The Future of Blockchain in Japan

This thought piece is contributed by Scott Gentry — Techemy Advisory’s Japanese representative and is written to provide insight into the macro of the Japanese financial market. It has been written on the back of the 20th Annual Japan International Banking & Securities System Forum 2019, which was held in the last week of February.

At this forum, Mr Motonobu Matsuo, a director of the Financial Services Agency (FSA) of Japan spoke about the FSAs digitalisation strategy and viewpoint on blockchain and cryptocurrencies. This article attempts to explain how Japan arrived at this particular place in history, followed by a summary of the key items from the Director’s speech:

Background:

The Japanese market has traditionally been risk-averse since the bubble period (1985–1990). As the bubble generation grew older, local investors increasingly demanded dividends rather than capital gains because of the long-term negative investment climate. Corporate Japan gradually, and begrudgingly, raised dividend payments in order to maintain as much stability as possible. Meanwhile, Japanese Government Bonds (JGBs) have consistently traded at 1% or less for years.

As share-owners accumulated dividends over the years, financial institutions and their sales teams developed financial products geared toward existing investors & shareholders. Over time, this generation grew older to the point that 63% of financial assets are now held by citizens 50 years and older, as seen in the graph below. Over 1000 trillion yen (approximately US$10 trillion) is held by 60 years and older individuals as of 2014. The 20–49-year-old demographic are not only lack the savings of their parents, but financial institutions haven’t created financial products that appeal to this younger generation.

Source: National Survey of Family Income by Ministry of Internal Affairs and Communications and estimates provided by the Ministry of Finance from Flow of Funds by Bank of Japan

Moreover, younger investors lucky enough to stash away some savings have faced increasingly bureaucratic procedures to open accounts. What used to be a simple 30-minute account-opening procedure back in the ’80s, can now take several days. For corporate accounts, the process can take longer, perhaps one month. On top of this, the KYC/AML compliance and procedures present a tremendous amount of friction. All of these things mean that for the younger generation, the anemic returns offered by current investment vehicles were not worth the hassle of navigating the bureaucracy.

Lurking beneath the surface lies the issue of Japan’s government debt, which is mostly financed through domestic means. There is also concern over estate taxes as a means of reducing the debt burden. So far, however, estate taxes are nudging down slightly, but not enough to inflate wealth prospects amongst the younger generation.

In reaction to this situation, a large proportion of the younger generation have used the rise of cryptocurrencies as an investment vehicle. They can invest small sums with the hope of substantially larger returns. This was especially true during the bull run of 2016–2017 and could explain why Japanese traders represented an estimated up to 57% of global BTC trading volume.

Since this type of vehicle was created outside of the traditional financial markets and corresponding regulations, the Japanese government stepped in with a view to providing an environment for the younger generations to invest in relative safety while at the same time dealing with bad actors, shoddily run institutions and remove the overly-speculative and spurious opportunities. This led to the original legal guidance in the new Payments Act from April 2017 which defined cryptocurrency holdings as a crypto asset. According to the FSA, the relatively lax regulation in the crypto market resulted in about a large proportion of the younger generation investing in this new market.

With this amount of popularity, it was inevitable that the FSA, under pressure from the central government would have to clamp down on money-laundering and KYC. However, it wanted to retain as much of the appealing features of early Crypto adoption as possible. To achieve this, the FSA has passed on some of this pressure to the Mega-banks (which own exchanges) and other institutions by encouraging them to work together to implement robust and strong technologies to enhance KYC and AML processes to simplify client onboarding.

The general assumption is that most of the institutional service providers require the same sort of application, verification and compliance process, therefore costs should be reduced by sharing, and eliminating much of the hassle from start to finish. This will lead to the overall market benefitting tremendously.

The FSA is also driving these changes as it believes that blockchain, AI and other assorted new technologies developed for the digital markets offer great promise in helping them achieve their goals, which will be outlined in the following section.

20th Annual Japan International Banking & Securities System Forum 2019 Summary

With this background in mind, we can move on to the summary of the forum keynote. The keynote speaker was, Mr Motonobu Matsuo, one of the FSA Directors who was tasked with articulating the Agency’s point of view. It was apparent that the FSA is seeking ways to contribute to the global crypto framework and has sought outside counsel to that effect.

The following bullet points summarise the Director’s discussion to a standing-room-only crowd of about 400 people.

FSA Digitalisation Strategy

6 major measurements of the FSA digitalisation strategy in regards to blockchain, digital assets and financial technology:

1. Information on digitalisation and financial literacy;
2. The digitisation of financial infrastructure that enables the transfer of financial and non-financial information;
3. Promotion of innovation through various regulatory sandbox system, where private enterprises report the commercialisation plan of innovative technologies and services to ministries concerned. Upon approval, private enterprises can conduct demonstration experiments without meeting the procedures and standards stipulated by each business law, and the government implements deregulation based on the results;
4. Promotion of innovation by open architecture;
5. International network (FSA contributing to global digital asset frameworks etc);
6. Promotion of blockchains, AI, big data technology etc. The foundation of digitisation;

Regulations Related to Digital Assets

Redlined virtual currencies to crypto assets:

• A draft for crypto assets is complete and ready for submission to Parliament in March.
• Utility tokens will be regulated under Payment Services Act and security tokens will be under Financial Instruments and Exchange Act, which means for security tokens, the first-class licence or the second-class licence are needed and stricter laws will be applied.
• Continued discussion of cross-sectional, comprehensive regulations especially in the settlement area.
• As regulations tend to get behind economic activities, the Japan Virtual Currency Exchange Association, a self-regulatory organisation for utility tokens, will take initiatives in setting up self-imposed regulation.

Examples of Blockchain Related Cases Under the Regulatory Sandbox

1. Mega three (MUFG, SMFG, Mizuho) and Deloitte: Are considering designing a system to jointly implement customer’s identity verification procedure jointly by financial institutions, with the utilisation of the regulatory sandbox.
2. Fujitsu and Zengin System: By utilising blockchain technology, conducted a demonstration experiment aimed at immediate settlement in a small-lot transaction between banks.

Key Takeaways from the Forum:

• Financial institutions have been neglecting younger generations. Because of this, the 20–49-year-old group are heavily over-represented in crypto, which is also the case globally.
• FSA sees these FinTech movements as an opportunity to provide financial services customised for the masses and are actively moving to both protect this group with regulation and force older more established businesses to adopt modern practices to ensure financial inclusion is more permanent
• Security tokens are expected to become a new opportunity for financial players with 1-class or 2-class licenses. Players with Class-1 licenses can handle derivatives transactions and margin transactions in addition to simpler products that can be handled by a Class-2 license holder.