In March 2019, the Financial Services Agency of Japan (FSA) proposed amendments to the Payment Services Act (PSA) and the Financial Instruments and Exchange Act (FIEA) to strengthen the protections for investors in crypto assets.[1] The proposed amendments were adopted by the Diet on May 31, 2019 and published on June 3, 2019.[2]

On April 3, 2020, the FSA published the finalized amendments to certain regulations and guidelines under the PSA and the FIEA to reflect and enforce these statutory amendments, together with the FSA’s answers to the public comments on the draft regulations published earlier by the FSA.[3],[4] The amendments to the PSA and the FIEA will come into effect as of May 1, 2020.

Below is a brief summary of the major amendments. The amendments to the FIEA also include changes to regulations related to electronically transferrable forms of securities, but we do not cover those amendments in this summary.

The final regulations are substantially the same as the draft published for public comments on January 14, 2020, which we introduced in our prior client alert[5] and have supplemented here with additional details concerning the amendments and the discussions on major issues in the public comment procedures.

The amendments taking effect as of May 1 are quite extensive and many issues regarding the scope, applicability, and relevance of the regulations remain open to interpretation. Therefore, operators who are engaged or are considering becoming engaged in the relevant business operations should be sure to confer with in-house or external counsel prior to engaging in crypto asset-related activities to confirm the precise requirements of the new regulations, which we expect will become clearer only over time.

1. Amendments to PSA regulations

The PSA regulates, among others entities, “crypto asset exchange service providers,” which is defined to include persons engaged in the business of selling, purchasing, intermediating the sale and purchase of, or providing custody services for, crypto assets. The custody service providers not engaged in the business of selling, purchasing, intermediating the sale and purchasing crypto assets were not previously regulated under the PSA, but have become subject to the PSA’s scope as of May 1, 2020, the effective date of the amendments.

The FIEA, and the regulations thereunder, are also amended as of May 1, 2020, and crypto asset-related derivatives businesses are now regulated under the FIEA, requiring registration under the FIEA to engage in such derivatives businesses. In this connection, crypto asset derivatives transactions to be settled by the delivery of crypto assets (as opposed to settlement by payment of cash), which are currently regulated under the PSA, will be regulated under the FIEA commencing as of May 1, 2020. However, if the provider of the crypto asset-related derivatives services also holds its customer’s crypto assets in custody, such service provider may also be deemed to be engaged in the provision of crypto asset custody services, which requires registration as a crypto asset exchange service provider after May 1, 2020 as well.

(1) Who will be deemed as engaged in the provision of crypto asset custody services?

Such services are defined in the amended PSA as “the business to be engaged in administration of crypto assets for third parties.”[6] The amended Administrative Guidelines (Book 3: Concerning Financial Service Companies; Chapter 16 Crypto Asset Exchange Service Providers)[7] (“PSA Guidelines”) sets forth in I-1-2-2 that “if the service provider holds secret keys sufficient for transferring the customer’s crypto assets for itself or together with its sub-contractor or related service provider, or can otherwise transfer in its initiative the customer’s crypto assets without the involvement of the customer, such service provider is considered as engaged in the administration of crypto assets for third parties” for the purpose of Article 2, Paragraph 5 of the amended PSA, and thus has to be registered as a crypto asset exchange service provider under the PSA.

A number of public comments were made concerning this provision of the PSA Guidelines.[8] According to the FSA’s answers to those comments, if under the system adopted for maintaining the customer’s crypto assets, a multi-signature system is adopted or otherwise the secret key is divided into pieces, and the service provider, together with its sub-contractor or sub-custodian, does not hold or control all of the necessary portions of the secret keys, such service provider would not be deemed to be “administering” the crypto assets and therefore would not be required to register under the PSA (unless it is engaged in sale and purchase, intermediary, or other forms of services as a crypto asset exchange service provider). It is suggested in the answers to the public comments that it would help to implement some multi-signature authorization system in which an essential piece of the secret key is maintained by the customer beyond the access by the service provider.  However, as the FSA emphasizes that case-by-case analysis based upon actual set of facts is required, each provider of services related to crypto asset custody should carefully review its business methods in determining whether the amended FSA applies to its services.

A person who is engaged in providing crypto asset custody services as of May 1, 2020 and becomes subject to the registration requirement under the amended PSA as of such date, may continue providing the custody services to its existing customers with respect to the same kinds of crypto assets[9] as are already under its custody for a period of six months after the effective date of the amendment. During this grace period, however, the conduct rules and other regulations under the amended PSA apply to the operations of the crypto asset custody services by such unregistered custody service provider. Such grace period will be extended if such unregistered custody service provider files for the registration as a crypto asset exchange service provider within such six-month period, until the result of such application becomes available or such person is ordered to stop providing the services under the amended PSA.[10]

(2) Certain additional requirements will apply with respect to applications for registration as a crypto asset exchange service provider, including:

• Holders of 10% or more of the voting rights in the applicant are required to be disclosed to the FSA.[11]
• With respect to capitalization and net assets, crypto asset exchange service providers will be required to maintain net assets of not less than the aggregate value of the crypto assets held in custody for customers in hot wallets, if the crypto asset exchange service provider holds customer assets in custody.[12] This is in addition to existing requirements that a crypto asset exchange service provider have a minimum stated capital of at least JPY 10 million and a positive amount of total “net assets” (total assets less total liabilities as reflected on its most recent balance sheet).

(3)  Requirements related to customer assets:

The amendment to the PSA made significant changes affecting crypto asset exchange service providers, including: a requirement that customer cash must be held in a trust account and an obligation to hold crypto assets in cold wallets or their equivalent (“cold wallets and equivalents”), with the limited exceptions and requirement that a crypto asset exchange service provider must hold its own crypto assets as security for potential customer claims in an amount equivalent to the customer assets held in hot wallets for exchange purposes.

The amended regulations require that the portion of crypto assets that can be held in a hot wallet must be 5% or less of the aggregate value of the customer crypto assets held in custody.

(i) Cash[13]

• Any cash held by a crypto asset exchange service provider for customers must be segregated from its own cash and maintained in a trust account opened with a licensed trustee, with the service provider’s customers designated as beneficiaries. The agents acting for the beneficiaries must be appointed by the crypto asset exchange service provider, at least one of which must be an attorney, an attorney corporation, a CPA, an accounting corporation, a tax accountant, a tax accountant corporation, or such other professional designated by the FSA. The trust assets may be invested in certain low-risk financial instruments, but this is subject to stringent restrictions. If the crypto asset exchange service provider loses its license or has its license suspended, becomes insolvent, or exits from the business, the trust assets will be placed under the control of the appointed agent in favor of the beneficiary.  In addition, crypto asset exchange service providers are required to compare the aggregate amount of customer cash held by such entity with the outstanding amount of trust assets every business day and, if there is any shortfall, must adjust the amount of the trust assets within two business days to become equivalent to or greater than customer cash held.

(ii) Crypto assets

• The customers’ crypto assets must be segregated from the crypto asset exchange service provider’s own assets and be maintained in cold wallets or their technical equivalents except to the extent necessary to facilitate the smooth operation of the exchange services. However, the portion of customers’ crypto assets that may be maintained outside cold wallets and equivalents (which must also be segregated) may not exceed 5% of the total value of all customer crypto assets under the custody of the crypto asset exchange service provider.[14]
• With respect to that portion of crypto assets not maintained in cold wallets and equivalents, the crypto asset exchange service provider must keep its own crypto assets (of the same kind and in the same quantity) segregated in separate cold wallets and equivalents, over which its customers will have priority claim over other creditors.[15]

• Under the amended PSA Ordinance, “cold wallets and equivalents” are described as follows:[16]

  “Methods of administering the information necessary for transferring the crypto assets of the users in the crypto asset exchange services by means of recording such information on electronic appliances, electromagnetic recording media or other recording media (which may include paper and other objects) which are always not connected to the internet, or, using other methods to administer such information with technological security measures of the equivalent safety level being implemented.”

  The PSA Guidelines clarify the meaning of the appliances/media “which are always not connected to the internet,” stating that “electronic appliances which have ever been connected to internet” do not satisfy such criteria.[17] The PSA Guidelines also refer to an example of “other methods to administer such information with technological security measures of the equivalent safety level being implemented.”[18] A number of public comments were made seeking additional guidance concerning “technological security measures of the equivalent safety level,” but the FSA did not provide additional examples, stating that whether a certain method satisfies the criteria must be examined on a case-by-case basis. Concerning public comments asking whether the “equivalent safety level” may be assured by procuring insurance or other contractual methods, the FSA responded that it is necessary to implement equivalent “technological security measures,” suggesting that the contractual measures would not be taken into consideration for this purpose.[19]

(iii) Audit[20]

• Crypto asset exchange service providers will have to have their administration and management of the assets referred to in (i) and (ii) above audited by a CPA or an accounting firm qualified to conduct such audit at least once a year.

(iv) Contingency Plan[21]

• Crypto asset exchange service providers must adopt and implement policies and plans to prepare for cases where such crypto asset service provider becomes unable to deliver crypto assets to the customers as required under its contracts with customers.

(4) Best execution, etc.

The amendments to the PSA also impose additional requirements on crypto asset exchange service providers, similar to those applicable to the securities brokers/dealers or the dealers of foreign exchange products pursuant to the FIEA (and regulations thereunder).

• The crypto asset exchange service provider must make available to its customers information regarding the most updated (recent) price at which it has executed orders for other customers, and the price quoted by the self-regulatory association (currently, Japan Virtual Currency Exchange Association).[22]
• The crypto asset exchange service provider must adopt appropriate procedures and policies for realizing “best executions” and publish such policy. The crypto asset exchange service provider must notify a customer if the service provider acted as the counter party in a transaction and explain why such activity is consistent with the best execution policy with supporting information in writing.[23]
• The crypto asset exchange service provider must adopt a system and policies to detect and monitor conflicts of interest in the transactions it facilitates and publish such policy.[24]
• The crypto asset exchange service provider must adopt measures to detect and suspend inappropriate trading (i.e., fraudulent conduct, market price manipulation, etc.).[25]
• The crypto asset exchange service provider is required to adopt the following measures:[26]
• Measures to avoid dealing with high-risk crypto assets;[27]
• Measures to administer non-public material information that may affect a customer’s decision as to whether to enter into transactions regarding crypto assets;[28]
• Disclosure of its accounting statements delivered to the FSA; and
• If it borrows crypto assets, measures to inform the counterparty regarding the accompanying risks and measures to avoid excessive borrowings.

(5) Prohibited actions[29]

A section entitled “prohibited actions” is also being added to the PSA. Once again, these requirements are similar to those applicable to securities brokers/dealers and/or the dealers of foreign exchange products pursuant to the FIEA (and regulations thereunder). The requirements imposed on crypto asset exchange service providers are quite detailed and beyond the scope of this article, but generally include:

• Provision of information on crypto assets or the crypto asset exchange service provider which is not based on reasonable grounds or supporting evidence;
• Solicitation without disclosing material information;
• Uninvited solicitation;
• Solicitation of transactions which are not suitable for respective customers;[30]
• Indication of assertive judgment on uncertain matters;
• Accepting orders with knowledge that the customer may be engaged in use of non-public material information or trading for another inappropriate purpose;
• Market price manipulations or its assistance;
• Communication or use of non-public material information that would affect investment decisions;
• Front-running; and
• Acts or omissions in violation of the rules of the JVCEA.[31]

(6) Regulations on margin trading transactions[32]

With respect to any margin trading transactions undertaken by a crypto asset exchange service provider, the PSA amendment imposes rules similar to, but more stringent than, those currently applicable to foreign exchange dealers.  These rules include requirements of appropriate disclosure and explanations regarding the transaction terms (including those concerning security deposits) and accompanying risks, mandatory obligations to receive security deposits (the minimum amount of which shall be not less than 50% of the value of the trade, or, alternatively for corporate customers, at a percentage calculated by the method prescribed by the order of the director general of the FSA), implementation of loss-cut rules, etc.

The 50% (or its alternative) deposit requirement does not apply until after May 1, 2021.[33]

The 50% deposit requirement and the threshold for the loss cut are quite stringent as compared to those imposed on FX transactions under the FIEA, and a number of requests were made in the public comments to revise the relevant provisions in the proposed amendments. However, the FSA did not change the provisions emphasizing the risks accompanying crypto asset transactions and the necessity of customer protection. The rules of the self-regulatory body had required a 25% deposit, and thus most service providers engaged in margin transactions will have to change their trade terms and to implement the amended regulations by not later than May 1, 2021.

(7) Restrictions on advertisements and marketingz

With respect to any advertisements for crypto asset exchange services, the amendments to the PSA will require the following information to be indicated “in accordance with the provisions in the Cabinet Office Ordinance”:[34]

• Corporate/trade name;
• The fact that the advertiser is a registered crypto asset exchange service provider and its registration number;
• The fact that crypto assets are not “currencies”;[35] and
• The nature of the applicable crypto assets, which may be material to a customer’s decision as to whether to enter into the transactions “and are designated in the cabinet Office Ordinance as such.”

The PSA Ordinance requires, in this respect, that the notification of these matters be made clearly and correctly, and that the latter two items must be conveyed using letters not smaller than the largest characters used in the same advertisement.[36]

The “natures of crypto assets” that are designated by PSA Ordinance as having to be indicated in advertisements are:[37]

• If the customer may suffer loss due to fluctuations in the value of the crypto assets, such fact and the reason why the customer may suffer loss; and
• The fact that crypto assets can be used for payments only if the counterparty consents to accept the crypto assets as payment.

The amended PSA also requires that, in conducting solicitations, a crypto asset service provider may not make any misleading statements “concerning the matters designated by the Cabinet Office Ordinance.”[38] Certain matters are designated as such in the PSA Ordinance.[39]

It must also be noted that, under the amended PSA, it will be prohibited to indicate in an advertisement any expression that would promote trades in crypto assets solely for the purpose of realizing capital gains as opposed to the purpose of using crypto assets as payment methods.[40]

(8) Other issues discussed in the public comments:

• A question was raised concerning whether so called “stable coins” are deemed crypto assets under the PSA.[41]  The FSA did not give a clear answer to the question.
• A question was raised as to, assuming that a fund investing in crypto assets is organized, whether the fund manager would be required to be registered as a crypto asset exchange service provider. The FSA responded that the fund manager may be required to be registered as such, assuming that it is authorized to purchase and sell crypto assets on behalf of the fund.[42]

2. Proposed amendments to FIEA-related regulations

Under the statutory amendments adopted by the Diet on May 31, 2019 and published on June 7, 2019, the FIEA was amended such that, among other things, (i) crypto assets are included in the definition of the “Financial Instruments,” (ii) investment interests in partnerships, etc. transferrable through a blockchain are treated as “securities” (i.e., not as “deemed securities” like usual partnership securities, the transfer of which is not in electronic methods), and (iii) fraudulent or deceptive acts, market manipulations, and other inappropriate conduct concerning crypto assets are prohibited and made subject to criminal sanctions.

Also, the securities falling under category (ii) above will be treated as “Paragraph 1 Securities” under the FIEA, which are subject to more stringent rules than those otherwise applicable to partnership interests deemed as securities (which are called “Paragraph 2 Securities”), for the purpose of the disclosure and broker/dealer registration requirements, unless the acquisition by or transfer to investors other than professionals or other qualified investors is restricted through implementation of technological measures.[43]

As a result of (i) above, crypto asset-related derivatives are included in the definition of “derivatives” regulated under the FIEA, and engaging in business to provide or intermediate crypto asset-related derivatives products/transactions constitutes a Type 1 Financial Instrument Business. As a result, engaging in business activities to provide investment advice or management concerning crypto asset-related derivatives constitutes an Investment Advisory Business or Investment Management Business. To engage in any such businesses, the relevant registration under the FIEA is required.[44]

As a result of (ii) above, broker/dealer business activities concerning security tokens (where the holder will participate in profits/losses of a business in which the proceeds from the tokens are invested)[45] constitute a Type 1 Financial Instrument Business (rather than the Type 2 Financial Instrument Business, which is a broker/dealer business concerning usual partnership interests, etc., and subject to a less stringent set of regulatory requirements), unless such tokens are made non-transferrable to persons other than limited categories of investors (in which case, dealing with such securities tokens will constitute a Type 2 Financial Instrument Business).[46]  In addition, to operate an exchange market for such tokens will be deemed as engaging in the operation of a securities exchange market, which requires much more stringent license and operational requirements.

If an existing registered financial instrument business operator engaged in a derivatives business also becomes engaged in a crypto asset-related derivatives business, such operator is required to file amendments to already filed documents, because, under the FIEA, crypto asset-related derivatives businesses are subject to requirements different from those applicable to other derivatives. In addition, Type 1 Financial Instrument Business Operators are required to notify the FSA of the fact that they have become engaged in crypto asset-related derivatives businesses and of certain particulars concerning such businesses.[47]  Registered investment advisors and investment managers are also subject to the same requirements if they are engaged in crypto asset-related businesses.

The amendments to the regulations under the FIEA include certain conduct rules applicable to the operators of Type 1 Financial Instrument Businesses related to crypto asset derivatives, many of which are similar to those applicable to the operators of currency derivatives businesses. Also included are requirements to provide information on the relevant crypto assets and accompanying risks, to implement rules and procedures for detecting and preventing transactions violating prohibitions of deceptive or fraudulent trades, market price manipulations, and other inappropriate conduct, which are similar to those applicable to crypto asset exchange service providers under the PSA.

For example, uninvited solicitations are restricted, and the Financial Instrument Business Operator entering into a renewable crypto asset-related derivatives transaction is required to receive security deposits for such a derivatives transaction subject to the requirements similar to those applicable to the margin transactions operated by the crypto asset exchange service providers.

* * * * *

The regulations coming into effect as of May 1, 2020 represent a significant change in the way the FSA will regulate cryptocurrency-related business activities of operators in Japan going forward. Due to the complexity of the new regulations and the breadth of changes being proposed, it will be important for both existing and new persons engaged in the business of selling, purchasing, intermediating the sale and purchase of, or providing custody services for, crypto assets to study these regulations closely and to confer with internal or external counsel to ensure that governing standards are understood and compliance is achieved.

[1] “Crypto assets” is the term assigned by the amended PSA to the cryptocurrencies/virtual currencies.  See Article 2, Paragraph 5 of the amended PSA.

[2] For the outline of these amendments, see: https://www.mofo.com/resources/insights/190409-japanese-crypto assets.html.

[3] Concerning the draft, see https://www.fsa.go.jp/news/r1/sonota/20200114/20200114.html.

[4] Concerning the results of the public comments and the final amendments, see https://www.fsa.go.jp/news/r1/sonota/20200403/20200403.html.

[5] https://www.mofo.com/resources/insights/200220-japanese-fintech-regulations.html.

[6] Article 2, Paragraph 7, Item 4 of the amended PSA.

[7] See https://www.fsa.go.jp/news/r1/sonota/20200403/21.pdf.

[8] Pages 5–9 of the FSA’s Answers to Public Comments at https://www.fsa.go.jp/news/r1/sonota/20200403/01.pdf.

[9] For the purpose of the PSA, for example “bitcoins” constitute a “kind” distinct from other crypto assets.

[10] Article 2 of the Supplementary Provisions to the amendments of June 3, 2019 to the PSA.

[11] Article 5, Item 3 and Article 8 of the draft amendments to the Cabinet Office Ordinance Concerning Crypto Asset Exchange Service Providers (“PSA Ordinance”).

[12] Article 9, Paragraph 1, Item 2 of the PSA Ordinance.

[13] Article 26 of the PSA Ordinance.

[14] Article 27 of the PSA Ordinance.

[15] Article 29 of the PSA Ordinance.

[16] Article 27, Paragraph 3, Item 1 of the PSA Ordinance.

[17] II-2-2-3-2(3)v of the PSA Guidelines.

[18] II-2-2-3-2(3)v of the PSA Guidelines.

[19] Pages 15–18 of the FSA’s Answers to Public Comments at https://www.fsa.go.jp/news/r1/sonota/20200403/01.pdf.

[20] Articles 28 and 30 of the PSA Ordinance.

[21] Article 23, Paragraph 3 of the PSA Ordinance.

[22] Article 23, Paragraph 2, Item 1 of the PSA Ordinance.

[23] Article 23, Paragraph 2, Item 2 of the PSA Ordinance.

[24] Article 23, Paragraph 2, Item 3 of the PSA Ordinance.

[25] Article 23, Paragraph 2, Item 4 of the PSA Ordinance.

[26] Article 23, Paragraph 1 of the PSA Ordinance.

[27] The Administrative Guidelines concerning crypto asset exchange service providers in I-1-2-3 refer to the factors that shall be considered in determining whether a particular crypto asset may be dealt with by a crypto asset exchange service provider.

[28] II-2-2-1-2(5)(i) of the PSA Guidelines refers to certain examples of the material information.

[29] Article 20 of the PSA Ordinance.

[30] II-2-1-3-2(1)(i) of the PSA Guidelines provides the FSA’s view concerning what kind of measures shall be implemented by the crypto asset exchange service providers in this connection.

[31] For JVCEA rules, see https://jvcea.or.jp/about/rule/. JVCEA has published proposed amendments to these rules, for public comments. See https://jvcea.or.jp/public_comment/. I-2-1-3-2(5)(iv) of the PSA Guidelines refers to the following examples: to recommend particular kind of crypto asset to an unidentified and large number of customers excessively for a certain period or otherwise take actions which may distort the pricing of such crypto asset; to sell to customers a particular kind of crypto assets in excess of the quantities held or having procured by the service provider; to provide special benefits to particular customers; to exercise deceptive or intimidating measures to cause the customer to enter into transactions; to conduct promotional activities at an inappropriate time of day or inappropriate place; and to enter into transaction for the account of the customer without prior consent by the customer.

[32] Article 25 of the PSA Ordinance.

[33] Article 3 of the Ancillary Provisions to the Cabinet Office Ordinance amending the PSA Ordinance.

[34] Article 63-9-2 of the amended PSA.

[35] “Currency” in this context means hard currency, the mandatory acceptance of which as payment is legally warranted by statute or regulation of some jurisdictions.

[36] Article 17 of the PSA Ordinance.

[37] Article 18 of the PSA Ordinance.

[38] Article 63-9-3 of the amended PSA.

[39] See Article 19 of the PSA Ordinance.

[40] Article 63-9-3, Item 3.

[41] “Economic value” denominated in some hard currency is excluded from the crypt assets by definition under Article 2, Paragraphs 5 and 6 of the PSA. If certain cryptocurrency is deemed as excluded from “crypto assets” because it is found denominated in some hard currency, there would arise different categories of issues such as whether its issuer is deemed to be taking deposits or providing fund transfer services, which are regulated by different sets of regulations and license requirements. These issues appear to have not been fully resolved, yet.

[42] Page 8 of the FSA’s Answers to Public Comments at https://www.fsa.go.jp/news/r1/sonota/20200403/01.pdf.

[43] Article 3, Paragraph 3 and Article 3, Item 3 “ro” of the FIEA, and Article 9-2 of the Cabinet Office Ordinance Concerning Definitions under Article 2 of Financial Instrument and Exchange Act.  Such qualified investors may include individuals with assets not less than JPY 100 million, at the time of the solicitation and actual acquisition of the “securities,” which the broker/dealer should verify by reasonable method. The placement of the securities token will be deemed as Financial Instrument Business even if the issuer itself conducts the solicitation, and therefore the issuer must retain a registered Financial Instrument Business Operator with the necessary qualification, or shall qualify for the exemption under Article 63 of the FIEA.

[44] Unlike other non-security-related derivatives, there is no exemption from the requirement to register as a Type 1 Financial Instrument Business Operator concerning crypto asset-related derivatives for solely trading with professionals to the extent the service provider has operations in Japan. There is some limited exemption for a foreign service provider legitimately operating a crypto asset derivatives business in its home country if such service provider solely trades with Japanese professionals operating solely from outside Japan.

[45] Such tokens are excluded from the “crypto assets” by definition. See Article 2, Paragraph 5 of the PSA.

[46] See footnote 44.

[47] Article 31, Paragraph 3 of the amended FIEA and Article 20-2 of the amended Cabinet Office Ordinance Concerning Financial Instrument Business Operators, etc.

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