The recent collapse of FTX, one of the world's major cryptocurrency exchanges, has prompted policymakers across the globe to examine stricter regulations for the industry. In Japan, the episode has sparked a sense of deja vu.
In January 2018, a massive hack of Tokyo-based crypto exchange Coincheck saw the theft of about ¥58 billion ($446 million at current exchange rates) worth of digital tokens, sparking calls for stringent regulations and prodding the country’s financial watchdog to initiate a sweeping crackdown on domestic exchanges.
Prior to the Coincheck incident, Japan had been seen as a leading nation in the crypto world, as the country set related regulations ahead of other major nations and enjoyed huge exchange volumes for bitcoin. But the tightened rules cast a pall over the sector, with a slew of the exchanges struggling to keep up with the regulatory standards.
Early indications in the wake of the fall of FTX — the low point of an already tough year for the wider crypto industry — are that Japan made the right move back in 2018. But amid 2022’s downturn and the ongoing impact of the nation’s tighter regulations, some ruling party lawmakers are pushing for a greater embrace of the virtual economy, betting that so-called Web3 businesses underpinned by crypto technology can be a pillar of growth.
Past fiascos
The Coincheck heist was not the first crypto debacle in Japan, with Mt. Gox, then the world’s largest crypto exchange, in 2014 losing a stash of bitcoin then worth about ¥48 billion.
Based on lessons from the Mt. Gox incident, Japan introduced legal revisions to tighten regulations on virtual currency exchanges in 2017.
The law mandates that cryptocurrency exchanges must register with the government and submit annual reports, while giving the Financial Services Agency the power to conduct on-site inspections and issue business improvement orders. The rules also require operators to confirm the identities of customers to prevent crypto assets from being used for money laundering or terrorism.
“Japan is quite well developed, comparatively speaking. Japan was an early mover in terms of regulating crypto and the activities surrounding cryptocurrencies,” said Maurizio Raffone, chief financial officer at Credify, a fintech startup focused on embedded finance and blockchain-based services in Asia.
“We’ve seen legislation coming in over the last few years. We have a self-governance entity ... which (does) a good job of promoting best practices in the industry and transparency. On the surface, from purely a regulatory point of view, Japan has got its act together.”
But to get to that point, Japanese exchanges had to learn the hard way.
Amid the crypto bubble in late 2017, a raft of exchange operators — often young startups — became preoccupied with just handling daily operations even as inadequate governance and security issues persisted, eventually leading to the Coincheck incident.
“We were in the middle of (the bubble). The speed of the market growth was so rapid that we were unable to build a robust business operational structure,” said Noriyuki Hirosue, who heads Bitbank, a Tokyo-based exchange that he founded in 2014. Hirosue also chairs the Japan Cryptoasset Business Association.
“We saw tens of thousands of customers wanting to be users on a daily basis. It was difficult to even properly handle their registrations.”
Then the industry was hit by the Coincheck incident, which revealed inadequate business practices among exchange operators and prompted the FSA to get serious about regulations to prevent another fiasco.
As a result of the sweeping crackdown, the FSA issued a series of business improvement orders, while some companies were even ordered to suspend their operations.
“The message from the FSA was that you needed to lay a solid foundation before growing your business, which was actually true,” Hirosue said.
Regulation to the rescue?
Japan’s tight regulations have garnered attention in light of the collapse of FTX, as its Japanese unit was apparently meeting capital requirements, thereby potentially saving customers’ assets.
Meanwhile, over 1 million FTX customers around the world may not be able to retrieve theirs.
Exchange operators in Japan are required to separately keep customers' funds from their own. To avert the risk of losing customers’ cryptocurrency in the event of a cyberattack, like the Coincheck incident, domestic exchanges must also manage 95% of customers assets offline in so-called cold wallets.
FTX Japan has reportedly said that it was following this rule and was storing about ¥19 billion in funds from about 100,000 customers. Its customers have been unable to withdraw their funds because the trading system has been halted, according to the firm, but it announced last week that customers will be able to do so in mid-February.
In early November, Japanese regulators told FTX Japan to suspend its operations for about a month, but the order was extended to March 9.
Given that FTX Japan retained customers’ assets, some have said that Japan’s strict regulations could be a role model for other countries looking to strengthen crypto-related legislation.
But Noritaka Okabe, chief of JPYC, which issues “stable coins,” or crypto assets pegged to traditional currencies or commodities, said it is premature to judge that Japan’s regulations have worked effectively until clients’ assets are actually returned.
The FTX case is also a bit complicated because it is uncertain how the collapse of the main unit overseas will affect the handling of assets held by its subsidiaries in other countries, Okabe added.
“If clients really get their money back, we can say that Japan’s regulations were effective ... but if they don’t, it will change everything,” he said during an online seminar in early December.
Before the FTX debacle, frustration over the regulations among crypto business operators was growing, with many saying that it was hampering the growth of the industry.
“I think it was right (that Japan imposed such regulations), but it was a bit too much. It’s a matter of degree,” said Hirosue of the JCBA.
To meet the regulatory standards, exchange operators have to spend a considerable amount of money on boosting governance, internal controls and security, damaging their profitability.
“As a financial institution, it is necessary to prepare a robust business operational structure, but the size of the industry is still small. The structures of some decent domestic exchange operators are as good as or even better than some regional banks,” Hirosue said.
The regulations have also made it difficult to attract investors.
For instance, the FSA tightened the cap on leveraged trading to two times the account balance in 2020. Prior to that, the cap was set at four times in line with a self-imposed rule by the industry, but some overseas exchanges allow leveraged trading equivalent to more than 100 times the balance.
Web3 gambit
Amid the crypto sector’s myriad challenges, there has been a movement among some ruling Liberal Democratic Party lawmakers to make Web3 a pillar of Japan’s economic policy.
The definition of Web3 is wide-ranging but often refers to decentralized web services, with blockchains, non-fungible tokens and crypto assets seen as key elements. As such, pushing Web3 in practice means promoting crypto assets.
There are emerging concerns that the collapse of FTX might stall Web3 momentum globally, as the company was making huge investments in related firms.
But the members of the LDP’s Web3 project team remain committed to the concept, said Masaaki Taira, who heads the team. In their view, Web3 services will become widespread as more people tire of the current internet sphere dominated by a few powerful players, namely Google, Apple, Facebook and Amazon.
“We believe that Web3 will have a significant impact on society in the medium to longer term, so momentum to promote related policies is unchanged,” Taira said.
One of the major objectives of the LDP project team is to create a business environment friendly for Web3 and crypto firms. To do that, it has proposed a number of revisions to tax rules.
At the moment, the imposition of a tax on unrealized profit from crypto tokens held by companies is seen as a heavy burden causing an outflow of entrepreneurs looking to launch blockchain businesses. Also, profits from the sale of virtual currencies are considered miscellaneous income for individuals, with the maximum tax rate set at 45%, compared with the 20% rate for capital gains and dividends from stocks.
“The easing of individual and corporate tax rules with regards to crypto holdings can help spur the growth of the industry, whilst ensuring Japan remains a competitive hub for innovation in the region,” said Stephen Richardson, head of product strategy and business solutions at crypto custody firm Fireblocks.
Last month, the LDP and its coalition partner, Komeito, compiled an annual tax reform package proposing a tax exemption for unrealized profit from crypto assets held by companies if they are issued by the firm itself. The question of how to handle tokens issued by other companies is set for further discussion.
Other crypto-related tax reform proposals from the Web3 project team did not come up for consideration, Taira said.
Hirosue said that the growth of the Web3 and crypto industries will largely depend on whether the government can make substantial changes to the business environment.
But he is not optimistic about such changes happening swiftly.
The general image of cryptocurrencies among the public is not necessarily positive, and this has been further damaged by the FTX collapse, making it tough for the government to openly promote the use of crypto assets.
Although the government is looking to embrace Web3, it will likely take time to redesign the business environment, Hirosue said.
“For the industry to grow bigger, manpower, products and capital are necessary,” but Japan doesn’t really have them, he said.
“Business conditions are still inadequate, so the industry is yet to reach a point where it can boost its growth.”
Crypto’s year to forget
2022 was a particularly eventful year for crypto worldwide, with law enforcement set on the trail of now notorious operators and the price of bitcoin tumbling more than 66% since the start of the year. The developments have set the tone for increased scrutiny of the industry.
In May, terra luna fell from a high of $116 to less than $1, leading to a mass selloff, with the turmoil beginning when the coin broke its 1:1 peg to the U.S. dollar. As a result, the term "cryptocrash" trended on Twitter and Google. South Korean founder Do Kwon, who also founded blockchain platform Terraform Labs, was subsequently accused of fraud by investors, and an arrest warrant was issued. According to South Korean prosecutors, Kwon is in hiding in Serbia.
The following month, U.S. crypto lending platform Celsius paused withdrawals, then filed for bankruptcy in July.
But the biggest shock came when former industry darling FTX collapsed in November after it emerged that the group’s hedge fund Alameda was trading and losing customer money. The company was promptly declared bankrupt.
FTX’s downfall has triggered far reaching turmoil in the industry in what some have described as crypto’s “Lehman moment.” Founder Sam Bankman-Fried was arrested and then released on a $250 million bond — he remains under home detention at his parent’s residence as he awaits trial on charges he swindled investors.
Meanwhile, a Reuters investigation in October found that almost half of Binance’s U.S. compliance team had quit by mid-2022 over concerns that sufficient money laundering checks were unable to be carried out. In December, the company published a Chinese-language blog post seeking to reassure market watchers that although traders had withdrawn $6 billion from the cryptocurrency exchange in just three days, it had enough capital to continue operations.
The knock-on effects of these major, and at times cataclysmic, developments will continue to play out in 2023. There is, for example, talk of increased regulatory attention, with the U.S. Securities and Exchange Commission mulling potential changes in enforcement, and officials in the U.K. reportedly finalizing plans for updated crypto regulations, setting up 2023 to be a year in which the spotlight is placed directly on crypto-related crime.
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