DIGITAL ASSETS AND MARKET INFRASTRUCTURES IN JAPAN (PART III)
Secondary markets for cryptocurrencies, utility tokens, investment tokens, and crypto derivatives
Similar to the offering of tokens on the primary market, the trading on the secondary market is subject to different laws depending on whether the token is a crypto asset under the PSA or a tokenized security/electronically recorded transfer right under the FIEA. Crypto asset exchanges licensed under the PSA may not trade security tokens and vice versa.
In this section, we take a closer look at the secondary markets and other key players supporting the trading infrastructure.
Utility tokens
Crypto Asset Exchanges
Under the PSA crypto asset exchanges and other companies providing crypto asset exchange services must register as crypto asset exchange service providers with the FSA. Crypto asset exchange services are defined broadly and cover the following activities, provided they are carried out as a business:
(i.) purchase and sale of crypto assets or exchange with other crypto assets
(ii.) intermediary, brokerage or agency services for the purchase and sale of crypto assets or exchange with other crypto assets
(iii.) custody services for crypto assets
Given the broad definition of crypto asset exchange services, not only crypto asset exchanges must register with the FSA but also other service providers engaging in crypto-related activities (for custody services see below).
Crypto asset exchanges must implement corporate governance and security systems that ensure fair dealing on the exchange and reduce operational risks.This includes among others to
(i.) establish and maintain a business management system
(ii.) comply with AML/CFT regulations
(iii.) eliminate relationships with anti-social forces
(iv.) ensure the protection of customers and their funds (e.g. segregation of funds, storing funds in cold wallets, and retaining own funds equivalent to the users’ funds held in a hot wallet)
(v.) implement and maintain an information security management system
(vi.) prepare, submit, and maintain records related to crypto asset exchange services
(vii.) prohibit misleading advertisement and advertisement of speculative trading
(viii.) prohibit and report unfair trading practices (e.g. market manipulation)
(ix.) make prior notification to the FSA in case of changes (e.g. listing of new tokens, change of scope of crypto asset exchange services)
This list is not exhaustive, and further obligations arise under subsidiary legislation and self-regulation imposed by the Japanese Virtual Currency Exchange Association (JVCEA). The self-regulation rules by the JVCEA consistently extend existing regulations and specify in greater detail the obligations under the PSA and AML/CFT regulations.
Crypto asset exchanges and other service providers registered as crypto asset exchange service providers must not engage in activities related to security tokens. These activities are exclusively subject to the FIEA and require additional registrations/licenses.
Excursion: Listing of new tokens
Each token must be analyzed in detail before listing. Where a token violates laws or is likely to be used for criminal activities (incl. money laundering), it must not be listed. This applies in particular for privacy coins for which transactions are anonymous or extremely difficult to track. The results of the analysis must be reported to the board of directors and eventually to the JVCEA. In cases in which the JVCEA does not approve the listing, the respective token must not be listed. The listing of the new token must further be notified to the FSA prior to the token being listed.
Excursion: Margin trading
Crypto asset exchanges providing leverage must inform their users about the risks of margin trading, circuit breakers (if any), as well as the deadline and modalities of repayment. For retail investors, the leverage must not exceed 2x. For corporate clients, there is no fixed maximum leverage. Instead, the ratio may be determined independently by the respective exchange based on a quantitative calculation model or by the JVCEA. Crypto asset exchanges that do not wish to use these ratios may alternatively use the standard leverage of 2x for corporate clients as well. Security deposits may be paid both in fiat and crypto assets. The amount required as a security deposit is calculated each business day. In case of deficiencies, additional payments must be made within 48 hours from the time detecting the deficiency.
Crypto asset exchanges lending fiat to their users must additionally apply for a money lending license under the Money Lending Business Act. Exchanges lending crypto assets do not have to apply for such license.
OTC trading
Given the broad definition of crypto asset exchange services, OTC desks generally seem to be regulated under the PSA at first sight. This applies to both principal desks and agency desks. A closer look at the definition of crypto asset exchange services reveals however, that this is not necessarily the case.
Principal desks: Principal desks buy and sell crypto assets in their own name and on their own account and become counterparty to each transaction. Exchanging crypto assets into fiat currencies and vice versa generally falls under buying and selling of crypto assets as defined in the PSA. The same is true for exchanging crypto assets with other crypto assets.
Agency desks: Agency desks do not become a counterparty to transactions. Rather they act as pure intermediaries and broker deals on behalf of their clients. Such activities constitute intermediary services that are generally covered by the PSA.
The reason why many OTC activities are excluded from the registration requirement under the PSA is that those activities are not performed ‘in the course of business’ as interpreted by the FSA. While the term is generally interpreted broadly, it only covers situations in which the respective party faces the public, i.e. an unspecified large number of people, and does so with a certain continuity. Whether this is the case must be determined on a case-by-case basis. Depending on the facts and circumstances of each case, OTC desks may or may not be covered by the definition of crypto asset exchange services. Engaging in trades with one or a few registered crypto asset exchanges does generally not trigger the license requirement under the PSA. A one-size-fits-all solution does, however, not exist.
Professional Traders / Market Makers / Liquidity Providers
Trading activities of professional traders and market makers do not constitute crypto asset exchange services under the PSA. This is due to the fact that proprietary trading is not considered a purchase or sale of crypto assets as a business under the PSA. The reason for this is that the PSA aims to regulate certain activities that pose a risk to the public. It does, however, not intend to regulate all activities related to crypto assets. Trading on regulated exchanges does not pose additional risks to the public and does therefore not fall within the ambit of crypto asset exchange services under the PSA.
Security tokens
The trading of security tokens on secondary markets is a problem not solved yet. While crypto asset exchanges typically have the infrastructure, they are not allowed to list security tokens on their exchanges. Regulated exchanges, OTC markets, and proprietary trading systems (PTS), as defined in the FIEA, on the other hand, are permitted to trade security tokens but currently lack the required infrastructure.
Exchanges for tokenized securities and electronically recorded transfer rights
The FIEA defines a financial instruments market as a market for the purchase and sale of securities and market derivatives. Accordingly, the definition comprises markets for tokenized securities and electronically recorded transfer rights as defined in part I. Persons who intend to operate a financial instruments market must obtain a license by the FSA. Something different only applies to the operators of OTC markets and PTS.
Financial Instruments Exchanges: Under the FIEA, a financial instruments exchange may only be established and operated by (i) a financial instruments membership corporation or (ii) a stock company.
A financial instruments member corporation is a legal entity established by a FIBO to operate a financial instruments exchange. Membership in financial instruments member corporations is restricted to FIBOs only. If the number of members falls below six members, the financial instruments member corporation must be dissolved. The same applies if the corporation is not granted a financial instruments exchange license by the FSA. Unlike financial instrument exchanges established by stock companies, exchanges established by financial instruments member corporations may not be operated for profit.
Stock companies establishing a financial instruments exchange must have a stated capital of at least JPY 1 billion. Shareholders are generally prohibited from holding 20 percent or more of the total voting rights.
Out of the five stock exchanges in Japan, two are established as financial instruments member corporations — namely the Fukuoka Stock Exchange (FSE) and the Sapporo Securities Exchange (SSE) — and three as stock companies. The latter comprise the Tokyo Stock Exchange (TSE), the Osaka Stock Exchange (OSE), and the Nagoya Stock Exchange (NSE).
None of the existing exchanges has expressed the intention to establish an exchange for tokenized securities and electronically recorded transfer rights so far. Since this is unlikely to change any time soon, this opens opportunities for challengers in the digital assets space.
OTC Markets: For securities not listed on a financial instruments exchange, the FIEA provides that these securities may be traded on an OTC market established by an authorized financial instruments firms association (SROs). SROs are incorporated by FIBOs as general incorporated associations to ensure fair and orderly trading of securities and derivatives as well as to protect investors. To be recognized as an SRO, the association must be authorized by the FSA. Only then it may carry out the self-regulatory functions laid down in the FIEA and operate an OTC market. Membership in an SRO is limited to FIBOs. Similar to financial instruments exchanges operated by financial instruments member corporations, OTC markets must not conduct business for profit.
Under the FIEA, SROs operating an OTC market are required to register the class and issues of securities traded on the OTC market and make a copy of the register available for public inspection. The SRO must further disclose the trading volume and other particulars for each trading day and issue to its members and the public and report the same to the FSA.
Securities traded on an OTC market may only be traded among the members of the SRO either on their own account or as intermediaries. Depending on its articles of incorporation, an SRO may prohibit its members from taking purchase orders other than from professional investors.
Currently, the only eligible SRO, the Japanese Securities Dealers Association (JSDA), does not operate an OTC market. The Japan STO Association, which currently applies to become the SRO for security tokens and comprising of six major Japanese brokerages, has not expressed the intention to operate an OTC market for tokenized securities or electronically recorded transfer rights yet.
PTS: PTS are similar to Alternative Trading Systems (ATS) in the U.S. and Multilateral Trading Facilities (MTF) in the EU. They were introduced in 1998 to improve investor confidence through competition and to respond to investor demands for more options. Until then, listed securities could only be traded on financial instruments exchanges.
A person operating a PTS conducts financial instruments business within the meaning of the FIEA and must, therefore, register as a type I FIBO with the FSA. According to the FIEA, the prices for securities traded on the PTS must be determined by one of the following methods:
(i.) methods that use the trading price of securities listed on a financial instruments exchange
(ii.) methods that use the trading price published by the financial instruments dealer association for securities traded OTC
(iii.) methods that use the price negotiated by buyer and seller
(iv.) methods that use prices indicated by a buyer and a seller and that match corresponding orders
(v.) methods by which the operator of a PTS offers ask or bid prices on its own or through price feeds of other FIBOs excluding such cases in which the FIBOs are legally obliged to constantly quote bid and ask prices (so-called market-making method)
(vi.) double auction methods
For PTS using a double auction method for price discovery, there are certain restrictions. According to the Enforcement Order, the average daily trading volume of listed securities on PTS may not exceed a certain percentage of the average daily trading volume on all financial instrument exchanges and OTC markets. Broadly speaking, the threshold is 1 percent of the total average daily trading volume for all securities listed on a financial instruments exchange or OTC market and 10 percent of the total average trading volume for single securities listed on a financial instruments exchange or OTC market. PTS exceeding these thresholds must apply for a financial instruments exchange license.
Given the fact that there are no security token markets which are operated by financial instrument exchanges or OTC markets, it is unclear whether PTS can only determine the prices of security tokens in accordance with the methods described under in item (iii) to (v) above.
Discussions are still ongoing, and the outcome is not clear yet. The argument for making PTS subject to the existence of financial instruments exchanges and OTS markets — at least for the methods indicated under items (i), (ii), and (iv) — is that the legislator only intended to increase competition with existing markets, but not to establish an independent framework for secondary markets. In order to maintain a level playing field between traditional securities markets and markets for security tokens, the same must apply to security token markets. On the contrary, it can be argued that the legislator only wanted to prevent liquidity drainage from financial instruments exchanges. For securities not listed on one of the licensed exchanges, such risk does not exist. Unlisted securities, whether tokenized or not, may therefore be traded on PTS, provided of course, the company establishing the PTS complies with other requirements laid down in the FIEA. The same applies to OTC markets. Where none of them exist, the risk of liquidity drainage is effectively non-existent.
Allowing FIBOs to operate PTS would also be in line with developments in other jurisdictions, namely the U.S., where crypto companies have acquired ATS in the past to get access to the desired license and to operate secondary markets for security tokens. Provided, the FSA follows this approach, companies seeking to establish a trading platform for security tokens by way of PTS must register as FIBO or acquire a company already registered. Compared to obtaining the financial instruments exchange license, this would most likely be the way to go for most companies. It is reported that several securities companies intend to jointly establish a new PTS securities company in 2020.
OTC
Proprietary trading of securities, and therefore also of tokenized securities and electronically recorded transfer rights, does generally not constitute financial instrument business under the FIEA. Something different applies, however, if the respective entity deals with an unspecified large number of people with a certain degree of continuity.
Intermediary services for OTC trading also fall under the definition of financial instruments business, so that it is necessary to register as a FIBO.
Professional Traders and Liquidity Providers
Proprietary trading on financial instruments exchanges and PTS is generally not regulated under the FIEA. This also applies to the vast majority of liquidity providers. An exception is made, however, for high-frequency traders which are not subject to other registration requirements under the FIEA. These traders are required to register with the FSA.
Derivatives
As indicated above, the FIEA distinguishes between market derivatives transactions and OTC derivatives transactions. Market derivatives transactions are such derivatives transactions that are conducted on a financial instruments market. The focus here will be on OTC derivatives transactions, i.e. derivatives transactions, which are performed on a bilateral basis.
Entities engaging in crypto derivatives transactions engage in the financial instruments business as defined in the FIEA and must, therefore, register as a Type I FIBO. An exception is generally made for entities engaging in crypto derivatives transactions with certain counterparties. This includes among others derivative transactions with type I FIBO and qualified institutional investors as defined in the Cabinet Order on Definitions (e.g. financial institutions, high-net-worth individuals). The same applies where the counterparties are equivalent to the aforementioned persons under the laws of another jurisdiction or where the counterparty is a company with a stated capital of JPY 1 billion or more. While this seems to be good news, crypto derivatives are explicitly excluded from the exemption. Companies engaging in crypto derivatives transactions must therefore generally register with the FSA as a type I FIBO. Something different only applies in cases where a FIBO, which conducts an OTC crypto derivatives business in Japan, executes cover transactions with a person engaging in the crypto derivatives business under the laws of another jurisdiction. Provided the foreign entity does not conduct the crypto derivatives transactions from Japan, it does not have to register as a type I FIBO in Japan.
Except for this particular case, companies engaging in crypto derivatives must register as type I FIBO in Japan.
Excursion: Margin trading
The maximum leverage for crypto derivatives transactions is 2x for individuals. For corporations, there is no maximum threshold. Similar to margin trading on crypto asset exchanges, the ratio must be determined by the service provider on a case-by-case basis. In the absence of such a decision, the maximum leverage will be 2x for corporate clients as well.
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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