Detailed Explanation of Japan's Web3 Regulatory Policies and Trends

Currently, Web3 is gaining momentum globally and has a significant impact on the economic market. The Japanese government is optimistic about the development potential of Web3. Since taking office in 2021, 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 considers the "key" to creating the economic future of Japan. In today's "intense global competition," Japan hopes to seize the momentum of blockchain development in East Asia by "exploring the future of Web3."

1. Background of Japan's Web3 Development

As early as the initial stages of Web development, Japan "led the global cryptocurrency industry." However, subsequent large-scale hacking incidents led to strong reactions from regulatory authorities. This burden of reputation and regulation, combined with high taxes and a lack of regulatory transparency, caused Japan's once-thriving cryptocurrency industry to fall into difficulties.

In 2014 and 2017, Japan's cryptocurrency industry faced two severe hacking incidents. MtGox was hacked, resulting in the theft of approximately 850,000 bitcoins (BTC), and Coincheck was attacked, leading to a loss of $500 million, severely damaging consumer confidence in the market. To prevent such significant losses from happening again, the Japanese government actively formulated regulations to protect consumers and investors in its cryptocurrency industry.

Subsequently, regulatory authorities further required that cryptocurrency exchanges operating in Japan separate customers' fiat currencies and crypto assets from the exchange's own assets, entrusting customer funds to third-party Japanese banks or trust companies managed by trustees, with customers identified as beneficiaries. At least 95% of customer funds must be stored in non-internet-connected "cold wallets," and all internet-connected funds must be supported by crypto assets held in the exchange's cold wallet.

Thanks to its strict consumer protection regulations, Japan has effectively mitigated the negative impacts brought by the collapse of some well-known global cryptocurrency exchanges in recent years. The Chief FinTech Officer of the Financial Services Agency (FSA) stated that despite FTX facing a "global bankruptcy crisis," all "Japanese customers affected by FTX are likely to be compensated due to the protections in place."

2. The Reform Path of Japan's Web3 Policies

Today, Prime Minister Kishida's government believes that "Japan plays a unique role in the cryptocurrency industry" and emphasizes that Japan now has the opportunity to implement a "national strategy" aimed at vigorously promoting the development of an internationally competitive Web3 business environment and regulatory framework.

In January 2022, the Japanese government launched a "national strategy," and the ruling Liberal Democratic Party established a Digital Society Promotion Headquarters. Since then, its Web3 project team has directly proposed legislative and regulatory reform suggestions to the ruling party, many of which have been adopted.

(1) Tax Reform in Japan

The "national strategy" initiated by Japan aims to create "a development environment and tax system attractive to entrepreneurs and engineers" to promote investment.

Currently, these tax reforms mainly focus on two areas of tax policy: corporate year-end tax and personal tax rates.

1. Corporate Year-End Tax. Theoretically, all crypto assets held by companies (if these assets have an active market) need to be valued at market prices. In other words, regardless of whether these assets can be actively traded by the company or whether there is a loss in value during the year, companies holding these assets must pay taxes based on their fair market value, which can sometimes be as high as 35%. Therefore, to promote a "token financing-friendly environment," Japan's Web3 policy team has proposed two additional reform policies.

First, the government exempts "tokens continuously held by issuing companies" and "year-end market-to-market tax on corporate income tax." Second, the government exempts "tokens issued by other companies, held by third parties, and not intended for short-term trading."

The first reform took effect in June 2023. The second reform was proposed by the FSA for Japan's 2024 legislative agenda and was approved by METI. Implementing these two measures may alleviate the long-standing disadvantage faced by domestic corporate investors compared to overseas investors who can rely on more favorable tax treatments.

2. Personal Tax Rates. Currently, income from cryptocurrency transactions in Japan is taxed as "miscellaneous income," with a "minimum tax rate of 55%" when "income tax and resident tax" are combined. Moreover, this tax is levied "not only when the held crypto assets are exchanged for fiat currency" but also "when they are exchanged for other crypto assets." This tax regime is stricter than in most other countries, leading to significant taxpayer outflow or hindrances in tax reporting, prompting the Web3 policy team to propose four reforms.

First, a unified 20% tax on cryptocurrency transactions. Second, taxing "gains and losses" only when converted to fiat currency, thus exempting taxation "when exchanging crypto assets." Third, allowing individuals to carry forward losses for up to three years. Fourth, applying the same tax rate to "cryptocurrency derivatives trading."

Although Japan's Digital Society Promotion Headquarters proposed urgent reforms in November 2022, these reforms were excluded from the 2023 agenda, and it remains unclear whether these proposals will become part of the 2024 legislative agenda^1^.

(2) Stablecoin Regulatory Framework

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 transparently" is essential for influencing and capturing parts of the market and promoting digital asset trading and other Web3 industries.

In June 2022, Japan became one of the first major economies globally to provide a regulatory framework for stablecoins. The newly amended Payment Services Act defines stablecoins as "electronic payment instruments" and establishes a new regulated category of "electronic payment instrument intermediaries," which took effect on June 1, 2023.

Under the law, trust companies and money transfer operators are authorized to issue and trade stablecoins based on existing capital maintenance requirements. This allows them to enter the "1 trillion yen" corporate payment settlement market. Four major banks and digital lending institutions have already planned to issue their own stablecoins, including Mitsubishi UFJ Financial Group (MUFG), which is preparing to issue the Progmat Coin pegged to the yen. Additionally, other traditional companies that previously "rarely engaged in crypto assets" are making significant investments in the Web3 space.

(3) 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," which includes "NFTs," marking the starting point of Japan's digital asset "national strategy."

Japan views NFTs as a catalyst for the "digital economy in the Web3 era." Consequently, the NFT market grew from "40 billion yen in 2020" to "over 4.7 trillion yen in 2021."^2^ Japan possesses rich and high-quality intellectual property, believing that its animation and gaming sectors are internationally competitive, giving Japan significant potential to lead in the NFT and Web3 fields.

To leverage its intellectual property and the growth 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 certain NFTs as crypto assets.

However, NFT businesses and content creators still "face significant obstacles." On one hand, the ambiguity of regulations has led companies to rush to adopt popular NFT models, combining "random sales of NFTs" with "secondary markets," which is common in fantasy sports in the U.S. and Europe. Companies are concerned that this may violate Japan's anti-gambling laws, and it remains unclear whether these laws allow Japanese companies to 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" on their valuable intellectual property.

In addition to protecting the rights of content holders and safeguarding their data, clarifying and updating these legal barriers is also necessary for "the further development of Japan's content industry in the Web3 era."

(4) Investment

Another aspect of Japan's "national strategy" is to reform existing business forms to promote "public and private funding for blockchain-related businesses." Globally, Web3 startups "raised $15.1 billion" in 2022, a 15-fold increase from 2018. Japan believes that if it "establishes an appropriate legal and tax framework," it can leverage this momentum to encourage investors to "gather in Japan"^3^.

Part of establishing an appropriate legal framework involves opening new financing channels for partnerships through digital assets and recognizing new business forms based on Web3 technology: Decentralized Autonomous Organizations (DAOs).

Currently, Japan restricts investment in limited partnerships to traditional fundraising methods (stocks, stock options, and security tokens). These partnerships are also required to invest more than half of their capital domestically. The Ministry of Economy, Trade and Industry (METI) 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, thus allowing for more reinvestment in domestic startups.

Another driving force is the recognition of DAOs. DAOs operate by granting governance voting rights to owners through secure tokens. This makes membership and operations smooth and quick. However, currently, "DAOs lack a clear legal framework to ensure their members bear limited liability," which hinders the establishment of sufficiently flexible corporate forms for their operations. Even the limited liability company model has certain rules, such as requiring limited liability companies to list all members and their personal information in the company bylaws, creating an unbearable management burden. While the Web3 policy team frequently suggests reforms in this area, it remains unclear when such reforms will take place. However, the Digital Agency has already created its own DAO to promote research.

(5) International Leadership

While the "national strategy" focuses on domestic development, a key goal has always been to achieve international leadership in this field.

Regionally, Japan has begun to emerge as one of the leaders in the digital market. In May 2023, Prime Minister Kishida launched a Digital Innovation Center at the ASEAN and East Asia Economic Research Institute, emphasizing a 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.

Globally, Japan is serving as the chair of the G7 in 2023 and seeks to leverage its role as the rotating chair to "play a positive leadership role" in this field. In particular, it aims to emphasize its strong history of "consumer and investor protection," establish a unified international private law regarding data and digital asset transfers, and promote the adoption of the "Travel Rule" for digital assets to combat money laundering and terrorism.

Japan has fully utilized its opportunity as the G7 rotating chair, and other member countries seem to support Japan's "national strategy" talking points. G7 leaders unanimously agree that regulation and oversight are crucial for addressing the risks posed by cryptocurrency activities and avoiding regulatory arbitrage while supporting responsible innovation. Central bank governors from various countries agree that "a reliable, stable, and transparent global payment system is a key foundation for their economies," and Web3 technologies such as CBDCs and stablecoins can "play a significant role." Digital and technology ministers from various countries agree with Japan's vision of Society 5.0 and its proposals for developing "innovative and competitive digital ecosystems."

3. Japan's Aspirations for New Web3 Policies

Japanese lawmakers Masaaki Taira and Hideto Kawasaki expressed their hope to establish formal Web3 policies for Japan in an interview with CoinDesk Japan on January 24, 2024.^4^

The country has been exploring various ways to regulate Web3. In April 2023, the LDP Web3 Project Team (Web3PT) released a white paper calling for the use of blockchain technology to develop various Web3 projects.

At the end of 2023, Japan also hosted a hackathon to formulate rules for Decentralized Autonomous Organizations (DAOs), where stakeholders could express their expectations to policymakers. "Through the hackathon, both short-term and long-term issues became clear," Kawasaki, who also serves as the executive director of Web3PT, added.

Another noteworthy area is the need for more clarity regarding DAOs and whether companies need to implement smart contracts to be classified as DAOs. Web3PT Chairman Taira believes that this scope will narrow over time.

Kawasaki also stated, "The next step will be to clearly reflect this in the next white paper." He added that they need to formulate regulations for DAOs, "In addition, we hope to grasp the current situation beyond DAOs and identify new policy points within Web3PT."

4. Other Regulations and Regulatory Policies

(1) Cryptocurrency Exchange Services

The regulations for cryptocurrency asset management came into effect on April 1, 2017. The PSA was amended to introduce registration requirements for "cryptocurrency exchange service providers." In June 2019, the PSA was further revised to strengthen customer protection by introducing stricter regulations applicable to cryptocurrency assets, with the amended PSA taking effect on May 1, 2020.

Under the PSA, "cryptocurrency assets" are defined as:

Proprietary value that can be used to pay for the price of any goods purchased or borrowed or any 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 electronically through electronic devices or other means, and (b) be exchanged with unspecified persons for the proprietary value specified above and can be transferred through electronic data processing systems.

Most so-called payment tokens and utility tokens fall within the definition of cryptocurrency assets.

Cryptocurrency exchange services ("CAES") are defined to include any of the following acts conducted as a business:

Selling/purchasing cryptocurrency assets or exchanging other cryptocurrency assets;

i. Providing intermediary, agency, or entrusted services related to the acts listed in i, or managing user funds related to i.

ii. Or managing cryptocurrency assets for the benefit of others.

Under 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. However, 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.

Notably, under the PSA's 2019 amendment, managing customer cryptocurrency assets and transferring such cryptocurrency assets to a customer-designated address 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 trust companies or any other similar entities. CAES providers should manage customers' cryptocurrency assets ("trust CA") separately from their own cryptocurrency assets. Additionally, CAES providers are required to manage at least 95% of the total value of trust CA through fully offline wallets or other technologies with equivalent security levels.

(2) Cryptocurrency Derivatives

The revised Financial Instruments and Exchange Act ("FIEA"), effective May 1, 2020, includes specific provisions for cryptocurrency derivatives. It incorporates "cryptocurrency assets" and standardized instruments created by financial instruments exchanges into the definition of financial instruments, includes cryptocurrency asset prices, interest rates, etc., in the definition of financial indicators, and now requires cryptocurrency derivatives trading to comply with FIEA regulations, regardless of the type of derivative trading involved. For example, providing over-the-counter cryptocurrency derivatives trading or acting as relevant intermediaries or brokers constitutes the first category of financial instrument business as defined by the revised Foreign Investment Law. Therefore, companies engaging in these transactions need to register as Type 1 Financial Instrument Business Operators ("Type 1 FIBO").

In addition to various conduct rules applicable to Type 1 FIBOs providing cryptocurrency derivatives services under the FIEA, it is noteworthy that the revised FIEA introduces strict leverage regulations. If a Type 1 FIBO engages in cryptocurrency derivatives trading, the amount of margin deposited by customers must: (i) not be less than 50% of the amount of cryptocurrency derivatives trading if the customer is an individual (i.e., leverage ratio limited to two times); (ii) not be less than 50% of the amount of cryptocurrency derivatives trading multiplied by 50% or based on the cryptocurrency risk-bearing rate specified in an announcement by the FSA titled "Establishing the Method for Calculating Cryptocurrency Risk-Bearing Rates in Cryptocurrency Leverage Trading."^5^

(3) Digital Securities

The FIEA categorizes securities into: (i) traditional securities such as stocks and bonds ("Type 1 Securities"); (ii) contractual rights such as trust beneficiary rights and collective investment scheme rights ("Type 2 Securities").

Due to the higher liquidity of Type 1 Securities, they are subject to relatively strict requirements regarding disclosure and licensing/registration, while Type 2 Securities, due to their lower liquidity, are subject to relatively lenient 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 those issued using traditional methods, regardless of whether they are Type 1 or Type 2 Securities. Therefore, the revised FIEA introduces a new regulatory framework for securities that can be transferred using electronic data processing systems. According to the revised FIEA, securities that can be transferred using electronic data processing systems are categorized into the following three types:

Type 1 Securities, such as stocks and bonds that can be transferred using electronic data processing systems (tokenized Type 1 Securities).

Contractual rights such as trust beneficiary rights and collective investment scheme rights, typically classified as Type 2 Securities, that can be transferred using electronic data processing systems (electronically recorded transferable rights ("ERTR")).

Contractual rights such as trust beneficiary rights and collective investment scheme rights, typically classified as Type 2 Securities, that can be transferred using electronic data processing systems but whose liquidity is subject to certain restrictions (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, just like traditional Type 1 Securities. Anyone engaged in the sale, purchase, or processing of tokenized Type 1 Securities or ERTR must register as a Type 1 FIBO. Given the high degree of freedom in designing tokenized Type 1 Securities or ERTR, as well as their high liquidity, Type 1 FIBOs handling these digital securities need to control risks associated with digital networks.

(4) Electronic Payment Intermediary Services

On June 1, 2018, amendments to the Banking Act came into effect, regulating electronic payment intermediary service providers to promote open APIs. The definition of electronic payment intermediary service providers is broad, including intermediaries between financial institutions and customers, such as entities that convey payment instructions to banks using information technology at the customer's request or entities that 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 provisions applicable to registered electronic payment intermediary service providers:

Electronic payment intermediary service providers intending to conduct services constituting electronic payment intermediary business must, in principle, disclose certain matters in advance. Such matters include business name or address, authority, compensation, and contact information for handling complaints.

For electronic payment intermediary services, electronic payment intermediary service providers must (a) provide information to prevent misunderstandings; (b) ensure the correct handling of user information; (c) maintain security management measures; and (d) take measures to manage outsourced contractors.

Before implementing electronic payment intermediary services, electronic payment intermediary service providers should enter into electronic payment intermediary service contracts with banks.

The contract must clearly specify (a) the allocation of compensation responsibilities when users suffer damages; (b) measures for properly handling user information; and (c) security management measures. Banks and electronic payment intermediary service providers must immediately disclose the above items (a) to (c) upon signing the contract.

(5) Financial Services Intermediary Business

In June 2020, the Financial Instruments Sales Act was amended to establish an industry suitable for financial services intermediary institutions, which seek to provide convenient one-stop services for users to access various financial services. This amendment took effect in November 2021, and the name of the act was changed to the Financial Services Provision Act.

Under Japan's previous regulatory framework, financial intermediary services were categorized by "function," such as bank agents and electronic payment service providers under the Banking Act, financial instrument intermediary service providers under the FIEA, and insurance agents and 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, by re-registering as "Financial Services Intermediary Business Operators" ("FSIBO"), operators will be allowed to act as intermediaries for cross-sector financial services.

Finally 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 Japan's Digital Agency stated, their work has only just begun.