Huang Yashen | How will the Japanese Financial Services Agency respond to the FTX incident? How will Japanese users be affected? The inevitable "trust" soul-searching.

This article is written by Arthur Huang, a lawyer and freelance Japanese translator, specializing in legal issues related to Fintech, startups, blockchain, and cryptocurrency assets. Currently exploring the world of Metaverse and advancing towards the path of a Coding Lawyer.

Japan's Financial Services Agency Response to the FTX Incident and Recent Developments at FTX Japan

Following the financial controversy surrounding FTX's affiliate Alameda Research, the Twitter feud between SBF and CZ, Binance's withdrawal of acquisition intentions for FTX, and The Wall Street Journal's report on FTX's suspected use of user assets, Japan's Financial Services Agency (FSA) issued an administrative action against FTX Japan on November 10th.

The reason for the action was due to FTX Japan's parent company, FTX Trading Limited, facing issues and failing to communicate its operational policies to users or provide a clear timeline for resuming operations after the incident at FTX.com. While user withdrawals were temporarily suspended, new user deposits were not prohibited. Concerned with potential credit risks associated with the parent company's assets, the FSA acted to prevent assets from being withdrawn to overseas affiliated entities, safeguarding the rights of investors and users within Japan.

Regarding the action taken, given FTX Japan's status as a "virtual currency exchange" and "financial instrument trading business operator," the FSA based its penalties on Japan's "Payment Services Act" and "Financial Instruments and Exchange Act", with detailed provisions as follows:

1. Penalties for Virtual Currency Trading Business：

• Order to suspend operations: From November 10th to December 9th, new user asset deposit activities are not allowed.
• Improvement order: Correctly manage user asset storage, take immediate preservation measures, ensure fair treatment of users, and protect user assets properly. FTX Japan must submit a written improvement plan by November 16th and report to the FSA. Until the improvement plan is completed, monthly progress reports must be submitted by the 10th of the following month.

2. Penalties for Financial Instrument Trading Business Operators：

• 1. Order to suspend operations: From November 10th to December 9th, activities related to user derivative financial products and margin deposits are not permitted.
• 2. Domestic asset custody order: Ensure sufficient assets are held in Japan based on the company's balance sheet liabilities, deducting non-resident liabilities.
• 3. Improvement order: Same as for virtual currency trading business, with additional emphasis on asset custody and management.

After receiving the administrative action, FTX Japan disclosed the amount of virtual currency and fiat assets it holds on November 14th, indicating that the assets held in cold wallets and trusts exceed the amount held by users. Additionally, FTX Japan revealed its current net worth in Japan, including available cash and deposits.

According to a report by NHK on November 21st, FTX Japan explained the difficulty in enabling withdrawals due to sharing the same settlement system with its parent company. They are working on developing their own system and plan to reopen withdrawals by 2022, allowing Japanese users to access their assets.

Relationship between FTX Japan and FTX

FTX Japan, formerly known as the exchange Liquid, obtained a license as a virtual currency exchange in 2017 and officially became part of the FTX group in February 2022, rebranding as FTX Japan. The primary issue in the current context revolves around FTX Trading Limited FTX.com, the parent company of FTX Japan. Due to legal restrictions in the US and Japan, US users can only use FTX.US, while Japanese users, post-Liquid's acquisition by FTX, are limited to FTX Japan. The usage of leverage by users in Japan is also restricted due to the Financial Instruments and Exchange Act.

For FTX, FTX Japan serves as an entry into the Japanese market by acquiring a local exchange license directly. Prior to joining the FTX group, Liquid Exchange was already regulated in Japan and complied with self-regulatory organization standards. Despite the challenges faced by global users in the FTX incident, Japanese users seem to have more protection due to Japan's historical experience with exchange closures and cybersecurity issues. The regulatory framework in Japan has been developed to safeguard users, allowing the FSA to conduct checks and request reports when necessary. Most Japanese exchanges have shown minimal exposure in this incident, and users are likely to have mechanisms to assert their rights under relevant regulations if affected.

Supervision of Japanese Exchanges: From the Mt.Gox Collapse Onwards

The collapse of Mt.Gox, once the world's largest Bitcoin exchange in 2014, continues to have repercussions to this day.

Mt.Gox claimed bankruptcy due to a hack that resulted in the theft of Bitcoin, leading to its closure and subsequent bankruptcy filing in April of the same year. This incident drew attention from Japanese society and Bitcoin investors worldwide.

One notable legal battle involved a Mt.Gox user suing for the return of 458 BTC, asserting ownership rights against the bankruptcy trustee, Nobuaki Kobayashi.

This lawsuit sparked a debate between "ownership" and "creditor" rights. The difference lies in the ability to receive full compensation. The Tokyo District Court ultimately ruled that BTC holders did not have a direct claim to retrieve their BTC but held creditor rights, entitling them to a share of the company's assets along with other creditors.

This ruling prompted extensive discussions within the Japanese government and parliament regarding the nature of Bitcoin. It was concluded that Bitcoin is neither a commodity nor a currency but a form of "value record" distinct from electronic cash.

Bitcoin was deemed to be an electromagnetic record of value, not fitting the definitions of money or property in existing laws. Consequently, its legal nature needed to be redefined, considering the Financial Action Task Force (FATF) guidelines on regulating the exchange of virtual currency and fiat currency. Japan amended its laws in 2016 to include the management of cryptocurrencies under the Payment Services Act, becoming one of the earliest countries to regulate virtual currency exchanges.

In 2018, Japanese cryptocurrency exchanges Coincheck and Zaif fell victim to hacking attacks, resulting in asset losses for users. These security breaches led the Financial Services Agency to tighten regulations on industry participants. The FSA issued administrative actions, requiring companies to explain the causes of incidents, respond appropriately to customers, manage system risks, outline clear responsibilities, and establish measures to prevent future occurrences.

In 2019, considering the possibility of exchange bankruptcies, the Japanese government mandated separate management of company and user assets, prioritizing user claims for effective protection. Amendments to the Financial Instruments and Exchange Act were made in response to ICO-related issues, requiring exchanges to obtain licenses for derivative financial product trading and limiting leverage ratios.

Japan's Three Pillars Post-Exchange Incidents

Following past exchange closures and cybersecurity incidents, Japan established three key standards for regulating cryptocurrency exchanges:

1. Separate Management of Exchange and User Assets:

Exchanges must manage company and user "virtual currency" and "fiat" assets separately, ensuring clear identification of asset ownership.

For fiat assets, user funds should be held in trust, while virtual currency assets require high-security storage methods such as cold wallets or equivalent technologies. External auditors must conduct annual audits to verify separate asset management.

2. Priority Repayment of User Assets:

In the event of exchange bankruptcy, user rights are legally prioritized for repayment ahead of other creditors, ensuring users are compensated first before other creditors.

3. Company Information Transparency:

Given the unique nature of cryptocurrencies, Japanese authorities require exchanges to disclose information to users regarding the differences between virtual currencies and fiat, price volatility risks, potential asset losses due to company financial changes, and external risks such as cyber-attacks or blockchain network failures.

Additionally, exchanges must provide details on user fees, calculations, dispute resolution methods, complaint procedures, financial reports, and asset management methods.

Defining Regulation: Slow but Steady Progress

Japan's cautious approach to exchange regulation has focused on internal control systems and risk management. While initially criticized for stifling innovation and financial development, recent government actions signal a shift towards supporting Web3 technologies as part of Japan's future strategic investments. Major Japanese corporations are also investing in Web3 industries, indicating a growing interest in NFTs, GameFi, and token economies.

Building Trust: Centralized vs. Decentralized Approaches

Centralized Approach: Transparency and Risk Management

The FTX incident highlights the risks of centralized exchanges, emphasizing the need for robust internal controls, regulatory frameworks, financial transparency, and insurance to establish trust. While centralized entities offer convenience, they also pose risks if not properly regulated.

Regulation and oversight are crucial in maintaining trust in centralized systems. A combination of legal frameworks, internal procedures, transparency, and dispute resolution mechanisms is essential to build confidence in centralized organizations.

Decentralized Approach: On-Chain Governance

Advocates of decentralized governance through blockchain and smart contracts aim to enhance transparency and public oversight. While promising, challenges such as user complexity, code security, and handling value judgments remain. Decentralized Autonomous Organizations (DAOs) may address some issues, but not all governance matters can be resolved through majority voting.

Legal frameworks play a crucial role in safeguarding minority interests and addressing unforeseen circumstances. The balance between centralized and decentralized trust mechanisms is essential in building industry confidence and resilience.

Rethinking the Value of Bitcoin's Inception

Amid misconceptions about decentralization and blockchain technology, the FTX incident underscores the importance of regulatory oversight and transparency. Bitcoin's value lies in offering choice and challenging regulated centralized financial institutions. It serves as a reminder that even regulated entities can pose risks if not properly managed. Bitcoin's birth symbolizes the right to choose and experiment in a rapidly evolving industry.

Ultimately, both centralized and decentralized trust models complement each other, emphasizing the need for robust risk management, transparency, and flexible mechanisms to build industry confidence.