyber-security for financial institutions, personal data protection and e-commerce.
Akihito Miyake
Partner, Anderson Mori & Tomotsune
Tokyo, Japan
Tel: +81 3 6775 1072
Akihito Miyake covers a wide range of financial regulatory matters. He especially focuses on all aspects of legal issues related to the asset management businesses. He has significant experience providing legal services and advice in relation to the formation, offering and distribution of various types of investment funds both inside and outside Japan; the registration of asset managers and distributors acting in Japan; the operations of financial instruments businesses regulated in Japan; business deployment in the Japanese market; inbound investments by foreign asset managers; and outbound investments by domestic investors.
His recent experience also encompasses support in various crypto-related projects such as formation of cryptoasset investment funds and security token offering platforms and advice on cryptocurrency copy trading services.