Decentralized finance – more commonly known as DeFi – has gained increasing traction over the last few months. With new services and platforms being launched every week, the environment has become increasingly complex despite its short history.
This article provides an overview of the key building blocks of DeFi and the regulatory implications under Japanese laws.
KEY BUILDING BLOCKS OF DEFI
1. decentralized exchanges
2. automated market makers
3. lending platforms
4. aggregators
5. vaults
6. derivatives
Decentralized exchanges (DEX) provide users with a marketplace where they can buy and sell crypto assets. The basic concept of DEXes is similar to that of centralized exchanges. Stated differently, DEXes typically maintain order books and matching engines.
In some cases, both the order book and matching engine are on-chain, in other cases they are off-chain and only the settlement occurs on-chain.
Examples
From a regulatory perspective it is necessary to distinguish between the order book/order matching and the settlement.
Depending on the degree of decentralization, i.e. the degree a creator of a DEX can access the funds or control the smart contract via admin rights, activities may either be regulated or unregulated.
(Potentially) Regulated Activities
|
|
custodial |
non-custodial |
regulated |
|
off-chain order book |
+ |
yes |
|
|
+ |
yes |
||
|
on-chain order book controlled |
+ |
yes |
|
|
+ |
yes |
||
|
on-chain order book not controlled |
+ |
no |
|
|
+ |
yes |
Automated Market Makers (AMMs) do not have order books. Instead they use liquidity pools that consist of at least one pair of crypto assets. The price of each crypto asset is measured against the other asset in the pool.
Uniswap for example uses the following formula to determine the price of each crypto asset in the pool:
x * y = k
In this equation, x and y represent the number of each token in the pool. While x and y vary over time, k remains constant and allows the AMM to determine the price of each asset at any point of time.
If a user exchanges ETH for DAI in an ETH/DAI pool, for example, the price of DAI becomes more expensive relative to ETH. This opens arbitrage opportunities if the ETH price in the pool deviates from the actual market price. To make use of the arbitrage opportunity a trader must only supply DAI to the pool and withdraw ETH. As a result, the price of ETH will be rebalanced and aligned with the overall market price.
The liquidity in the pools is provided by liquidity providers (LP). In exchange for providing liquidity LPs participate in the fees charged for interacting with the pool and in some cases receive a governance token as additional incentive.
Examples
(Potentially) Regulated Activities
To borrow funds via one of the existing lending platforms, users must deposit crypto assets to the protocol. When supplying funds to the lending protocol, lenders receive a token representing their share in the lending pool. This token may be used as collateral when borrowing funds from the protocol.
Depending on the protocol, an additional token, typically in form of a governance token, may be issued to both the lender and borrower as an incentive to use the platform.
Borrowers pay interests to the protocol which either forwards them directly to the lender or releases them once the lender decides to unlock his funds from the protocol.
Examples
(Potentially) Regulated Activities
Aggregators connect users, wallets, and smart contracts with liquidity. By doing so, they allow them to swap tokens for the best price available across multiple platforms.
Other aggregators constantly look for the best yield and distribute the supplied funds accordingly.
Examples
(Potentially) Regulated Activities
Vaults automatically optimize the returns on the funds supplied to them. To do so, they plug into multiple AMMs and lending protocols and move the funds wherever they generate the highest returns.
Where AMMs and lending protocols issue tokens as incentive, vaults automatically sell and reinvest them into the vault. One of the most prominent examples is yearn.finance.
Examples
(Potentially) Regulated Activities
Derivatives platforms allow users to speculate and hedge their positions. For efficiency and cost reasons exchanges such as dydx use a hybrid off-chain/on-chain solution. The order book and order matching is performed off-chain while the margins paid by users of the platform are maintained by the protocol on-chain.
The infrastructure most derivatives exchanges operate on is similar to that of DEXes.
Examples
(Potentially) Regulated Activities
DISCLAIMER
THIS DOCUMENT IS FOR GENERAL INFORMATION purposes only. It does not constitute legal advice; thus, it may not be relied upon regarding a specific legal issue or problem. The projects mentioned in this document are used for illustrative purposes only. Given the format of the document not all details of the token design and underlying business model have been considered, so that the results of the assessment may deviate from the results by the regulator or a legal opinion prepared for the respective project.
Crypto derivatives have become increasingly popular and account for over 90 percent of the total trading volume in Japan. Internationally, crypto derivatives have gained increasing traction as well. Only in June, Deribit reported that BTC options on the exchange have reached a new all-time high with a total of USD 1.4 billion open interest. Almost at the same time, the daily exchange volume of CME bitcoin futures reached USD 1.3 billion.
The success of crypto derivatives has also caught much attention in the DeFi space. Projects such as dydx try to replicate the success of their peers while giving users more control over their funds.
Before diving into derivatives on dydx, namely perpetual futures, we will first explain how perpetuals work. In the second part, we will then analyze each step from the deposit of margins to the trading of derivatives in more detail.
Key Findings
| Derivatives exchange services | Crypto derivatives are financial instruments. A platform providing exchange services must therefore generally register as a type I financial instruments business operator. This may not apply for completely decentralized platforms without an operator. |
| Deposit of margin | Deposit-taking activities may be considered a crypto asset exchange service that must be registered with the FSA. This applies to both centralized and – depending on the functionality of the smart contract and admin rights – decentralized projects. |
| Derivatives transactions | Platforms themselves do generally not engage in crypto derivatives transactions directly. They do therefore not have to register as a financial instruments business operator with the FSA in respect to the trading activities. Despite providing liquidity on exchanges, users do generally not have to register with the FSA. In most cases, their activities are likely considered proprietary trading which is unregulated. |
One of the best ways to understand perpetuals is to look at forward contracts and standard futures first.
Forward contracts: Forward contracts are bilateral agreements according to which the parties trade a specified quantity of a particular good at a certain price at a predefined date in the future. The contract is typically negotiated between the parties and tailored to their needs. A unilateral transfer of rights and obligations is generally not possible.
Futures: Futures are similar to forward contracts in that they also concern the trade of a specified quantity of a particular good at a certain price at a predefined date in the future. Unlike forward contracts, futures are however highly standardized and traded on exchanges. For trades on the exchange, the exchange becomes the buyer to each seller and the seller to each buyer. The users of the exchange therefore only bear the counterparty risk of the exchange but not the default risk of the other party.
Perpetual contracts: Perpetual contracts – for the large part – are perpetual futures, i.e. futures without a maturity date. Often provided via offshore jurisdictions, they allow traders to get leveraged exposure to bitcoin or other crypto assets. Typically, the margin requirements are 1 percent of the contract value for the initial margin and 0.75 percent for the maintenance margin. Where the margin falls below the prescribed thresholds, the position is automatically liquidated by the exchange. In some cases, the position is completely liquidated at once. In other cases, the liquidation occurs incrementally.
To ensure that the price of perpetuals does not deviate too much from the index price of the underlying asset, perpetual contracts use a certain funding mechanism. Where the perpetual contract is traded above the index price of the underlying asset, the trader holding the long position must pay the difference to the trader holding the short position and vice versa. Funding payments are calculated in regular intervals. In some cases, these intervals only account for milliseconds.
Most exchanges maintain an insurance fund to cover losses from bankrupt traders. Only if the insurance fund is depleted, losses from bankrupt traders are socialized.
| Criterion | Collateral | Futures | Perpetuals |
| Buyer-seller interaction | Direct | Via exchange | Via exchange |
| Contract terms | Can be tailored | Standardized | Standardized |
| Unilateral reversal | Not possible | Possible | Possible |
| Default-risk borne by | Individual parties | Exchange | Individual parties |
| Default controlled by | Collateral | Margin accounts | Margin accounts and insurance fund |
Perpetuals traded on dydx are not different from perpetuals traded elsewhere. Unlike other platforms dydx uses a different approach for the trading and settlement, however, by utilizing a hybrid on-chain/off-chain approach.
While the order book and the order matching is off-chain, all other actions are performed by smart contracts on-chain. These smart contracts are either developed by dydx or third parties (e.g. MakerDAO BTC-USD Oracle). Some of them have backdoors for administrators.
According to dydx, the hybrid solution is meant to combine the best of both worlds, i.e. off-chain speed and efficiency, and on-chain security.
In order to trade on dydx users have to pay a margin to dydx’s protocol. If the margin falls below the maintenance margin, an account may be liquidated. In the liquidation process anyone may assume the margin and position balances of the liquidated account, provided of course, he has sufficient margin on his own.
Where an account falls short and has a negative net value the admin of the perpetual smart contract or a third party can call an offsetting account to take over the balance. This account is typically the insurance fund maintained by dydx. If the insurance fund is depleted, the admin may determine another account with a high amount of profit and margin to take over the balance.
From a regulatory point of view, there are three different activities that must be assessed independently: (i) exchange services for derivatives, (ii) safekeeping of the margin, and (iii) engaging in derivatives transactions.
Crypto derivatives platforms are generally not considered financial instruments markets under the Financial Instruments and Exchange Act (FIEA). Yet, it is still necessary to register as a type I financial instruments business operator (FIBO) when operating a platform. This also applies to entities that use hybrid solutions, i.e. an off-chain order book and matching engine combined with on-chain settlement. The hybrid solution of dydx, for example, would be subject to registration requirements.
Something different may apply where the order book and matching engine are on-chain and where there is no operator. The smart contracts should further not be controlled by the project’s developers. Projects that have originally controlled the entity but subsequently transferred control to the community may not be covered by the registration requirement anymore. Where the project team remains the majority owner of the governance tokens, it may still be seen as the operator of the platform. A careful analysis is therefore necessary.
Users who wish to trade perpetuals must generally deposit a margin. This applies to both centralized and decentralized platforms, whereas for the latter, the amount is not paid to the platform, but a smart contract deployed by the platform.
Typically, the margin is either paid in bitcoin or some other cryptocurrency or, as in the case of dydx, stable coins. While bitcoin and other crypto currencies constitute crypto assets under the Payment Services Act (PSA), stable coins must be analyzed more carefully. Depending on their design, stable coins may either be classified as crypto assets or money orders. The safekeeping of stable coins that are crypto assets is regulated as crypto asset exchange services as written below. Where stable coins constitute money orders, regulations do generally not apply to the safekeeping of stable coins in Japan.
The custody of crypto assets for others is generally considered a crypto asset exchange service under the PSA and must be registered with the Financial Services Agency (FSA). Since custody requires control over the crypto assets, services are not covered if a platform does not have ability to transfer a user’s funds. The fact that funds are locked into a smart contract does not automatically mean that the platform does not have control over the funds. In particular, where the platform is able to modify the smart contract in such a way that allows it to transfer the funds, the platform will still be deemed to have control. It is therefore necessary to analyze the administrator rights carefully, and where necessary to modify them to avoid registration.
Crypto derivatives constitute financial instruments within the meaning of the FIEA. This applies irrespective of whether they are settled in fiat or cryptocurrencies. Entities engaging in derivatives transactions must therefore generally register with the FSA as a FIBO. An exception may however be made for entities engaging in transactions with certain counter parties.
Since crypto derivatives platforms do not engage in transactions with their users but only provide the marketplace, they must generally not register as FIBO with regard to entering into transactions as such.
For users something different might apply since they can act both as makers, i.e. liquidity providers, or takers. A registration is only required however if the respective person engages in derivative transactions in the course of their business. In general, the activities on the exchanges are more akin to proprietary trading which is unregulated. This applies irrespective of whether the trader acts as a maker or taker.
It should be noted that the provision of a leverage exceeding 2x to retail investors is not allowed under Japanese laws.
The principle “same business same rules” also applies to derivatives. DeFi and offshore projects may therefore be required to register with the FSA if they want to offer their services to users in Japan. For fully decentralized projects without an operator something different may apply. The law, at least, is silent in this respect and leaves room for interpretation. DeFi projects that have transferred control over the protocol to their users, may therefore decide to enter the Japanese market without registration. For other projects smart technical solutions backed by legal arrangements may ease the regulatory burden and should be considered.
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