DIGITAL ASSETS AND MARKET INFRASTRUCTURES IN JAPAN (PART I)
The legal classification of cryptocurrencies, utility tokens, investment tokens, and crypto derivatives
Starting with Bitcoin in 2009, crypto assets have come a long way. Now, ten years later, the ecosystem is more diverse than ever, and bitcoin and other crypto assets are on the verge of becoming a new asset class. At the same time, blockchain technology has made significant progress and evolved from a pure state transition system to fully programmable networks. 2nd and 3rd generation networks allow other projects to build dApps on their platform and to deploy smart contracts to issue their own tokens. With the rise of these platforms, Initial Coin Offerings (ICOs), Initial Exchange Offerings (IEOs), and Security Token Offerings (STOs) have become a popular mechanism to raise funds. The flexibility offered by 2nd and 3rd generation networks also opened up new possibilities for more complex applications such as DeFi.
The potential of blockchain technology has also been recognized by governments around the globe. Experiencing pressure from projects such as Libra, some of them have intensified their research on central bank digital currencies and other blockchain applications.
While the industry is increasingly professionalized, major hacks exposed vulnerabilities in the existing infrastructure. Money laundering is another concern for policymakers. In view of these challenges and an increasingly diversified environment, the Japanese legislator amended the Japanese crypto regulations and published subsidiary legislation for public comment more recently. The changes will enter into force around May this year.
In this article, we take a closer look at the regulatory treatment of different digital assets, analyze the primary and secondary markets for them and provide an overview of different players in the industry, reaching from exchanges to liquidity providers and custodians.
Our article does not consider the current regulatory environment. For more information on the existing framework, please visit our older articles, which can be found here.
DIGITAL ASSETS
There is no general definition of digital assets under Japanese laws. Rather, the Payment Services Act (PSA) and the Financial Instruments and Exchange Act (FIEA) define certain types of digital assets. The definitions are mutually exclusive and — seen as a whole — form a complete picture covering cryptocurrencies, utility tokens and investment tokens.
In this article cryptocurrencies, utility tokens, and investment tokens have the following meanings: (i) cryptocurrencies are tokens which are intended to be used as means of payment, (ii) utility tokens give token holders access to an application or service and often serve as a platform-internal currency, (iii) investment tokens allow token holders to participate in the profits of the issuer or the underlying network. Besides these pure forms, hybrid forms exist. The regulatory treatment of these hybrid tokens must be assessed carefully on a case-by-case basis and are therefore not covered by this article.
Non-fungible tokens (NFT) and stable coins are not necessarily covered by the definitions in the PSA and the FIEA.
Crypto assets under the PSA
The PSA defines crypto assets exhaustively. Type I crypto assets are defined as property value that can be (i) used with unspecified persons for purchasing goods or services, (ii) purchased from and sold to unspecified persons acting as counterparty, and (iii) transferred electronically.
Type II crypto assets are property values that can be (i) mutually exchanged with type I crypto assets with unspecified persons acting as a counterparty and (ii) transferred electronically.
Currency denominated assets and electronically recorded transfer rights as defined in the FIEA are explicitly excluded from the definition of crypto assets.
Type I crypto assets: cryptocurrencies
Type II crypto assets: utility tokens
Electronically recorded transfer rights under the FIEA
For a better understanding of electronically recorded transfer rights, it is worth looking at the definition of securities under the FIEA. The FIEA contains a comprehensive list of securities and distinguishes between type I and type II securities. Type I securities are traditional securities such as bonds and stocks, which are generally perceived as being highly liquid. Type II securities are, for example, units in a fund, beneficial interests in a trust, membership rights in a general partnership or limited partnership, and equity in limited liability companies. These securities are generally much less liquid than type I securities and are therefore subject to lighter regulation. With the occurrence of tokenization, type II securities became, however — at least in theory — much more liquid. As a response, the legislator introduced electronically recorded transfer rights into the FIEA. These rights represent type II securities which are treated as type I securities.
The FIEA defines electronically recorded transfer rights as (i) electronically recorded property values that (ii) represent type II securities and can be (iii) transferred by electronic means. In addition, (iv) there must not be any liquidity constraints or other circumstances specified by cabinet order. Tokens that are sold to professional investors and for which the transferability is technically restricted, fall under the exemption of item (iv).
Tokens representing type I securities are not covered by the definition of electronically recorded transfer rights and are therefore not excluded from the definition of crypto assets. According to unofficial statements, the Financial Services Agency (FSA) considers type I securities as currency denominated assets, however, which are excluded from the definition of crypto assets as well.
Crypto derivatives
Crypto derivatives such as CFDs, futures, options, and swaps have become increasingly popular more recently. Some of them are said to legitimize crypto assets as a whole and to provide additional liquidity to crypto markets. In Japan, crypto derivatives account for roughly 90 percent of the total crypto trading volume.
Crypto assets as defined above are financial instruments within the meaning of the FIEA. Derivatives using crypto assets as underlying or crypto asset indices as reference indices are therefore covered by the FIEA. The FIEA distinguishes between derivatives transactions conducted on financial instruments market and OTC derivatives transactions.
Market derivatives transactions include futures, index futures, options, and swaps.
OTC derivatives transactions include forward contracts, index forward contracts, options, index options, and swaps.
Excursion — Physical Settlement and Crypto Asset Exchange License
Crypto assets are deemed money under certain provisions of the FIEA. Derivatives transactions may therefore be settled in cash or physically, i.e. by using crypto assets for settlement. The guidelines for crypto asset exchanges explicitly state that a crypto asset exchange license is not required in such cases. In cases of margin trading where crypto assets are taken as collateral, something different might apply.
If you want to learn more or should you need legal or regulatory advice, please feel free to contact us directly under https://innovationlaw.jp/en/.
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