Bitcoin and Beyond: Understanding Virtual Currency Regulation in Japan

Japanese Attorney at Law - Bengoshi L.L.

• 8 min read

The ascent of virtual currencies, also commonly referred to as cryptocurrencies (and more recently in Japan, 暗号資産 - angō shisan or crypto-assets), has presented both exciting technological frontiers and complex regulatory challenges worldwide. Japan has been a prominent market in this domain and was among the first major economies to establish a comprehensive legal framework for the oversight of these digital assets. Understanding this regulatory landscape is crucial for any business or individual engaging with virtual currencies in or from Japan. This article delves into the definition and technological underpinnings of virtual currencies, using Bitcoin as a key example, and provides an in-depth examination of Japan's regulatory approach, primarily under its Payment Services Act (PSA).

The journey from traditional cash to digital representations of value has seen several evolutionary steps, from early concepts of digital cash and e-money to the more decentralized and globally transferable instruments now known as virtual currencies. In the Japanese legal context, these are distinguished by several key characteristics:

  • They are not denominated in or backed by a sovereign fiat currency like the Japanese Yen or the US Dollar.
  • They can be used as a means of payment (支払手段 - shiharai shudan) to unspecified persons for goods or services.
  • They can be mutually exchanged with fiat currencies (e.g., Yen, USD) or other virtual currencies.
  • They are recorded and transferred electronically.

Japan's Payment Services Act (資金決済法 - Shikin Kessai Hō), particularly after its significant amendments in 2016 (often referred to in conjunction with other reforms as the "FinTech Law" ), provides the primary legal definition for what it termed "virtual currency." This definition encapsulates the properties above, focusing on their function as a payment method and their digital, transferable nature.

The scope of what constitutes a regulated instrument can be nuanced. For instance, the treatment of in-game currencies or items has been a subject of discussion, hinging on whether they meet the criteria for "prepaid payment instruments" (前払式支払手段 - maebarai-shiki shiharai shudan) under the PSA, or potentially virtual currencies. This assessment generally considers whether the item is purchased for monetary value, stores that value, and can be used to acquire goods or services. A No-Action Letter issued by Japan's Financial Services Agency (FSA) on September 15, 2017, clarified that certain in-game items, under specific conditions such as a user agreement stipulating that the provision of the item completes the service, might not be considered prepaid payment instruments. This illustrates the careful line-drawing involved in applying these definitions. While the terminology has more recently shifted towards "crypto-assets" in line with G20 and Financial Action Task Force (FATF) usage, the foundational regulatory principles established under the "virtual currency" framework remain largely relevant.

Bitcoin: A Technological Archetype

Bitcoin, introduced in a 2008 paper by the pseudonymous Satoshi Nakamoto, is often considered the archetypal virtual currency and serves as a useful example to understand the underlying technology.

  • Decentralized Nature: Unlike fiat currencies issued and backed by central banks (like the Bank of Japan), Bitcoin has no central issuer or administrator. New Bitcoins are generated through a decentralized process known as "mining".
  • Limited Supply: The total number of Bitcoins that can ever be created is capped at approximately 21 million, a feature designed to mimic the scarcity of precious metals.
  • Peer-to-Peer (P2P) Network: Transactions are conducted directly between users via digital "wallets" without the need for traditional financial intermediaries like banks. While transaction fees are typically paid to miners, these can often be lower than conventional banking fees, especially for cross-border transfers.
  • Blockchain Technology: Bitcoin's operations are underpinned by blockchain, a distributed and immutable public ledger that records all transactions in a verifiable and transparent manner. Transactions are grouped into "blocks," which are cryptographically linked together to form a chain.
  • Mining and Proof-of-Work (PoW): New blocks are added to the Bitcoin blockchain through a competitive process called mining. "Miners" (マイナー - mainā) use specialized hardware (often in large "mining farms" - マイニングファーム - mainingu fāmu) to solve complex computational puzzles. The first miner to solve the puzzle validates a block of transactions and adds it to the chain, receiving newly minted Bitcoins and transaction fees as a reward. This PoW mechanism secures the network and ensures consensus on the transaction history.
  • Exchangeability and Acceptance: Bitcoin can be exchanged for fiat currencies on various virtual currency exchanges, and its acceptance as a direct means of payment for goods and services, while not universal, has been growing.

While Bitcoin uses PoW, it's worth noting that the broader crypto-asset ecosystem features various other consensus mechanisms (e.g., Proof-of-Stake) designed to address different trade-offs in terms of energy efficiency, transaction speed, and security.

Japan's Regulatory Framework for Virtual Currencies

Japan was one of the earliest major economies to implement a specific regulatory framework for virtual currencies, primarily through amendments to the Payment Services Act. The approach has been driven by a desire to mitigate risks such as money laundering, terrorist financing, and consumer harm, while not unduly stifling innovation. This framework predominantly focuses on regulating the intermediaries that facilitate the exchange and management of these assets.

A. Registration of Virtual Currency Exchange Service Providers (VCESPs)

The cornerstone of Japan's regulatory approach is the mandatory registration of Virtual Currency Exchange Service Providers (VCESPs) (暗号資産交換業者 - angō shisan kōkan gyōsha, previously 仮想通貨交換業者 - kasō tsūka kōkan gyōsha). Article 63-2 of the PSA stipulates that no entity may engage in virtual currency exchange services as a business without being registered with the Prime Minister (with operational oversight delegated to the FSA).

"Virtual currency exchange services" are defined to include:

  1. The sale and purchase of virtual currencies or their exchange with other virtual currencies.
  2. Intermediary, brokerage, or agency services for the activities mentioned in (1).
  3. The management of users' money or virtual currencies in connection with the activities mentioned in (1) or (2).

To obtain registration, applicants must satisfy a range of requirements (PSA Arts. 63-3, 63-5), including:

  • Financial Soundness: Demonstrating adequate financial basis, including minimum capital requirements.
  • Robust Internal Systems: Establishing robust systems for managing operations, ensuring cybersecurity, complying with legal obligations, and managing risks. This includes segregating customer assets (both fiat and virtual currencies) from the VCESP's own proprietary assets.
  • Fit and Proper Management: Ensuring that directors and key personnel have the requisite knowledge and experience and are not disqualified under specified criteria.
  • Information Disclosure: Providing detailed information about the VCESP's business, including its trade name, address, capital, office locations, names of directors, and the types of virtual currencies it intends to handle.
    The registry of VCESPs is publicly accessible, enhancing transparency.

B. Anti-Money Laundering and Countering the Financing of Terrorism (AML/CFT) Obligations

A key driver for regulating VCESPs was the need to address AML/CFT risks associated with the pseudo-anonymous nature of some virtual currency transactions. Under Japan's Act on Prevention of Transfer of Criminal Proceeds (APTCP, 犯罪収益移転防止法 - hanzai shūeki iten bōshi hō), VCESPs are designated as "specified business operators". This designation imposes several critical obligations:

  • Customer Identification (KYC): VCESPs must verify the identity of their customers at the time of account opening and for certain transactions, as stipulated by Article 4 of the APTCP.
  • Record-Keeping: They are required to create and maintain detailed records of transactions and customer identification for a prescribed period (Article 7 of the APTCP).
  • Reporting of Suspicious Transactions (STRs): VCESPs have a legal duty to report any transactions they deem suspicious to the relevant authorities (Article 8 of the APTCP).
  • Internal Controls: They must establish and maintain appropriate internal systems and controls to ensure compliance with these AML/CFT obligations.

C. User Protection Measures

Beyond AML/CFT, the regulatory framework incorporates several measures aimed at protecting users of virtual currency services:

  • Information Disclosure: VCESPs are obligated to provide users with clear and comprehensive information regarding the terms of service, fees, the specific risks associated with virtual currency transactions (such as price volatility and potential for loss), and details about how customer assets are managed and protected. This addresses what the source material refers to as managing "agency risk" (代理人リスク対応 - dairinin risuku taiō) and maintaining user trust (信頼の維持 - shinrai no iji).
  • Segregation of Customer Assets: A critical user protection measure is the requirement for VCESPs to segregate customers' fiat currency and virtual currencies from their own proprietary assets. This is intended to safeguard user funds in the event of the VCESP's insolvency or operational failures. Major incidents at exchanges globally, including some in Japan, highlighted the severe consequences when this segregation was inadequate, prompting stricter enforcement of this rule.
  • Cybersecurity and System Security: Recognizing the significant threat of hacking and cyberattacks targeting virtual currency exchanges, VCESPs are required to implement and maintain robust cybersecurity measures to protect their systems, networks, and customer assets. This includes conducting regular security audits and assessments.
  • Complaints Handling and Dispute Resolution: VCESPs must establish effective procedures for handling complaints from users and for facilitating the resolution of disputes. Some VCESPs are also members of industry self-regulatory organizations that may offer alternative dispute resolution mechanisms.

D. FSA Oversight and Enforcement

The Financial Services Agency (FSA) is vested with broad powers to supervise registered VCESPs and enforce compliance with the PSA and related regulations. These powers include:

  • The authority to request reports and submission of materials regarding a VCESP's business operations and financial condition (PSA Art. 63-14).
  • The power to conduct on-site inspections of VCESPs' premises to examine books, records, and systems (PSA Art. 63-15).
  • The ability to issue business improvement orders if a VCESP's operations or financial condition are deemed inadequate or non-compliant (PSA Art. 63-16).
  • In cases of serious violations or unrectified deficiencies, the FSA can order the suspension of business operations or revoke a VCESP's registration entirely (PSA Art. 63-17).

The FSA has demonstrated a willingness to use these powers, particularly in the wake of significant security incidents at exchanges, to drive improvements in governance, internal controls, and cybersecurity practices across the industry. The role of self-regulatory organizations (SROs), such as the Japan Virtual and Crypto assets Exchange Association (JVCEA), is also significant, as they work in conjunction with the FSA to establish industry best practices and conduct oversight.

Beyond the specific VCESP regulatory regime, other legal and risk factors pertain to virtual currencies in Japan:

  • Taxation: Profits derived from virtual currency transactions are generally subject to taxation in Japan. For individuals, these profits are typically classified as miscellaneous income.
  • Securities Regulation (Financial Instruments and Exchange Act - FIEA): The distinction between virtual currencies that primarily function as a means of payment (utility tokens) and those that have investment characteristics (security tokens) is crucial. Initial Coin Offerings (ICOs) or Security Token Offerings (STOs) that bear the hallmarks of securities (e.g., promising a share of profits or returns on investment) may fall under the purview of Japan's FIEA. This would trigger requirements for registration, disclosure, and compliance with investor protection rules analogous to those for traditional securities. The concerns around "agency risk" noted in the source material hint at the need for consumer protection similar to that in the sale of financial products.
  • Legal Status and Contractual Issues: While the PSA recognizes certain virtual currencies as a means of payment, they do not have the status of legal tender like the Japanese Yen. Their treatment in areas such as contract law, inheritance, or bankruptcy proceedings continues to be a subject of legal discussion and development.
  • Price Volatility and Investment Risk: The inherent price volatility of many virtual currencies poses significant risks to users and investors. VCESPs are obligated to clearly explain these risks to their customers.

The regulatory landscape also continues to adapt to newer innovations within the crypto-asset space, such as Non-Fungible Tokens (NFTs) and Decentralized Finance (DeFi) applications, with ongoing discussions about how existing frameworks apply or whether new regulatory approaches are needed.

Conclusion: Japan's Ongoing Journey in Virtual Currency Regulation

Japan has distinguished itself as a jurisdiction that has taken proactive steps to establish a regulatory framework for virtual currencies. This approach aims to foster innovation in the burgeoning crypto-asset sector while concurrently addressing the critical need for user protection, financial system integrity, and the prevention of illicit activities. The amendments to the Payment Services Act have laid a foundational structure for VCESPs, emphasizing registration, robust AML/CFT measures, asset segregation, cybersecurity, and clear information disclosure.

However, the world of virtual currencies is exceptionally dynamic. New technologies, applications, and associated risks emerge continuously. Consequently, Japan's regulatory framework is not static; it is an evolving landscape, with the FSA and other relevant bodies actively monitoring market developments and adapting rules and oversight practices as necessary. For any business or individual involved with virtual currencies in Japan, maintaining a thorough understanding of these evolving regulatory requirements and committing to rigorous compliance practices is paramount for lawful operation and sustainable participation in this innovative field.