The Current Development of Web3 in Japan and Its Impact on the Economy
Web3 is currently gaining momentum globally and has a significant impact on the economic market. The Japanese government is highly optimistic about the development potential of Web3. Since taking office in 2021, Japanese Prime Minister Fumio Kishida has been seeking to establish "a new form of capitalism" in Japan. The core of this initiative is to develop Japan's "digital economy in the Web3 era," which the government views as the "key" to creating Japan's economic future. In the current global "intense competition," Japan hopes to seize the momentum of blockchain development in East Asia by "pioneering the future of Web3."
I. Background of Web3 Development in Japan
In the early stages of Web development, Japan had once "led the world in the cryptocurrency industry." However, large-scale hacking incidents and strong regulatory responses led to a decline in the industry's reputation and regulatory burden. High taxes and a lack of regulatory transparency caused the once thriving cryptocurrency industry in Japan to fall into a predicament.
In 2014 and 2017, Japan's cryptocurrency industry experienced two serious hacking incidents. MtGox was hacked, resulting in the theft of approximately 850,000 bitcoins (BTC), and Coincheck suffered a hack that led to a loss of $500 million, severely damaging market consumer confidence. To prevent such major losses from recurring, the Japanese government actively formulated regulations to protect consumers and investors in its cryptocurrency industry.
Subsequently, regulatory authorities further required cryptocurrency exchanges operating in Japan to segregate customers' legal tender and cryptocurrency assets from the exchange's own assets. They were also required to entrust customers' funds to third-party Japanese banks or trust companies managed by trustees, with customers designated as beneficiaries. At least 95% of customers' funds were to be stored in "cold wallets" not connected to the internet, and the exchange was to support all internet-connected funds with cryptocurrency assets held in its own cold wallets.
Due to its strict consumer protection regulations, Japan was able to effectively mitigate the negative impact of the collapse of some well-known cryptocurrency exchanges in recent years. The Chief Financial Technology Officer of the Financial Services Agency (FSA) of Japan once stated that despite the "global bankruptcy crisis" faced by the FTX exchange, all "assets of Japanese customers are likely to be compensated due to protection from FTX."
II. The Road to Reform of Japan's Web3 Policies
Currently, the government of Prime Minister Kishida believes that "Japan plays a unique role in the cryptocurrency industry" and emphasizes that Japan now has the opportunity to implement a "national strategy" to vigorously promote the development of a Web3 business environment and international regulatory environment with international competitiveness.
In January 2022, the Japanese government launched a "national strategy," and the ruling party, the Liberal Democratic Party, established the Digital Society Promotion Headquarters. Since then, the Web3 project team has directly proposed legislative and regulatory reform suggestions to the ruling party, many of which have been adopted.
(A) Tax Reform in Japan
The most basic component of the "national strategy" launched by Japan is to create "a development environment and tax system that is attractive to entrepreneurs and engineers" to promote investment.
Currently, these tax reforms mainly focus on two aspects of tax policy: corporate year-end tax and individual tax rates.
1. Corporate year-end tax. In theory, all cryptocurrency assets held by companies (if these assets have an active market) need to be valued at market value. In other words, regardless of whether these assets are actively traded by the company or whether there is a loss of value during the year, companies holding these assets must be taxed based on their fair market value, which can sometimes be as high as 35%. Therefore, to promote a "token financing-friendly environment" for businesses, the Japanese Web3 policy team has proposed two additional reform policies.
First, the government exempts "tokens held by issuing companies" and "year-end market-to-market tax on corporate income." Second, the government exempts "tokens issued by other companies and held by third parties for non-short-term trading purposes."
The first reform took effect in June 2023. The second reform was proposed by the FSA to the Japanese legislative agenda for 2024 and was approved by METI. Implementing these two measures may alleviate the long-term disadvantage of domestic corporate investors in Japan compared to overseas investors who can rely on more favorable tax treatment.
2. Individual tax rates. Currently, income from cryptocurrency asset trading in Japan is taxed as "miscellaneous income," with a "minimum tax rate of 55%" when "income tax and resident tax" are combined. This tax is levied not only when cryptocurrency assets are exchanged for legal tender but also when they are exchanged for other cryptocurrency assets. This tax system is more stringent than that of most other countries, leading to a significant outflow of taxpayers or hindering taxpayers from filing taxes. Therefore, the Web3 policy team has proposed four reforms.
First, a unified tax of 20% on cryptocurrency asset trading. Second, taxation of "gains and losses" only when converted to legal tender, exempting taxation when exchanging cryptocurrency assets. Third, allowing individuals to carry forward losses for up to three years. Fourth, applying the same tax rate to "cryptocurrency derivative trading."
Although the Digital Society Promotion Headquarters of Japan proposed emergency measures in November 2022, these reforms were excluded from the 2023 agenda, and it is currently unclear whether these proposals will be part of the 2024 legislative agenda.
(B) Regulatory Framework for Stablecoins
Another pillar of Japan's "national strategy" is to promote the issuance and circulation of unlicensed stablecoins. As of this year, the total market value of stablecoins is $129.5 billion. Creating a market environment where stablecoins can be used safely and openly is essential for influencing and capturing part of the market and promoting digital asset trading and other Web3 industries.
In June 2022, Japan became one of the first major economies to provide a regulatory framework for stablecoins. Japan's newly revised "Payment Services Act" defines stablecoins as "electronic payment tools" and establishes a new regulated category of "electronic payment tool intermediaries," which came into effect on June 1, 2023.
Under the law, trust companies and fund transfer operators have the right to issue and trade stablecoins based on existing capital maintenance requirements. This enables them to enter the "¥100 trillion enterprise payment settlement market" annually. Four major banks and digital lending institutions have planned to issue their own stablecoins, including Mitsubishi UFJ Financial Group (MUFG), which is preparing to issue Progmat Coin pegged to the yen. In addition, traditional companies that previously "rarely ventured into cryptocurrency assets" are making significant investments in the Web3 field.
(C) Non-Fungible Tokens (NFTs)
In April 2022, the Web3 policy team (then known as the NFT Policy Project Team) released its first white paper outlining the "national strategy for developing (Japan's) digital economy in the Web3 era," including "NFTs," which marked the starting point of Japan's "national strategy" for digital assets in the Web3 era.
Japan views NFTs as a catalyst for the "digital economy in the Web3 era." The NFT market has grown from "¥40 billion in 2020" to "over ¥4.7 trillion in 2021." Japan possesses rich, high-quality intellectual property and believes that animation and games have international competitiveness, giving Japan enormous potential to lead the world in the NFT and even the Web3 field.
To leverage its intellectual property and the growth advantage of the NFT market, Japan has been seeking to promote the development of its NFT industry. One of the measures it has taken is to relax regulations on some NFTs as cryptocurrency assets.
However, NFT companies and content creators still "face significant obstacles." On the one hand, the ambiguity of regulations has led companies to adopt popular NFT models, such as the "random sales model of NFTs" combined with "secondary market trading," which is common in fantasy sports in the United States and Europe. Companies are concerned that this may violate Japan's anti-gambling laws, and it is unclear whether Japanese companies can legally license their intellectual property for overseas NFT businesses. The inability of Japanese companies to enter the market has raised concerns about other companies "free-riding" and their valuable intellectual property.
In addition to protecting the rights of content holders and safeguarding their data, clarifying and updating these legal barriers is necessary for "the further development of Japan's content industry in the Web3 era."
(D) Investment
Another aspect of Japan's "national strategy" is the reform of existing corporate forms to promote "public and private funding for blockchain-related businesses." Globally, in 2022, Web3 startups "raised $15.1 billion," a 15-fold increase from 2018. Japan believes that with the establishment of "appropriate legal and tax frameworks," it can leverage this momentum to encourage investors to "gather in Japan."
Part of establishing an appropriate legal framework is opening up new financing channels for partnerships through digital assets and recognizing new company forms based on Web3 technology: Decentralized Autonomous Organizations (DAOs).
Currently, Japan restricts investment business limited partnership enterprises to raise funds only through traditional means (stocks, stock options, and security tokens). These partnerships also need to invest more than half of their capital domestically. The Ministry of Economy, Trade, and Industry of Japan is considering lifting these two restrictions in 2024. This would allow startups to raise funds by selling digital assets and provide more investment opportunities to maximize capital growth, allowing for more reinvestment in domestic startups.
Another driving force is the recognition of DAOs. DAOs are entities operated by granting governance voting functions to owners through secure tokens. This makes membership and operations smooth and fast. However, currently, "there is no clear legal framework to ensure that members of DAOs have limited liability," which hinders the operation of sufficiently flexible company forms. Even the limited liability company model has certain rules, such as requiring the listing of all members and their personal information in the company's articles of association, creating an unbearable administrative burden. Although the Web3 policy team often recommends reforms in this area, it is unclear when such reforms will take place. However, the Digital Department has already created its own DAO to promote research.
(V) International Leadership
While the "national strategy" focuses on domestic development in Japan, a key goal has always been to gain international leadership in the field.
Regionally, Japan has begun to emerge as one of the leaders in the digital market. In May 2023, Prime Minister Kishida launched the Digital Innovation Center at the ASEAN+3 Economic Research Institute, emphasizing the regional cross-border payment system developed in collaboration with Japanese startups and the National Bank of Cambodia, called the "Bakong system," which connects cross-border payments across the region using Cambodia's CBDC and stablecoins.
On a global scale, Japan holds the presidency of the G7 in 2023 and seeks to "play an active leadership role in the field" during its tenure as the rotating presidency. In particular, it is trying to emphasize its strong history of "consumer and investor protection," establish unified private international law on data and digital asset transfers, and promote the adoption of "Travel Rules" for digital assets to combat money laundering and terrorism.
Japan has fully utilized its opportunity as the rotating presidency of the G7, and other member countries seem to support the key points of Japan's "national strategy" talks. G7 leaders unanimously believe that regulation and supervision are crucial for addressing the risks of cryptocurrency activities, avoiding regulatory arbitrage, and supporting responsible innovation. Central bank governors of various countries unanimously agree that a "reliable, stable, and transparent global payment system is a key foundation of their economies," and Web3 technologies such as CBDCs and stablecoins can "play a significant role." Digital and technology ministers of various countries agree with Japan's vision of "Society 5.0" and the proposal to develop an "innovative and competitive digital ecosystem."
III. Japan's Hopes for the New Web3 Policies
Japanese lawmakers Masaaki Taira and Hideto Kawasaki expressed their hope for Japan to formulate formal Web3 policies in an interview with CoinDesk Japan on January 24, 2024.
The country has been exploring different ways to regulate Web3. In April 2023, the Liberal Democratic Party's Web3 Project Team (Web3PT) released a white paper calling for the development of various Web3 projects using blockchain technology.
At the end of 2023, Japan also held a hackathon to develop rules for Decentralized Autonomous Organizations (DAOs), where stakeholders could express their expectations to policymakers. "Through the hackathon, short-term and medium-term issues became clear," added Kawasaki, who also serves as the Executive Director of Web3PT.
Another area of note is the need for clearer regulations for DAOs and whether companies need to implement smart contracts to be classified as DAOs. Taira, the chairman of Web3PT, believes that over time, this scope will narrow.
Kawasaki also stated, "The next step will be to clearly reflect this in the next white paper." He added that they need to establish regulations for DAOs, "Furthermore, we hope to grasp the current situation outside of DAOs within Web3PT and identify new policy points."
IV. Other Regulations and Regulatory Policies
(A) Cryptocurrency Exchange Services
The Cryptocurrency Asset Management Regulations came into effect on April 1, 2017. The PSA was amended to introduce registration requirements for "cryptocurrency asset exchange service providers." In June 2019, the PSA was further revised to strengthen customer protection by introducing stricter regulations applicable to cryptocurrency assets, and the revised PSA came into effect on May 1, 2020.
As per the PSA, "cryptocurrency assets" are defined as:
A proprietary value that can be used to pay for any goods or services provided to unspecified persons, where such proprietary value can (a) be sold to or purchased from unspecified persons, provided that such sales and purchases are recorded through electronic means on electronic devices or other devices, and (b) be transferred through an electronic data processing system; or
Can be exchanged with unspecified persons for the aforementioned proprietary value and can be transferred through an electronic data processing system.
Most so-called payment tokens and utility tokens fall within the definition of cryptocurrency assets.
Cryptocurrency Asset Exchange Services ("CAES") are defined to include any of the following activities conducted as a business:
Selling/purchasing cryptocurrency assets or exchanging other cryptocurrency assets;
Providing intermediary, agency, or trust services related to the listed activities, or managing user funds related to the listed activities.
Or managing cryptocurrency assets for the benefit of others.
According to this definition, not only typical cryptocurrency exchanges but also so-called over-the-counter (OTC) brokers are regulated as CAES providers under the PSA. Additionally, most initial coin offerings (ICOs) or token sales fall within the definition of CAES. Therefore, as a general rule, if a token sale (i.e., ICO) targets Japanese residents, the token issuer must register as a CAES provider. Despite the above provisions, if the issuer has completely outsourced its token issuance to a reliable ICO platform provider registered as a CAES provider, the token issuer does not need to register as a CAES provider.
It is worth noting that according to the 2019 amendment to the PSA, managing customers' cryptocurrency assets and transferring such assets to addresses specified by customers constitutes CAES, as "managing cryptocurrency assets for the benefit of others" has been included. Therefore, if a custodial wallet service provider offers wallet services to Japanese residents, it must register as a CAES provider.
CAES providers must manage their customers' funds separately from their own funds and entrust their customers' funds to a trust company or any other similar entity. CAES providers should manage entrusted cryptocurrency assets ("entrusted CA") separately from their own cryptocurrency assets. Additionally, CAES providers also need to manage the total value of entrusted CA at 95% or above through fully offline wallets or other technical measures with an equivalent level of security.
(B) Cryptocurrency Derivatives
The revised "Financial Instruments and Exchange Act" ("FIEA"), which came into effect on May 1, 2020, contains specific provisions for cryptocurrency derivatives. It includes the standardization of cryptocurrency assets created by financial instrument exchanges as financial instruments, and incorporates cryptocurrency asset prices, interest rates, etc., into the definition of financial indicators. Trading in cryptocurrency derivatives must now comply with the regulations of the FIEA, regardless of the type of derivative trading involved. For example, providing over-the-counter cryptocurrency derivative trading or acting as a related intermediary or broker constitutes the first category of financial instrument business under the revised "Foreign Investment Law." Therefore, companies engaging in these transactions need to register as Category 1 Financial Instruments Business Operators ("Category 1 FIBO").
In addition to various conduct rules applicable to Category 1 FIBOs providing cryptocurrency derivative services under the FIEA, it is noteworthy that the revised FIEA introduces strict leverage ratio regulations. If a Category 1 FIBO engages in cryptocurrency derivative trading, the amount of margin deposited by clients must: (i) if the client is an individual, not be less than 50% of the cryptocurrency derivative trading amount (i.e., the leverage multiple is limited to two times); (ii) if the client is a company, not be less than 50% of the cryptocurrency derivative trading amount multiplied by 50% or based on the cryptocurrency risk-bearing rate based on historical cryptocurrency volatility specified in the announcement issued by the FSA titled "Establishment of Cryptocurrency Risk-Bearing Rate Calculation Method in Cryptocurrency Leverage Trading."5
(III) Digital Securities
In accordance with the FIEA, securities are conventionally divided into: (i) traditional securities such as stocks and bonds ("Type 1 Securities"); and (ii) contractual rights such as beneficial interests in trusts and interests in collective investment schemes ("Type 2 Securities").
Due to the higher liquidity of Type 1 Securities, they are subject to relatively strict disclosure and licensing/registration requirements, while Type 2 Securities, due to their lower liquidity, are subject to relatively lenient disclosure and licensing/registration requirements. However, if securities are issued using electronic data processing systems such as blockchain, it is expected that such securities may have higher liquidity than securities issued using traditional methods, whether they are Type 1 or Type 2 Securities. Therefore, the revised FIEA introduces a new regulatory framework for securities transferable through electronic data processing systems. According to the revised FIEA, securities transferable through electronic data processing systems are classified into the following three categories:
Type 1 Securities, such as stocks and bonds transferable through electronic data processing systems (tokenized Type 1 Securities).
Contractual rights such as beneficial interests in trusts and interests in collective investment schemes, typically classified as Type 2 Securities, transferable through electronic data processing systems (electronically recorded transferable rights ("ERTR")).
Contractual rights such as beneficial interests in trusts and interests in collective investment schemes, typically classified as Type 2 Securities, transferable through electronic data processing systems, but with a certain degree of liquidity restriction (non-ERTR tokenized Type 2 Securities).
In principle, issuers of tokenized Type 1 Securities or ERTR must submit a securities registration statement before conducting public offerings or secondary offerings, similar to traditional Type 1 Securities. Anyone engaged in the sale, purchase, or handling of tokenized Type 1 Securities or ERTR issuance business must register as a Category 1 FIBO. Given the high degree of freedom in designing tokenized Type 1 Securities or ERTR and their high liquidity, Category 1 FIBOs handling these digital securities are required to control risks related to digital networks.
(IV) Electronic Payment Intermediary Services
On June 1, 2018, the "Banking Act" was amended to regulate electronic payment intermediary service providers to promote open APIs. The definition of electronic payment intermediary service providers is broad, including entities that act as intermediaries between financial institutions and customers, such as entities that convey payment instructions to banks using information technology on behalf of customers or provide customers with information about their financial accounts using information technology. Entities providing financial account aggregation services are also classified as electronic payment intermediary service providers. They must register with the FSA to provide these services.
The following are the main regulations applicable to registered electronic payment intermediary service providers:
Providers of electronic payment intermediary services intending to engage in electronic payment intermediary business must disclose certain matters in advance as a principle. These matters include the merchant number or address, permissions, compensation, and contact information for the office handling complaints.
For electronic payment intermediary services, providers must (a) provide information to prevent misunderstandings; (b) ensure the proper handling of user information; (c) maintain security management measures; and (d) take measures to manage outsourced contractors.
Before implementing electronic payment intermediary services, providers of electronic payment intermediary services must enter into electronic payment intermediary service contracts with banks.
The contracts must specify (a) the allocation of liability for compensation when users suffer damages; (b) measures for the proper handling of user information; and (c) security management measures. Banks and providers of electronic payment intermediary services must immediately disclose items (a) to (c) above when entering into contracts.
(V) Financial Services Intermediary Business
In June 2020, the "Financial Instruments Sales and Other Laws" were amended to establish an industry suitable for financial services intermediary businesses. Financial services intermediary businesses seek to provide convenient one-stop services, allowing users to access various financial services. The amendment came into effect in November 2021, and the law was renamed the "Financial Services Provider Act."
Under Japan's previous regulatory framework, financial intermediary services were divided by "function," such as bank agency and electronic payment service providers under the "Banking Act," financial instrument intermediary service providers under the "FIEA," and insurance agents and insurance brokers under the "Insurance Act." Therefore, operators handling products and services across multiple "functions" would need to apply for multiple licenses.
Under the new framework, operators will be allowed to act as intermediaries for cross-sector financial services by re-registering as "Financial Services Intermediary Business Operators" ("FSIBO").
Conclusion
Japan's WEB3 regulatory policies will continue to be updated and implemented in the coming years, with the government proposing new reform suggestions and tracking progress. Japan is taking the future of the digital economy seriously, but as the head of the Japanese Digital Department said, their work is just beginning.
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