Image in courtesy of Ken Shishido

The new virtual currency law will be introduced in Japan this Spring and contrary to some positive media coverage and perception in the Bitcoin space, this may do more damage to the Bitcoin/blockchain space in Japan than the Bitlicense has done to the state of NY.

This might sound a bit strange to some as this law has been touted as the culmination of local Bitcoin/blockchain pioneers’ efforts and praised as a great progressive step by the Japanese government repeatedly on various Bitcoin media. As a matter of fact, I haven’t come across any visible criticism against this law in Japanese nor in English. All they say is mostly how it is a “progressive” law and how it validates the legal status of this new technology in Japan. But is it really true? I suspect they are not looking into the situation closely enough and just repeating what the authority or the interest groups tell them.

Contrary to the popular narratives so far, I personally have serious doubt about this law being a long term positive for the Japanese community and it may even set a bad precedent for other areas of the world similar to how people in the community were worried about the Bitlicense.

(Disclaimer: I am not a legal expert in any way and this article likely contains many small errors if not critical in my assessment or understanding of the law. However, the main point is to shed some light on the coming regulation in Japan and start the conversation. If someone finds any errors or think it needs corrections, I’d welcome it.

Also, I personally prefer the term “Cryptocurrency” over “Virtual currency” but in the law, cryptocurrency is termed as “仮想通貨”, which literally means virtual currency so I will stick with it in this post)

Aims of the new law

Before I start nitpicking at the negatives, let me state briefly what the main aims of this new law are and why it is considered progressive and a welcoming change by many.

To put it simply, the essence of it is consumer protection (just like the Bitlicense claimed to achieve) and from that standpoint, it can be considered progressive. With introduction of this law, the Japanese government draws a line between “safe(approved)” and “unsafe(unapproved)” territories for consumers and aims to prevent the uninformed public from getting defrauded by scammers who are selling useless “virtual currencies” or losing their money in some other way.

This probably doesn’t come as a surprise for bitcoiners elsewhere although the severity of scams in Japan may be even worse than any other areas in the world. One (at least seemingly) scamcoin operation is rumored to have raised more than 20 millions dollars worth of money from the ill-informed, pretending a legitimate decentralized project. Some others are just selling useless Ripple IOUs or Counterparty tokens for bitcoin, claiming it is trustworthy and the price will rise without a fail. You may even overhear people talking about Bitcoin and virtual currencies at a regular cafe in Tokyo now but most of them are scammers sweet talking the lesser informed unfortunately.

Thus, considering the current situation, the law is expected to put a stop to rampant scams in Japan and protect uninformed consumers. It’s hard to argue against that. (although I have some doubt about its effectiveness against scams)

Another benefit the new law will bring in favor of the community is legal clarity for larger corporations who have been looking for the right timing to enter the market. Also, it will bring more perceived legitimacy of virtual currencies and related technologies to the public, likely pushing the adoption further.

Points like the above have been already made repeatedly on the media and they are not hard to understand. Actually similar claims had been made in favor of the Bitlicense too. The difference is the general perception of Bitlicense in the Bitcoin community was very poor whereas the new law in Japan has been touted as a huge success for the community and rarely criticized. Why? Is it because in some way it is so much better or more progressive than the Bitlicense? I’d actually argue that this law may turn out to be more damaging to the Japanese industry in the long run than what Bitlicense has been to NY.

Where it resembles the Bitlicense

The biggest criticism of the Bitlicense was that it was excessively expensive to apply for a license and stay compliant for smaller Bitcoin startups. Some argued that this would stifle innovations in the state of NY. In fact, many startups such as Poloniex, ShapeShift and Kraken have already left NY after the Bitlicense, publicly criticizing or voicing out concerns about it. The long term effects are yet to to be determined but the general consensus in the Bitcoin community has been overwhelmingly negative.

If you are not a fan of the excessive cost for legal and compliance fee for Bitcoin startups, however, the new law in Japan is certainly not exciting news for you.

Just like with the Bitlicense, if you are considered a virtual currency trading business, you have to submit a numerous amount of paperwork and follow the rather strict procedures it requires. Main criteria for registration are as follows:

・Capital requirements

You have to reserve capital worth more than approx $100,000 USD. (vs the Bitlicense’s $5,000 application fee)

・Submission of a 3-year business plan

・Reporting detailed organizational structure

・Need to join the government appointed industry association

・Implementation of an internal training program for compliance and virtual currency management

・Segregated fund management, frequent reporting to authority and external audit

・KYC/AML requirements

Standard procedure most in the community have heard of already. Require to gather customer information from all users even for $1 worth of trading.

・ And lots and lots more “fun” paperwork

Overall, just in order to meet all the conditions above and become properly registered, it is estimated to cost around $300,000～$500,000 USD equivalent for the applicant(a rough estimation by a few experts that I have talked to). That’s for the initial registration and of course the cost of staying compliant and submitting more paperwork as it scales can add up to potentially millions of dollars.

It’s hard to say whether the regulation in Japan is more costly than the Bitlicense but I can say it’s expensive enough to put serious financial pressure on startups and may force them to go out of business completely in some cases.

The cost of compliance alone should be a serious concern for the community and more specifically smaller companies, but in some sense, this may not be surprising. After all, as long as you are in the business of transmitting money and holding customer funds, it’s natural to assume there will be some kind of intervention from the authority and regulation isn’t usually cheap. This not really a unique exception in Japan in that sense.

However, the more worrisome aspect of the law is that the regulation applies to not just custodial exchanges, but also to many other legitimate small companies and projects in the space who don’t even hold custody of user funds or are simply working on new and innovative technology.

Where it deviates from the Bitlicense

The prohibitively expensive legal cost alone is worrisome but some may even argue this is necessary to protect consumers and to prevent money laundering. However, what alarms me most about the law is not the legal cost but the other aspects which may seriously hinder innovations and set the Japanese Bitcoin and blockchain space back in the long-term.

The law is complex and I certainly do not understand it completely but the following two points in my opinion are the key to understanding its essence.

1. Only approved virtual currencies by the authority are considered legitimate and can be traded, sold or promoted to public

2. Regulation applies to non-custodial businesses too

Only approved virtual currencies by the authority are considered legitimate and can be traded, sold or promoted to public

One of the unique characteristics of this law is that the authority along with the pre-appointed industry association creates and updates a list of approved or “official” virtual currencies. Only those approved currencies are allowed to be sold, traded or promoted to the general public by registered trading entities already described above. On the flip side, selling, trading or promoting unapproved virtual currencies repeatedly in any form as a for profit entity will be technically prohibited by law.

This is clearly made this way for consumer protection and to put a stop to a bunch of scam coins sold to the uninformed public. To be fair, I believe it will address this issue at least to some degree. This will make it more difficult for scammers to legally sell their useless coins and get away with it.(Currently, there is not much to stop them from doing this over and over again and they usually target non-technical people such as the elderly)

However, it may come with the cost of destroying legitimate businesses who wish to experiment with altcoins or blockchain technology in general and the potential effect to the Japanese Bitcoin/blockchain industry is profound.

First of all, this list of approved currencies will likely be very exclusive and only a few major virtual currencies such as Bitcoin and Ether will be approved. The authority cannot tell “good” coins from “bad” and they will stay more or less conservative about adding new ones to the list to avoid the risk of potential mistakes even with help from the industry organization. The direct outcome of this is buying, trading or investing in many smaller altcoins in Japan may become more cumbersome or they will be forced to pay premium to acquire those coins from Japan.

Secondly, this will make it very difficult to sell and/or promote new coins with ICOs in Japan. The Japanese have been probably one of the most active ICO “investors” in the world and for lots of ICO projects, Japan has been an important target market. That will have to change with the new regulation.

Not just selling unapproved coins directly but promoting those ICOs targeting Japanese will be prohibited and potentially punished. Although how strictly this will be enforced by the authority is still unclear, but technically speaking, most standard ICO models at the moment, where basically anyone from any country can buy any coins without restriction, will be affected and they may need to limit or block access from Japan. At the very least, this will make it much more difficult for Japanese companies or projects to do ICOs in Japan.

Whether most ICOs are good or ethical is a completely different topic of its own and this may turn out to be a blessing in disguise for the industry, but it can also potentially block the Japanese community from investing in the cutting edge technology or participating in innovative new services.

Thirdly, many blockchain 2.0 projects who have their native tokens or use custom tokens on blockchain will get affected significantly.

Even if you are not doing an ICO and just use cryptographic tokens to grant access to your service or use open source software for example, promoting or selling those access tokens to Japanese may become restricted. Off the top of my head, decentralized service providers like Storj, Siacoin or Augur, which have decent following in Japan but probably not major enough to be approved by the government, are some of the projects which will potentially get troubled by this.

Also, the projects I’m involved in (Project ORB, IndieSquare, Spells of Genesis) which use the Counterparty protocol to issue custom tokens on the Bitcoin blockchain for gaming and content creation will likely be affected by the new law directly as well.

So, simply put, it can potentially kill altcoins and blockchain 2.0 development and adoption in Japan.

Well, but as long as you are dealing with approved currencies such as Bitcoin and you are not selling them or holding customer funds, the law cannot hurt you much, can it? Unfortunately, not so fast. The law can seriously hinder Bitcoin and other P2P technology development, too.

Regulation applies to non-custodial businesses too

Another rather troubling aspect of the law in my opinion is that it doesn’t concern whether trading entities are custodial or non-custodial.

While the Bitlicense received harsh criticism from the Bitcoin community, it was mostly about exchanges who hold users’ money. In that sense, regulating those custodial centralized exchanges made at least some sense for the sake of consumer protection or in preventing illegal fiat cash flow to/from crypto. On the other hand, as Airbitz, a mobile Bitcoin wallet and security solution provider, stated victoriously in their open letter at the time, non-custodial, decentralized services were unaffected. So, is it the same case in Japan? Unfortunately, it is not.

By definition, the regulation applies to those who facilitate or promote the sales or trading of virtual currencies regardless of whether they are holding customer funds. Thus, those trading facilitators are required to do KYC(Know-Your-Customers) and AML(Anti-Money-Laundering) to the users just like with centralized exchanges. While simple bitcoin wallets won’t be affected by this, if you offer some kind of virtual currency trading features to the Japanese public, even though you are not holding their money, you will be subject to the regulation and need to pay the hefty price. Who is in this category?

One good example would be P2P decentralized trading on blockchain. There is a high possibility that even if you are merely offering an interface to those P2P decentralized exchanges, you are considered a trading facilitator and thus required to be compliant with the law. You need to collect user data and follow other requirements as already described in this article as a registered entity.

Openledger(decentralized exchange using Bitshares2.0 protocol) is one example and Bitsquare(Fiat to crypto as well as crypto to crypto decentralized exchange) is another. In fact, we, IndieSquare(provider of mobile decentralized token exchange via the Counterparty protocol), will most likely be affected by the new law; 1. for dealing with unapproved user created custom tokens on the blockchain; 2. for providing an interface to the decentralized exchange even if we are not holding user funds.

The whole point of decentralized exchange is that there is no Counterparty or Gox risk and users are protected by the security of blockchain. I’m not sure how requiring a security audit to decentralize exchange providers helps protect consumers or have any effect against money laundering when you can just access unregulated ones outside Japan with relative ease.

Another example is that the same requirement will apply to payment hubs for the lightning network, tumblebit or any other new exciting trustless technologies currently under development. I’d be very worried about its implication to user privacy if payment hubs gather data about all of our micro payments and are required to report it to the authority. Although the restriction doesn’t apply for developers who’s just testing out the technology obviously, applying the same restrictions to payment hubs run by companies may end up slowing down the development of new P2P payment technology and destroy user privacy in Japan.

To sum up, the majority of altcoin and blockchain 2.0 projects will be negatively affected in one way or the other by the new law and development of trustless P2P decentralized payment or exchange technology may seriously be stalled in Japan.

Outcomes and implications

Finally, I will present some more specific predictions and likely scenarios that will transpire in Japan this year:

Foreign companies exit the Japanese market (at least “officially”)

Foreign exchange services such as Poloniex, Bittrex, ShapeShift, and Local Bitcoin will have to “officially” stay out of the market unless they decide to become a registered business in order to lawfully promote their service in Japan. Even if they only offer crypto to crypto exchange and no yen to crypto exchange, they are not exempt under the new law. Similar phenomena happened with the Bitlicense and many Bitcoin startups have left New York.

How strictly this will be enforced for foreign services accessible from Japan by the authority is unclear at this point and more informed users will probably keep using those services anyways at least for a while. However, it should be noted that foreign services may be forced to shut down their service in Japan in the future on the regulator’s whim as long as you are offering trading services to the Japanese public.

2. Smaller local businesses and projects will shut down their services, get acquired by larger companies or leave the market.

The law doesn’t affect technology providers to corporations or businesses who don’t deal with tokens on public blockchains. For example, if you are a private blockchain company who can limit the tradability of coins on the platform and if the blockchain use is for closed and internal value transfer, then there is a good chance you will be exempt from the expensive regulation.

However, if you are running a business or a project which involves some kind of tokens on public blockchains or selling/trading/or promoting those virtual currencies, you may have to decide to shut down your business in Japan, sell it to a larger company or possibly move elsewhere.

Some businesses may change the business model completely to accommodate the law and stay operational in Japan without getting registered. For smaller startups and projects without large funding, however, getting registered and staying compliant with the regulation is too expensive and not really a viable option in my opinion.

3. Bitcoin trading volume will accelerate further while the other facets of technology stagnate

Who benefits the most from this regulation? Exchanges with enough funding to survive the cost of compliance and larger corporations who are looking to enter the market are probably the winners here. (Private blockchain solution providers to large institutions that won’t be affected by the law directly may be in this category, too.)

In fact, the wave of large companies joining the race has already started and the GMO group, one of the internet giants in Japan, recently announced doing a virtual currency exchange business for example and several others are expected to follow GMO.

As I wrote in my previous post, the bitcoin trading volume is on the rise in Japan and with the entrance of larger players and virtual currencies’ perceived legitimacy to the public, I predict the bitcoin trading volume in Japan will shoot up at the accelerating speed this year.

On the other hand, however, outside of trading and speculation, it will become harder to experiment with new technology and start a small business in the space. This is unfortunate because other than trading, Japan has transformed into an interesting experiment field for token economy as well as some other altcoins and hold distinctive advantages in those areas over other countries at this point in my opinion.

The likely scenario is all those exchanges and subsidiaries of large companies are going to consolidate and offer all sorts of different services as platformers such as wallet, payment processing, debit card, storage solutions and so on altogether whereas small companies struggle or are forced to change the business model completely.

I am not entirely sure if the consolidation will turn out a bad thing for the community yet, but unique and disruptive services often come from smaller and more agile companies. Thus, I’m concerned innovations and a variety of unique services or technologies may start stagnating in Japan.

Conclusion

While I acknowledge that the new regulation in Japan will have some positive effects in reducing the number of scams and protecting uninformed consumers, it will come at the cost of potentially driving smaller experimental and unique projects out of the market, hindering diverse virtual currency and blockchain innovations in the country in the long term.

I may be overreacting in regards to the negative aspects and a lot still depends on the enforcement. It may end up being much more loose than I just described and small experimental startups and companies may mostly stay unaffected in the end. In fact, Japanese laws tend to be ambiguous in details and the impact often depends largely on the enforcement by nature. Thus, if enforcement turns out to be favorable for legitimate innovative projects, the extended Bitcoin community may not get affected negatively at all and may even benefit hugely from the added clarity and legitimacy the law provides.That’s certainly my personal hope as well.

However, I feel it’s important to raise concerns about the potential drawbacks and negative implications for the Bitcoin community as a whole inside and outside Japan, especially since many people seem to misunderstand the true nature of this law.

Although regulation of Bitcoin and other virtual currencies is inevitable in Japan or in any other country eventually, it shouldn’t assume it’s all about exchanges or financial applications(“Fintech”) and slow down innovations in other fields. After all, Bitcoin can disrupt a number of industries in unprecedented ways just like the internet did and missing out on its potential is not the best interest for the government either.

I am hoping this new virtual currency law in Japan is better understood by the wider Bitcoin community and they learn from this going forward before making misguided assumptions about it. Japan may have messed this up already just like New York did but others don’t have to follow the same path.

(A lot of credit goes to Atsushi Goto for untangling the legal complexity for me and giving me some solid advice and insight. His article provides more details about the law (written in Japanese though))