Detailed Analysis of South Korea's Web3 Regulatory Policies and Trends

Author: Lawyer Chen

South Korea is considered one of the most active countries in the world in the field of cryptocurrency and blockchain. It has a large and vibrant crypto community with millions of users, investors, and traders, as well as hundreds of startups, exchanges, and service providers. South Korea is also at the forefront of cryptocurrency adoption and trading globally.

However, like other regions, South Korea faces many challenges and risks in the cryptocurrency sector, such as hacking, fraud, money laundering, tax evasion, and market manipulation. These issues have prompted the South Korean government and regulatory agencies to adopt more proactive and stringent cryptocurrency regulations to protect users, the industry, and society from potential harm.

In March 2023, the National Assembly passed the "Virtual Asset User Protection Act," marking an important step by the government towards establishing a legal framework for crypto assets. The law defines virtual assets as digital assets that can be traded or transferred electronically and outlines the basic rights and obligations of users and service providers. It also grants the Financial Services Commission (FSC)—the main financial regulatory body in South Korea—the authority to oversee and regulate the cryptocurrency industry and to issue detailed implementation rules and guidelines. The FSC has been actively drafting and proposing various rules and regulations to complement this law and address specific issues and emerging challenges in the cryptocurrency sector.

However, due to the significant differences between cryptocurrencies and traditional assets in terms of issuance and market structure, existing regulations such as the "Electronic Financial Transactions Act" and the "Capital Markets Act" show limitations in comprehensively regulating cryptocurrency crises. In particular, the decoupling of UST and the bankruptcy of FTX in 2022 caused significant damage to the global crypto industry and increased calls for regulatory frameworks that establish safe and reliable systems not limited to specific countries. Therefore, countries such as the United States, the European Union, and Japan have also accelerated the formulation of cryptocurrency regulations to enhance investor protection.

In South Korea, the regulatory framework for virtual assets began to take shape in 2021, and its outline has become clearer in the following years. Currently, there are three key regulations related to virtual assets in South Korea: Security Token Guidelines, Mandatory Reporting of Virtual Assets by Senior Officials, and the Virtual Asset User Protection Act (Virtual Asset Act).

This article aims to explore the trends in South Korea's WEB3 regulation by introducing the legislative background, legislative content, and the current status of the aforementioned three regulations.

1. Security Token Guidelines

On February 5, 2023, the Financial Services Commission (FSC) released guidelines regulating the issuance and circulation of security tokens, with the aim of implementing them by the second half of 2024.

1. Background

With advancements in information and communication technology, an increasing number of people in South Korea emphasize the need to prevent existing regulations from hindering the development of emerging financial industries such as fintech and blockchain. In response, the FSC implemented a financial regulatory sandbox system starting in April 2019 under the "Special Act on the Support of Financial Innovation."

2. Content

(1) Definition

Security tokens are defined as "digital securities that use distributed ledger technology under the Capital Markets Act." This analogy compares securities to food and their issuance form to a container, emphasizing that despite the new "container" or token form, the essence of securities remains unchanged. Therefore, in addition to physical securities recorded on certificates and electronic securities registered in centralized accounts, securities tokens recorded on distributed ledgers will also be subject to regulation under the Capital Markets Act.

(2) Primary Market

A notable aspect of the primary market for security tokens is the introduction of "issuer account managers," who can handle both the issuance and registration of securities simultaneously. Under current law, when an issuer issues securities, account managers from securities companies, banks, etc., register them with a custodian institution. However, for tokenized securities, the issuer account manager can perform both issuance and registration simultaneously, eliminating the intermediate step and aiming to simplify the securities issuance process.

To become an issuer account manager, one must meet the standards set by the FSC. Issuers that do not meet these standards will follow the traditional securities issuance structure, solely responsible for issuance and completing registration through an account manager.

(3) Secondary Market

The secondary market can be divided into on-exchange and OTC (over-the-counter) markets.

On-exchange: The introduction of a digital securities market at the Korea Exchange (KRX) for trading unconventional securities.

OTC: Establishing OTC brokers to allow retail investors to engage in multilateral trading.

Notably, the FSC announced plans to differentiate the authorization requirements for becoming an OTC intermediary based on the type of securities. This includes exemptions from sales disclosure and market supervision, effectively encouraging new entrants to make small-scale investments. This move demonstrates a proactive approach to revitalizing unconventional securities trading, which previously fell outside the scope of existing distribution systems and market management.

3. Current Status

At the "Public Hearing on the Legislation of Electronic Securities and Capital Markets Act" held on July 13, the People Power Party representative Chang-Hyun Yoon revealed regulatory amendments concerning security tokens. The amendment was proposed on July 28 and is planned to be reviewed by the government committee and the Ministry of Justice before being finalized through a vote in the National Assembly. However, as it has not yet been formally promulgated, details may change after further discussion. The current amendment was submitted to the Political Affairs Committee on November 15 and has passed the bill subcommittee.

To formalize the security token guidelines, substantial amendments to the Electronic Securities Act and the Capital Markets Act are required. The industry is widely discussing these two laws to facilitate the rapid and safe growth of South Korea's security token industry.

The key to the Electronic Securities Act amendment is recognizing blockchain electronic registration as an input method for an official ledger, granting it the same presumption of ownership transfer as centralized electronic registration. Therefore, defining the scope of securities that can be registered using distributed ledgers, specific requirements for using distributed ledgers as an input method, and managing personal information recorded on distributed ledgers are considered urgent tasks.

The Capital Markets Act amendment aims to expand investor choices by allowing the circulation of unconventional securities, which was previously unachievable due to investor protection concerns. Therefore, issues regarding authorization requirements for OTC brokers, operational methods, and investment limits for general investors are actively being discussed.

With the guidelines released in February and the amendments proposed in July, expectations for South Korea's security token market are rising. The South Korean securities industry is forming various security token alliances to gain a first-mover advantage. These alliances are voluntary organizations composed of securities companies, banks, and innovative financial services (sandbox) aimed at creating a security token ecosystem through specialized areas such as customer fund management and trading platform support.

The KRX has also applied to designate the on-exchange trading market for security tokens as an FSC sandbox. Il-Chan Ahn, head of digital business at the Korea Exchange, expects that listed security tokens worth over 3 billion won will allow investors to trade them freely through securities companies without needing separate dedicated accounts, just like existing stocks. However, even after the on-exchange market is established, it will take about six months from the start of trading to commence trading, as it must undergo the same processes as currently listed securities, including preliminary review, submission of securities reports, public listing, and offering procedures.

2. Mandatory Reporting of Virtual Assets by Senior Officials

The bill titled "Mandatory Reporting of Virtual Assets by Senior Officials" (informally known as the "Kim Nam-kook Prevention Law") was passed by the National Assembly on May 25, 2023, and came into effect on December 14 of the same year. As a result, senior officials are now obligated to report any virtual assets held by themselves, their spouses, and immediate family members.

1. Background

On May 4, 2023, reports emerged that Congressman Kim Nam-kook (a former Democratic Party member) held WEMIX worth 6 billion won in his personal virtual asset wallet, which intensified attention on this legislation. Subsequent scrutiny of unclear sources of funds and transaction processes led to Kim being referred to the National Assembly's Ethics Committee under the "Prevention of Conflicts of Interest Act." It was revealed that the assets held by Congressman Kim were greater than previously reported. This incident sparked public demands for senior officials to transparently report their virtual assets, ultimately leading to the passage of the bill.

2. Content

According to the amended Public Service Ethics Act, all members of the 21st National Assembly must voluntarily report the status of virtual assets acquired and held from the start of their term (May 30, 2020) to May 31, 2023, including the services used and transaction details of their names. This includes transaction dates, purchase prices, sale prices, transaction costs, and counterparties. The Anti-Corruption and Civil Rights Commission (ACRC) will collaborate with relevant departments such as the FSC and KRX, as well as virtual asset exchanges, to oversee this process to ensure the integrity of officials' asset declarations.

3. Current Status

The registration period for the status and changes of virtual assets held by senior officials began on June 15, 2023, and ended on June 30. According to a meeting of the National Assembly's Ethics Advisory Committee on July 21, among the 299 members who submitted details, 11, including Nam-Kuk Kim, had a history of holding virtual assets. However, these reports were initially limited to assets owned personally, and starting in 2024, virtual assets held by immediate family members and spouses will be subject to mandatory disclosure.

The Kim Nam-kook incident raised awareness and accelerated the legislation of the Public Service Ethics Act. Consequently, the number of suspicious transaction reports submitted by virtual asset exchanges has increased. Under the current "Reporting and Use of Specific Financial Transaction Information Act," exchanges must report suspicious transactions to the FSC's Financial Intelligence Unit (FIU). As of September 2023, the number of such reports for the year has exceeded the total for 2022, indicating an increase following the implementation of the amended law.

3. Virtual Asset User Protection Act

On June 30, 2023, the "Virtual Asset User Protection Act" (Virtual Asset Act) was passed by the National Assembly and is expected to be implemented in July 2024. The introduction of this law aims to address the limitations of managing virtual assets solely based on existing legal provisions such as the "Electronic Financial Transactions Act" and the "Capital Markets Act." In response to these limitations, particularly after the 2022 Terra incident highlighted the challenges of preventing unfair trading practices, the Yoon government listed the establishment of digital asset infrastructure and regulatory systems as one of the 120 national tasks in July 2022.

1. Background

Due to the inadequacy of the current "Electronic Financial Transactions Act" and "Capital Markets Act" to comprehensively manage virtual assets, the South Korean government introduced a reporting system for virtual asset service providers and various regulatory measures for anti-money laundering and investor protection. In March 2021, an amendment to the "Reporting and Use of Specific Financial Transaction Information Act" was passed. However, this amendment primarily focused on anti-money laundering and faced difficulties in preventing unfair trading practices, as evidenced by the 2022 Terra incident.

As a result, in July 2022, the Yoon government designated "35. Establishing digital asset infrastructure and regulatory framework (Financial Services Commission)" as one of the 120 national tasks and announced the formulation of a dedicated "Basic Law on Digital Assets" (now the Virtual Asset Act).

Both the ruling and opposition parties in South Korea agreed to actively establish a minimum necessary regulatory framework for virtual assets and then gradually refine the details. The promulgation of the Virtual Asset Act is the first phase of this regulatory policy, focusing on the most urgent aspects: investor protection and regulation of unfair trading practices among various sectors of the virtual asset industry.

2. Content

The Virtual Asset Act defines virtual assets and virtual asset service providers similarly to the "Reporting and Use of Specific Financial Transaction Information Act," but excludes central bank digital currencies (CBDCs) issued by the Bank of Korea from the category of virtual assets.

Virtual assets: Transferable electronic certificates with economic value, excluding game coins, electronic money, and electronic registered stocks.

Virtual asset service providers: Operators of virtual asset trading, custody, wallet services, etc.

The first phase of the law focuses on protecting users' assets, regulating unfair trading practices, and strengthening the regulatory authority of financial regulatory agencies.

(1) Protecting User Assets

The law introduces specific provisions not found in the "Reporting and Use of Specific Financial Transaction Information Act," such as detailed methods and measures to ensure the security of held virtual assets. Virtual asset service providers must separate user funds from their own and maintain them with reputable institutions such as banks or trusts. Additionally, they must hold virtual assets of the same type and quantity as the deposited funds. Service providers are also required to store a certain percentage of deposits in cold wallets, which are disconnected from the internet to protect users' assets from hacking risks. They must also purchase insurance or reserves to address incidents such as hacking attacks or system failures and retain transaction records for 15 years after the transaction.

(2) Regulation of Unfair Trading Practices

The first phase of the Virtual Asset Act includes and regulates the following five types of unfair trading practices:

Using undisclosed information: Prohibiting trading activities based on information that significantly impacts investment decisions before it is disclosed to the public.

Market manipulation: Prohibiting all forms of market manipulation based on trading, including order matching, trading manipulation, and actual trading.

Fraud and deceptive trading: Prohibiting transactions involving false input of important details, false pricing, or dishonest means.

Trading of virtual assets issued by oneself or related parties: Learning from incidents like FTX, prohibiting trading of virtual assets issued by oneself or related parties, with specific exceptions.

Arbitrarily blocking deposits and withdrawals: Prohibiting unjustly blocking deposits and withdrawals and requiring any unavoidable reasons to be promptly communicated to users and reported to the Financial Services Commission.

Specific exceptions: Virtual assets issued as a means of payment for specific goods or services, where virtual asset service providers provide promised specific goods or services to users and receive virtual assets in return (Article 10, Paragraph 5, Clause 1).

Additionally, virtual asset exchanges and other market operators must monitor and report any abnormal transactions indicating unusual changes in asset prices or trading volumes to protect users. Therefore, by July 2024, exchanges must develop systems to monitor these transactions and have the necessary resources to execute related tasks.

(3) Increased Regulatory Authority

The law also clarifies and strengthens the regulatory authority of financial regulatory agencies to prevent unfair practices and lay the groundwork for smooth enforcement. The FSC now has the authority to require virtual asset service providers to provide various documents, statements, and witnesses to appear when necessary. The new regulations also allow for recommendations for dismissal, suspension, or service suspension for employees of service providers who violate these regulations.

Furthermore, sanctions for engaging in prohibited activities have been significantly increased. Criminal penalties include at least one year of imprisonment or fines of three to five times the illegal profits. Additionally, administrative fines equivalent to twice the amount of avoided losses have been introduced, along with provisions for collective lawsuits for damages.

3. Current Status

On December 11, the FSC issued a legislative notice regarding the implementation order and regulatory provisions for the first phase of the Virtual Asset Act, detailing the content of the first phase of the Virtual Asset Act, which will be implemented on July 19, 2024. This implementation order is significant as it specifies the detailed content of the first phase of the Virtual Asset Act. The current Virtual Asset Act lacks regulatory guidelines.

The implementation order of the Virtual Asset Act includes additional exclusions for virtual assets, specifies the proportion of cold wallet storage, and defines undisclosed information, directly impacting virtual asset service providers and investors.

Notably, the "User Deposit Management Institution Management Measures" stipulate that only banks can manage user deposits. It further requires virtual asset service providers to essentially hold virtual assets of the same type and quantity as the deposits, making it nearly impossible for third parties to manage or operate custody and operational businesses in South Korea.

The Financial Supervisory Service (FSS) announced the establishment of a specialized agency for virtual assets, indicating that the reporting and inspection processes for virtual asset service providers will be strengthened. The digital asset research group responsible for legislative support and market monitoring will be divided into the "Virtual Asset Regulatory Bureau" and the "Virtual Asset Investigation Bureau." The Regulatory Bureau is a comprehensive department for managing and supervising service providers, while the Investigation Bureau is responsible for investigating unfair trading practices. The goal is to prevent money laundering through virtual assets, enhance user protection, and strictly reorganize the review processes for existing virtual asset service providers.

4. Travel Rule

1. Background and Content

The Travel Rule originally referred to the requirement for financial institutions to record remitter information in the format required by the Society for Worldwide Interbank Financial Telecommunication (SWIFT) when conducting international transfers. However, as virtual assets increasingly became a global money laundering issue, the Financial Action Task Force (FATF) proposed in 2019 to expand the scope of the Travel Rule to virtual assets, urging countries worldwide to apply it to their virtual asset service providers.

Under the "Reporting and Use of Specific Financial Transaction Information Act," South Korea became the first country to implement the Travel Rule in virtual asset transactions on March 25, 2022. The regulation stipulates that when virtual asset service providers transfer virtual assets worth over 1 million won, the sending service provider must provide and store relevant information for the recipient.

However, the current transfer rules only apply to transfers between domestic virtual asset service providers. The four major exchanges in South Korea (Upbit, Bithumb, Coinone, Korbit) are using solutions such as VerifyVASP (Upbit) and Code (Bithumb, Coinone, Korbit) to comply with this rule. However, transfers between domestic exchanges and foreign exchanges or personal wallets are not covered by this regulation. Therefore, exchanges are following the FSC's guidelines and adopting a whitelist approach on their own.

2. 2024 Travel Rule

On June 27, the FATF released a report titled "Virtual Assets: Targeted Update on the Implementation of FATF Standards for Virtual Assets and Virtual Asset Service Providers," announcing that as part of the FATF, it will continue to monitor criminal activity related to DeFi and private wallets. Additionally, the EU's regulation on virtual assets, MiCA (Markets in Crypto-Assets), has been implementing regulations on personal wallets since June 2022, regardless of whether the transfers are domestic or international.

As South Korea is the first country in the world to implement the Travel Rule, the current "Reporting and Use of Specific Financial Transaction Information Act" does not reflect the FATF's revised recommendations for the Travel Rule. This has led to some identified issues, such as the limited applicability of the rule to domestic exchanges and a lack of consistency with international regulations, thereby limiting trading transparency. There are calls to continuously revise the Travel Rule in line with international trends, especially since the virtual asset industry is not bound by national borders, making the "sunrise problem" (regulatory differences between countries) even more pronounced. By 2024, there is an increasing need to expand the regulatory scope to include not only transfers between exchanges but also personal wallets, and the industry is intensifying efforts to address this demand.

For example, on November 29, multi-chain infrastructure provider PiLab (operator of Bifrost), the Korea Information Certificate Authority (KICA), and Travel Rule solution provider CODE signed a memorandum of understanding to develop and deploy Web3 KYC services. Bifrost has been collaborating with KICA since October 2022 to develop a KYC solution for personal wallets and plans to expand the current Travel Rule KYC application scope conducted by virtual asset service providers to personal wallets.

5. Conclusion

In 2023, South Korea's virtual asset industry laid the foundation for flexibility in the capital market through the implementation of security token guidelines, established market trust and integrity through mandatory reporting of virtual assets by senior officials, and prepared a solid groundwork. The promulgation of the Virtual Asset Act lays the foundation for the industry to become a legitimate sector, aiming to enhance investor protection. Additionally, plans for accounting standards related to virtual assets have been introduced to address the accounting uncertainties faced by companies holding virtual assets.

Since 2022, there has been an increasing recognition of the need for comprehensive national regulation of virtual assets, and 2023 has been a year of laying the groundwork for such regulation. These foundational measures are expected to be fully implemented in 2024. Particularly in South Korea, regulatory attention has increased due to the planned execution of key legislative progress, especially the first phase of the Virtual Asset Act and the amendments concerning security tokens. The latter is particularly significant as it is expected to provide channels for traditional financial institutions such as brokerages and banks to enter the virtual asset industry, marking a significant convergence between traditional finance and the emerging virtual asset sector.

The new rules proposed by the Financial Services Commission represent a positive and necessary step for South Korea's cryptocurrency industry and society, as these rules aim to provide a more sound and comprehensive regulatory framework to balance the interests and needs of users, service providers, and regulators. The new rules can also enhance the credibility and legitimacy of the cryptocurrency industry and promote its development and innovation by aligning with global standards and trends.

However, the public remains generally cautious, and many industry insiders also believe that the new rules are still not sufficiently comprehensive, as they leave some gaps and uncertainties in the crypto space, especially in emerging areas such as NFTs, DeFi, and the metaverse. These areas require more attention and research, as they have the potential to change and disrupt various fields, including culture, entertainment, education, healthcare, and governance.