Japan’s Exchanges Regulatory Turning Point: How and Why Authorities Wrested Control

Japan — once seen as a crypto-liberal haven — now has some of the most stringent and decisive regulations for exchanges. But is it for the greater good?

On March 8, 2016, Japan announced Bitcoin as a legal form of payment; its adoption was flourishing and only positive things could be said about the digital currency as the digitally inclined population embraced cryptocurrencies. Japan was a leader in Bitcoin and cryptocurrency innovation and adoption.

From ‘Miss Bitcoin’ to the slew of businesses that the island nation received after China’s ban on cryptocurrencies, Japan was becoming a super power of digital currency and happily taken the mantle, headlong.

Bitcoin businesses were booming in Japan — especially exchanges — but there came a turning point. Japan’s boom had been down somewhat to its hands-off approach to regulation, waiting to see how the rest of the world handled this tricky business. That was until a second major Tokyo hack.

Mt. Gox was, by now, mostly put away to the annals of history, but the lessons were not learnt when, on January 26, it was revealed that Tokyo-based exchange Coincheck had been robbed of 523 million NEM coins, worth approximately $534 mln.

This prompted Japanese authorities to finally step in and begin a path of strong and rigid regulation on cryptocurrency exchanges across the nation. It has seen sweeping changes affect the face of Japanese exchanges, with many being called out for poor management while others have banded together to form a self-regulatory board to try help clean up the space.

Coincheck turning point

It could be understandable why Japanese authorities decided that enough was enough after they picked up a second unwanted record  — holding the two biggest cryptocurrency exchange hacks in history, in just one town, does not look good for a government.

It led to the Financial Services Agency (FSA) getting their hands dirty and beginning to look into how these exchanges were being run. They, of course, began with Coincheck and quickly discovered how badly things were being run.

The FSA moved on 15 exchanges that were currently awaiting registration and also ordered all crypto exchanges in Japan to submit a risk management system report in the wake of the hack. It was clear that the hands-off approach was over and that the FSA and regulators were looking at the exchanges to explain just exactly how they had been running things.

In their findings, the FSA disclosed some damming issues they found with an exchange — which they kept anonymous.

“The company does not properly evaluate in the virtual currency space, as a result, an appropriate internal control system has not been established”. They went on to list a number of other major faults:

• Regarding the in-house issued virtual currency, price formation was done by matching the company's own account and the individual sales of the president.
• The representative of the company temporarily diverted the money deposited from the user, in order to devote it to paying the expenses of the company.
• The 100% shareholder of the company was privatizing the virtual currency (Bitcoin) deposited from users.
• Despite the frequent occurrence of system failure cases while the business is rapidly expanding, it does not analyze the root causes sufficiently and does not take appropriate measures to prevent recurrence.
• In trading a large number of virtual currencies over several times, the company does not make confirmation at the time of transaction and judgment on necessity of notification of suspicious transactions.
• The company has not prepared a system to verify transactions at time of trading, and training for staff has not yet been done.
• There is no one who fully understands the content requested by the authorities for improvement.”

This led to the FSA dishing out penalties — as well as orders — for the companies to stop operating. But, some companies didn’t let it get that far, as they decided to shut up shop before the new regulatory expectations became too much to bear.

Taking matters into their hands

This turning point of the Coincheck hack, and the FSA involvement, sparked some of the bigger and more established exchanges to band together. There were two ways they could have taken this intrusion by the government, but they decided to try and side with them to help.

A self-regulatory body was formed by 16 registered exchanges whose aim is to work together to produce industry-wide investor safety standards, including the creation of guidelines for Initial Coin Offerings. So, created in April, the Japan Virtual Currency Exchange Association (JVCEA) has been trying to clean up the crypto space going forward, while the FSA continues to sweep up the rubbish remaining, having just recently dished out five more improvement notices to exchanges.

The JVCEA’s own work also continues, as they are set to release more rules of their own organization this week in their continued bid to keep cleaning up the Japanese cryptocurrency space.

The official announcement of the regulatory guidelines, set for June 27th, will reportedly include a ban on insider trading and penalizing cryptocurrency exchange employees if they engage in “inappropriate” trading due to their firsthand knowledge.

All of these rules seem to be in reaction to the findings of the FSA, taking aim mismanagement of funds and poor dealings by the staff of the exchanges. And it is interesting to note that the JVCEA is also cracking down on anonymity coins, such as Zcash and Monero — two coins that are not favored by the FSA.

Japan Virtual Currency Exchange Association feeling the sting

In an interesting turn of events, the JVCEA took a rather large body blow on June 25 when it lost two of its vice presidents. Yuzo Kano and Noriyuki Hirosue, the CEOs of bitFlyer and Bitbank respectively, vacated their posts at the top of the organization.

What was the reason for their decision? Their own cryptocurrency exchanges had been served with business improvement letters from the FSA. This move, from both the CEOs and the FSA, just indicates the seriousness of the crackdown on exchanges in the company.

Even as part of an organisation aimed at trying to improve the standard of exchanges, the likes of bitFlyer and BitBank were not immune to the FSA’s rigorous requests for betterment. Kano and Hirosue’s departure from the organization is still open for interpretation, but the feeling is that they have focused their attentions toward their core business.

The JVCEA meanwhile appeared unphased by the news, with a statement promising it would continue on its mission.

“We will continue to do our utmost to protect the interests of users and to promote the sound development of the virtual currency exchange industry, including the early establishment of voluntary regulation rules.”

Still building towards regulations

With all the work and effort that has been done by both the FSA and the JVCEA, there is yet to be any hard and fast regulation in place. Rather, a it is bringing them in line with the general financial practices expected from businesses.

However, there is now work being done by the FSA to see which direction the actual regulation should go, as a Crypto Study Group has been formed. Members of the study group will come from academic institutions, cryptocurrency exchanges as well as government agencies as observers.

According to Cointelegraph representatives who have attended meetings of such groups, there seems to be a divide in the group along two different ideals

The one side of the group is a product of the FSA’s inspection and the issues they have uncovered. They are concerned and are arguing for much more investor protection from the regulators. The other side appears to be more balanced. They are looking for innovation and regulation to work together and want to fix the problems without killing the entire ecosystem.

According to the minutes of the first meeting, the participants discussed — with respect to leveraged trading — the need for a margin requirement with a limit on maximum level of leverage and, with respect to ICOs, appropriate regulatory framework.

Rocky, but steady

Japan’s regulatory framework has now, because of the mishaps of Coincheck, been given a regulatory bedrock that will no doubt be important globally. The FSA has had to come out hard and put money exchanges to the sword, prompting the formation of the JVCEA and helping address the poor state of Japanese exchanges.

A lot of the cryptocurrency regulation will happen within the framework of exchanges, and — by putting their current operating businesses through these strict and stringent laws — the FSA and the Japanese government appear to be hoping that they are setting the tone for how the entire space should be governed.

Currently, throughout the globe, there is an ongoing battle on regulations as how to balance the promotion of innovation and the security of crypto users from regulatory intervention. Japan now has a reason to be a lot more strict with its regulations, as it has suffered the consequences already with both Mt. Gox and Coincheck.

To this end, when its regulatory rules do start to roll out, it is going to be hard to argue with stricter and tighter controls by the government, as they can always count with the millions that were lost in those two major hacks alone.

If Mt. Gox showed Japan what is possible, Coincheck sparked them into action. They have hard and fast rules for exchanges now in place, but those rules could be the bedrock on which the regulations are built on. It may be strict, but it will also be secure.