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In recent years, quantum computers and other “quantum technologies” have rapidly been attracting attention. Specifically, quantum technology is expected to bring about high computing power and innovations in encryption technology that surpass conventional information technology, and various parties both in Japan and overseas are working on its practical application.

On the other hand, new issues are emerging, such as the risk of existing encryption being broken, and it is expected that there will be an increasing number of situations in which quantum technology will be required in national security, cybersecurity, and contract practice. This article focuses on quantum computers as a representative example of quantum technology, providing an overview of quantum computers and summarizing the main points of contention under current Japanese law.

I. Summary of Relevant Legal Frameworks

II. Overview of Quantum Computers
1. Basic Principle

Quantum computers use quantum properties such as “superposition”, “entanglement”, and “quantum tunneling” to perform calculations, which are expected to enable calculations that are significantly faster than conventional computers (known as classical computers) for certain problems.

There are two main types of quantum computers: Gate-Based Quantum Computers and Quantum Annealers.

The Gate-Based Quantum Computers are “general-purpose quantum computers” that can execute general-purpose quantum algorithms. Various methods are being researched, including superconductivity, semiconductors, ion traps, light, and neutral atoms. However, mainstream technology has not yet been established, and there are issues such as error correction before it can be put into practical use. In contrast, the  Quantum Annealers are specialized for combinatorial optimization problems, and D-Wave Quantum Inc. provides commercial machines. In general, when people say “quantum computer,” they are often referring to the Gate-Based Quantum Computers, but the terms are used differently depending on the application and implementation technology.

*Gate operation: A basic operation in which a quantum bit is given a certain stimulus (such as a microwave pulse or laser pulse) to change its state, and corresponds to the logical gates (AND/OR/NOT, etc.) of a classical computer. Examples include the X gate (which swaps the quantum bit’s 0 and 1) and the H (Hadamard) gate (which puts the quantum bit into a superposition state). The key to developing quantum hardware is to perform these gate operations quickly and with high precision.

On the other hand, Quantum Annealers are specialized for “combinatorial optimization” and cannot perform general-purpose calculations, but it is more advanced in practical use than Gate-Based Quantum Computers. In addition to the commercial machine provided by D-Wave, a Canadian company, “Quantum-Inspired Annealing” (Fixstars Amplify AE, Fujitsu Digital Annealer, etc.), which reproduces the behavior of classical computers in a pseudo-manner, has also been developed.

2. Current Status of Quantum Computers

In January 2025, NVIDIA CEO Jensen Huang said that it would take about 20 years to realize a practical quantum computer, causing a sharp drop in quantum-related stocks in the United States. This is thought to be a forecast referring mainly to Gate-Based Quantum Computers, and at the time of writing this article (end of May 2025), many experts believe that it will take a considerable amount of time before they can be put to practical use. The main reason is that errors (decoherence due to external noise) that occur in the process of maintaining “superposition” and “entanglement” in Gate-Based Quantum Computers are serious, and advanced “error correction” technology is essential to resolve this. However, it is still thought that a considerable amount of time will be required to establish error correction technology, which is the background to the view that it will take 10 to 20 years.

However, research and development of various Gate-Based Quantum Computer approaches are accelerating around the world, and in Japan, large companies, startups, research institutes, and universities are competing to develop actual machines. In addition, commercial machines for the Quantum Annealers are already in widespread use, and an environment for online use has been established. In this way, quantum technology is not a “Matter of the distant future”, but technology that is currently being implemented in society.

3. Applications of quantum computers and risks to existing technologies

In the fields mentioned above, there are hopes for the realization of “quantum supremacy,” which would enable calculations that would take years on classical computers to be completed in a short time. However, quantum supremacy does not necessarily come with benefits; it also comes with risks to existing technologies. A typical example is the weakening of encryption technology, and there are concerns that quantum computers may be able to crack conventional public key cryptography.

Current encryption technology is based on mathematical problems that are difficult to decrypt using classical computers, but when quantum computers become practical, they may be decrypted in a short time using techniques such as “Shor’s algorithm.” This puts public key cryptography, which is used in every aspect of business and daily life, at risk, and is also thought to affect blockchain, which is based on tamper resistance. Furthermore, a method known as the “Harvest Now, Decrypt Later attack” has been pointed out as a risk of intercepting and storing data at present, and then decrypting it all at once in the future when quantum computers become practical. For this reason, there is an urgent need to transition to “Post-Quantum Cryptography (PQC),” which is difficult to decrypt even with a quantum computer. In the United States, the National Institute of Standards and Technology (NIST) selected several PQCs as candidates for standardization in August 2024, and has continued to consider them since then. In Japan, CRYPTREC (Cryptographic Technology Evaluation Committee), which evaluates and monitors cryptographic technologies, will publish the “CRYPTREC Cryptographic Technology Guidelines (Post-Quantum Cryptography) 2024 Edition” at the end of March 2025.¹, which provides technical explanations, evaluations, and implementation guidance for various PQCs. Since encryption technology is the foundation of all services, each business operator needs to pay close attention to the standardization trends of these PQCs and begin preparations early.

4. Trends of foreign governments regarding quantum technology

Overseas, major countries are making large-scale investments in quantum technology, and some countries are also focusing on developing legal infrastructure. Japan must also keep a close eye on these trends and strive to balance its international competitiveness with issues such as cybersecurity and national security.

III. Quantum Technology and Japanese Law

In Japan, at the time of writing this article (end of May 2025), there is no specific law targeting quantum technology. Looking at other cutting-edge technology fields, various regulations have already been imposed on blockchain (crypto assets, etc.), and in May 2025, the Act on Promotion of Research, Development and Utilization of AI-Related Technologies was passed with the aim of promoting utilization and reducing risks.^{2 3} It is possible that a dedicated law for quantum technology will be enacted in the future, but for now, it is necessary to consider the applicability of existing laws for each use case. Specifically, we will review (1) how national security-related laws relate to export control and development support for quantum equipment and technology, and (2) how cybersecurity legislation will handle the impact of quantum technology on existing cryptography. Furthermore, (3) when providing and using quantum services, new issues will arise that need to be considered, such as contractual allocation of responsibility and exemptions, and quality assurance. We will provide an overview of the legal framework regarding these issues.

1. Quantum Technology and National Security
(1) Risks of quantum technology to national security

The United States and China are investing heavily in quantum technology on a national scale, as it is directly linked to national security in terms of invalidating existing encryption technology and making communications difficult to intercept. In the United States, the National Quantum Initiative Act was enacted in 2018 with the aim of maintaining and strengthening both economic competitiveness and national security. A quantum R&D system was established through collaboration between universities, companies, and research institutes and large-scale budget investment. Japan does not have a law specifically related to quantum, but the advanced quantum field may be subject to existing security-related laws (Foreign Exchange and Foreign Trade Act, Economic Security Promotion Act, and Important Economic Security Information Protection and Utilization Act). We will consider how research and development of quantum computing and quantum sensors can be regulated and supported from a security perspective within the framework of these existing laws.

(2) Foreign Exchange and Foreign Trade Act
(i) Overview of the Foreign Exchange and Foreign Trade Act

The Foreign Exchange and Foreign Trade Act is a law that controls the overseas provision of goods and technology and investment from abroad from the perspective of national security. Specifically, it stipulates 1) export restrictions (to prevent overseas outflow), 2) restrictions on service transactions (including the provision of intangible technology), and 3) restrictions on inward direct investment (prior notification for investment and acquisition by foreign capital).

(ii) Restrictions under the Foreign Exchange and Foreign Trade Act that apply to quantum technology

Quantum technology is one of the areas in which there is concern about the risk of goods and technology being leaked overseas. For this reason, a revision to the Cabinet Order and Ministerial Ordinance in September 2024 will make quantum computers subject to export controls, and permission will be required for exports to all regions.⁴ Furthermore, the amendments coming into force on May 28, 2025 will similarly add key technologies and materials essential to practical-scale quantum computers as targets for regulation.^{5 6} In addition, the transfer of technology regarding quantum computers and related items that are subject to export controls is also subject to regulations.⁷

Given that export and technology transfer restrictions under the Foreign Exchange and Foreign Trade Act are currently expanding, quantum-related companies will need to establish a system that allows them to constantly check whether their products and technologies are subject to restrictions.

(3) Economic Security Promotion Act
(i) Outline of the Economic Security Promotion Act

The Economic Security Promotion Act (“Act on Promoting Security through Integrated Economic Measures”) enacted in 2022 aims to support the technology and materials of domestic companies and research institutions and strengthen national security from an economic perspective. The specific mechanism is based on the following four pillars. These measures⁸hope to reduce risks through public support and information sharing.

1. Ensuring a stable supply of essential materials
2. Ensuring stable provision of core infrastructure services
3. Supporting the development of cutting-edge technologies
4. Non-disclosure system for patent applications

(ii) Relationship with quantum technology

In the third pillar- advanced technology support, “quantum information science” has been designated as a specific important technology.⁹ Research and development will be promoted and utilized through the provision of financial support, the establishment of a council to provide support through public-private partnerships, and the outsourcing of research and study work.

In addition, the fourth pillar, the patent non-disclosure system, allows for measures such as withholding the disclosure of inventions that pose security risks and prohibiting foreign applications. At the time of writing this article (end of May 2025), quantum computers and quantum cryptography communication have not been designated as “specific technology fields” that are subject to this system. However, given the intent of the law, the assumption can be made that they may be designated in the future, so it is a system that developers should be aware of.

(4) Act on Protection and Utilization of Important Economic and Security Information
(i) Overview of the Act on Protection and Utilization of Important Economic and Security Information

On May 16, 2025, the Act on Protection and Utilization of Important Economic and Security Information came into force. Previously, the Act on the Protection of Specially Designated Secrets was a security clearance system for defense, diplomacy, terrorism, and espionage-related information.¹⁰, but this Act aims to expand into economic security, establishing a system for protecting and utilizing information related to important economic infrastructure.

The Act first defines the systems for providing critical infrastructure and the supply chains of important materials as “critical economic infrastructure” (Article 2, Paragraph 3). It then defines four types of information as “critical economic infrastructure protection information,” including measures to protect the critical economic infrastructure, and information on the vulnerabilities of the critical economic infrastructure and innovative technologies related to security (Article 2, Paragraph 4). Furthermore, among the information that falls under the category of critical economic infrastructure protection information, there is a mechanism by which the government may designate information that is not publicly known and meets the requirement of confidentiality as “important economic security information” (Article 3, Paragraph 1).

The purpose of this law is to both “protect” and “utilize” designated important economic and security information. Specifically, to properly handle economic information held by the government that is important for national security, the law stipulates the requirements for businesses that are permitted to provide information designated as important economic and security information, as well as the methods of evaluating the suitability of individuals who handle the information. Note that the designation is strictly limited to government-held information, and technical information independently developed by private companies is not unilaterally designated and its handling is not restricted.

(ii) Relationship with quantum technology

As mentioned in (i), the Act on the Protection and Utilization of Important Economic and Security Information covers four types of information related to the protection of important economic bases (critical infrastructure and supply chains of important materials). Specifically, it includes information directly related to national security, such as measures, plans, and research to protect infrastructure from external threats, infrastructure vulnerabilities, and innovative technologies. The infrastructure and materials covered are to be determined by reference to those stipulated in the Economic Security Promotion Act and the “Action Plan for Cybersecurity of Critical Infrastructure.”¹¹This includes infrastructure such as electricity, gas, water, communications, transportation, logistics, finance, chemicals, and medicine, as well as important supplies such as semiconductors and advanced electronic components.

Quantum technology, such as quantum computers that pose a risk of breaking existing encryption, and quantum cryptography communication that increases security, is highly likely to fall under the category of information relating to the protection of critical economic infrastructure mentioned above, and it is quite possible that it will be designated as important economic and security information in the future. However, to repeat what was stated in (i), only government-held information can actually be designated as important economic and security information, and technologies developed in-house by private companies are not unilaterally designated as such.

2. Cryptography and Cybersecurity Legislation

In addition to national security, quantum technology is also an issue in Japanese law in relation to cybersecurity. As mentioned in II 3., the development of quantum computers poses the risk that conventional encryption technologies may be decrypted.

(1) Legal level

In Japan, the Basic Act on Cybersecurity imposes the responsibility to ensure security on the state and businesses, and the Personal Information Protection Act requires the appropriate management of personal data. At the time of writing this article (end of May 2025), these laws do not specifically mention quantum technology or Post-Quantum Cryptography (PQC). However, if the spread of quantum computers compromises existing cryptography and increases security risks, it is possible that necessary measures will be required to be taken based on these laws even if they are not explicitly stated in the articles.

(2) Guideline level

In response to this, quantum technology has already been mentioned at the guideline level. The Financial Services Agency has published the “Guidelines on Cybersecurity in the Financial Sector” for financial institutions.¹²” (published on October 4, 2024). It clearly states that when collecting and analyzing threat and vulnerability information, “collect information while paying attention to the circumstances surrounding the organization, such as new technologies (AI, quantum computers , etc.), geopolitical trends, disinformation, and industry trends” as “matters that it is desirable to address.”

Furthermore,  according to the Nihon Keizai Shimbun (dated May 14, 2025)¹³, the Financial Services Agency is calling on major and regional banks to immediately begin preparations to transition to PQC. It appears that the agency is calling for an immediate response, as PQC compliance will require years of system modifications and other costs.

3. Contractual Issues Regarding the Use of Quantum Computers

When users use quantum computers, the question of how to deal with possible errors and fluctuations in the quantum computing results in a contract may arise. Such questions may arise due to the challenges and characteristics unique to quantum computing.

(1) Issues and characteristics specific to quantum computing (errors, algorithm-level probability, difficulty in verifying calculation results)

As mentioned above, errors that occur during calculations are a major issue with Gate-Based Quantum Computers. In addition, some quantum algorithms are run repeatedly to extract the statistically best solution, meaning that the same input does not always produce the same output. The Quantum Annealers may also produce different solutions each time it is executed due to the nature of its principle (probabilistically searching for solutions with low energy), hardware noise, thermal noise, etc. In addition, large-scale calculations that involve quantum supremacy are difficult to reproduce and verify on classical computers.¹⁴, meaning one cannot fully guarantee the correctness of the output.

For these reasons, there is a risk that the results of quantum computing will contain errors and fluctuations, which will affect subsequent predictions and simulations. As the number of services using quantum computers increases, it may become necessary to clarify the scope of responsibility for hardware (quantum processors), software (algorithms), user circuits and data, and to introduce clauses that differ from traditional IT contracts, such as disclaimer clauses that assume that results are probabilistic and that there are potential errors.

(2) Contractual considerations regarding cloud-based quantum computing

Because the actual equipment for both the Gate-Based Quantum Computers and the Quantum Annealers are large-scale and expensive, cloud-based quantum computing, in which equipment provided by hardware vendors is used via the cloud, is expected to become the standard method of use for the time being.

In conventional cloud computing, a certain level of uptime is guaranteed under a service level agreement (SLA), but in the case of cloud-based quantum computing, the question of what kind of quality guarantees (error rate, uptime, etc.) should be made can become an issue. For example, IBM Quantum Platform (Gate-Based Quantum Computer), D-Wave Leap (Quantum Annealer), and Amazon Braket (which handles multiple external Gate-Based Quantum Computers and Quantum Annealers via API) each publish various indicators (gate error rate, coherence time, time required to process a job, etc.), but it seems that a standard approach has not yet been established.

Disclaimer
The contents of this document have not been verified by the relevant authorities and are merely a description of arguments that are reasonably considered in accordance with the law. In addition, they represent only our current views and may be subject to change.
This is just a summary for the blog. If you need legal advice for a specific case, please consult a lawyer.

I. Introduction

I’ve recently become obsessed with visiting the Osaka Kansai Expo. Recently, I received an invitation from a company where I serve as an external director to visit the “Future of Life” pavilion (official website: https://expo2025future-of-life.com/en/) by Professor Hiroshi Ishiguro, who is renowned for his work with androids. This experience made me deeply contemplate legal issues.

While this might be a slight spoiler, the exhibition presents a future where humans can become androids. It features a story of a grandmother and granddaughter who are close to each other. As the grandmother’s health deteriorates, she faces a choice: to die naturally or to continue living through androidization. The pavilion also features numerous other androids, creating an exhibition that makes visitors contemplate what “life” truly means. I should note that while I have visited over 40 pavilions so far, the “Future of Life Pavilion” is particularly recommended among them!

This raised a legal question for me as a lawyer. If humans could transfer their consciousness and memories to androids and “continue living” for 100, 500, or even 1,000 years beyond their biological lifespan, what stance should the law take? Specifically, can we legally treat the original human and their post-androidization existence as the same legal person?

An android gazing at itself in a mirror – can it truly be called “the former me”?

II. An android gazing at itself in a mirror – can it truly be called “the former me”?

Under the laws of most countries today, a person acquires rights at birth and loses them upon death. This fundamental principle of “biological death = extinction of legal personality” has been the foundation of legal systems worldwide for hundreds of years.

However, if technology enables consciousness and memories to be electronically preserved and transplanted into a different body (an android), this principle would face fundamental reconsideration. How should the law treat an existence that is biologically dead but whose personality and memories continue?

Note: This paper discusses androidization through digital transfer of consciousness and memory, not physical brain transplantation. It also distinguishes from cyborgization (replacing parts of living organisms with machines) and deals with complete personality transfer to an artificial body.

III. Four Legal Approaches

Legal approaches to this problem can be broadly divided into four categories:

(i) Non-Personality Theory

This position treats the android as a “thing” without legal capacity once the physical body perishes and legal personality ends. From the standpoint of current law, this would basically be the prevailing view.

The android would be owned by heirs as inherited property, and the original human’s rights and obligations would be processed through normal inheritance procedures. In this case, the inheriting grandchild would own grandmother’s android as a “thing,” making it legally possible to sell it on marketplace apps or dispose of it as bulky waste – a result that borders on dark humor.

While legal stability would be maintained, the motivation to choose androidization would be significantly undermined. Few people would actively desire androidization if they might be treated as “things” subject to sale or disposal. Moreover, since they would lose all property rights and contractual status, they would be completely severed from the social positions and relationships they had built.

Is grandmother just a “thing”?

(ii) Personality Continuity Theory

This position emphasizes the continuity of memory, personality, and self-consciousness, treating the android as the same legal subject as the original human. In this case, property rights, family relationships, and contractual status would all be inherited as-is, and the person would be treated as “living” in the family registry.

While this would be the most desirable outcome for the individual, the impact on the entire legal system would be enormous.

(iii) New Personality Theory

This position recognizes personality in androids, but the android is registered as a completely new legal subject, while the original human’s rights and obligations are processed through normal inheritance procedures.

From this standpoint, the android would begin a new life from zero as a “newly born adult.” While freed from past entanglements, they would also lose the human relationships and social status they had built.

(iv) Limited Succession Theory

This is a compromise position that allows succession of only certain rights through special legislation. For example, a system could be designed where personal rights and family relationships are inherited, but property rights go through inheritance procedures.

Specifically, personal rights such as name rights and portrait rights, status relationships as spouse or parent-child, and support claim rights would be recognized for succession, while property rights such as real estate ownership, stocks, and deposits would still require traditional inheritance procedures.

The significance of this Limited Succession Theory lies in legally protecting the emotional connections of families and personal identity while ensuring the stability of socioeconomic systems. It can legally guarantee, albeit limitedly, the continuity of human relationships that would be lost through complete severance.

Comparison of Legal Positions on Androidization

IV. Legal Chaos Brought by Super-Longevity Society

Would current legal systems function when androidization allows humans to live for 1,000 years? If androidization achieves effective immortality, many current legal systems could become dysfunctional.

(i) Impact on Civil Law

The inheritance system would fundamentally change. If people don’t die, inheritance doesn’t occur. As a result, assets like real estate and stocks would be permanently occupied by the same individuals, severely impeding social fluidity.
Contract relationships would also become abnormally long-term, potentially causing rigidity in the entire socioeconomic system.

(ii) Impact on Family Law

If one spouse becomes an android, what happens to the marriage relationship? Since the androidized spouse is legally “living,” the other spouse’s remarriage would raise bigamy issues.
Parent-child relationships would also become complex. The relationship between androidized parents and subsequently born children, and the scope of support obligations across generations – these are problems traditional family law never anticipated.

(iii) Impact on Criminal Law

The penal system would require fundamental revision. The meaning of life imprisonment would be relativized, and consistency with statute of limitations would become problematic. The concept of “rehabilitation potential,” one of the foundations of punishment, would also change significantly when premised on lifespans of hundreds of years.

V. Impact on Political and Social Systems

Would democracy remain viable if immortal beings continued to hold political power? The impact extends beyond legal issues to affect democratic institutions themselves.

In a society where only the wealthy can choose androidization, they would continue exercising political and economic influence for hundreds of years. An “immortal elite class” with voting and candidacy rights could monopolize decision-making, impeding social renewal through generational change. As Piketty pointed out that “the return on capital exceeds economic growth rate (r > g),” the phenomenon of wealth accumulation and expansion could be further accelerated by the perpetual androidization of the ultra-wealthy.

Pension systems, healthcare systems, and education systems – current social security systems are designed based on average human lifespan. These systems would also require fundamental revision.

“I’m the real one!”

VI. Possibilities for Legal System Design

How should our legal system evolve to address such a future society?

(i) Digital Personality Registration System

This would establish a new family registry system specifically for androids, recognizing personality succession based on clear expressions of intent made during one’s lifetime. The scope of inheritable rights would be clearly defined in written law to ensure legal predictability.

Digital Personality Registration System Process Flow

(ii) Time-Limited Personality System

To ensure social fluidity, this system would limit personality succession to a specific period (for example, 50 years). After the period expires, mandatory status transfer would occur, legally guaranteeing generational change.

(iii) Hybrid Legal Personality System

This would create “Android Corporations” as entities between individuals and corporations, recognizing limited legal personalities that inherit only specific rights. This system aims to balance continuity of social roles with legal stability.

(iv) Utilization of Trust and Corporate Schemes

As background, I previously worked as a financial lawyer creating Charitable Trusts in jurisdictions like the Cayman Islands and establishing corporations with no shareholders. Even if android personality rights were restricted, it might be possible to create a system where companies and foundations are established, all assets transferred to them, and the android embodiment directs these entities. This could potentially enable survival while maintaining assets for 1,000 or even 2,000 years.

By applying such existing legal schemes, we could potentially achieve substantial rights succession after androidization. We may need to consider whether such schemes should be prohibited.

Android Substantial Rights Holding Structure (Cayman Islands-type Scheme Example)

VII. Impact on Legal Practice

If such technology becomes reality, significant changes will be required in legal practice. New legal service demands will emerge, including preparation of lifetime intent documents regarding androidization, establishment of digital asset management and succession contracts, and support for family consensus building.
The legal profession will also urgently need to establish ethical codes responding to new technologies and continuous training systems.

Humans as Digital Information

VIII. Conclusion

What I felt from viewing Professor Ishiguro’s exhibition was the magnitude of technology’s impact on legal systems. While the issue of personality succession through androidization remains in the realm of thought experiments at present, considering the speed of technological development, this is an area where the legal profession should begin discussions early.

Legal studies must find answers to fundamental questions: What is humanity? What is personality? What is the individual’s position in society? In an era where technology transforms society, new challenges await legal professionals.

Note: This paper represents the author’s personal views as part of thought organization and does not predict or guarantee future legal systems. While Saito is somewhat positive about androidization, there is absolutely no intention to encourage readers to “please become androids!”

This article describes the structure of “Babylon,” a pioneering Bitcoin (BTC) staking project and considered the largest of its kind today, and the related issues under Japanese law.

Until now, staking has mainly taken place on Proof of Stake (PoS) chains such as Ethereum. Staking in PoS is a mechanism to increase the security of the chain by participating in the validation of transactions on the network, etc., in exchange for a reward.

In contrast, because Bitcoin employs Proof of Work (PoW), it has been believed that, in principle, there is no revenue opportunity from staking in the traditional sense of the term. The most common means of monetization using BTC has been through centralized lending services and tokenization solutions such as wBTC (Wrapped BTC).

Babylon is a project that aims to overcome these limitations of BTC utilization and realize trustless staking using BTC, and is currently one of the most popular protocols in this field. This paper examines its technical structure and issues under Japanese law.

In order to fully understand Bitcoin staking, it is helpful to have a foundational understanding of the staking mechanisms used in PoS chains, as well as the concepts of liquid staking (e.g., by LIDO) and restaking (e.g., by EigenLayer).

For more information on these topics, please refer to the following articles authored by our firm:

I. Overview of Legal Issues

II. Basic Overview of Babylon

1 What is Babylon’s Bitcoin Staking?

Bitcoin uses PoW (Proof of Work), which means that staking is not possible in the same way as with Ethereum.
Babylon introduces a new mechanism that enables BTC staking, with the following key features:

2 What does it mean to stake BTC to secure other PoS networks?

One of Babylon’s most important features is that it uses Bitcoin to enhance the security of “other” PoS networks.

The eligible networks are those that meet certain technical requirements and generally fall under the broad category of PoS-based systems—i.e., networks that have their own validator sets.

Currently, Babylon has announced test integrations and partnerships with various types of networks, including rollups, data availability (DA) chains, and oracle networks.

3 PoS Network Security and Staking

n a Proof-of-Stake network, security is provided by validators who stake assets—either their own or those delegated to them by third parties—to verify transactions and produce blocks.

If validators behave dishonestly, the staked assets may be slashed (i.e., partially confiscated), creating a strong financial incentive to act honestly and support the stability of the network.

In many PoS networks, delegated staking is possible, allowing token holders who do not run validators themselves to delegate their tokens to trusted validators.
In such cases, validators are responsible for the staked assets regardless of whether they are self-staked or delegated.

However, in order to participate in staking—either directly or via delegation—users must first acquire the native token of the target PoS network.

For emerging or smaller-scale networks, this presents several challenges:

• There are relatively few holders of the token (due to acquisition costs and price volatility),
• Token ownership may be highly concentrated,
• As a result, there may be a limited number of validators or insufficient total stake, weakening the network’s security guarantees.

Babylon aims to address these challenges by allowing Bitcoin holders to contribute to the security of such networks—collectively referred to as Bitcoin-Secured Networks (BSNs)—without requiring them to acquire the native token or transfer custody of their BTC.
Security participation is instead enabled through a trustless, signature-based mechanism.

4 Enhanced security with BTC

As mentioned above, Babylon introduces a mechanism to enhance the security of PoS-based networks by leveraging BTC, an external asset, to address the inherent security limitations these networks may face.

Specifically, BTC holders contribute economic security by staking their BTC, which is used to support the security of external networks.

Importantly, this BTC collateral is not transferred directly to the PoS networks. Instead, it remains in the user’s self-managed script on the Bitcoin network, and staking is performed via the Babylon protocol through a cryptographic signature (digital proof of intent).

This design enables non-custodial and trustless participation, eliminating the need to deposit or lock up BTC with a third party.

By introducing such externally sourced security, PoS networks can leverage BTC’s high liquidity and market capitalization to reinforce their security infrastructure—without relying solely on their native tokens.

This mechanism is particularly promising for emerging PoS networks, where token distribution may be highly concentrated and the validator set small, leading to weaker security. Babylon’s BTC-based model may serve as a viable complement to address these vulnerabilities.

5 Rewards Are Paid in Tokens on the PoS Network

The rewards for staking BTC through Babylon are not paid in BTC itself, but in the native tokens designated by the PoS network that receives the security service.

From the perspective of the PoS network, this structure allows it to externally source economic security (in the form of BTC) by using its own native tokens as incentives. Through appropriate token issuance and incentive design, the network can attract BTC stakers without requiring external capital.

For BTC stakers, this provides the benefit of earning yield in the form of external PoS network tokens—without needing to transfer or wrap their BTC. This feature may present a new yield opportunity, particularly for long-term BTC holders looking to earn passive returns on their assets.

Risk Associated with Rewards Being Paid in Other PoS Tokens

While Babylon offers BTC holders the opportunity to earn yield, there are several risks associated with the fact that rewards are paid in the native tokens of external PoS networks rather than in BTC.

This structure may also present practical and regulatory challenges, especially for users staking through crypto asset exchanges in Japan. As discussed in Section IV-3 below, it could act as a disincentive for such platforms to offer Babylon staking services.

6 Trustless Staking Without Private Key Transfer in Babylon

Babylon is designed to allow BTC holders to participate in network security as providers of economic collateral—autonomously and non-custodially, without transferring their private keys to any third party.

This architecture enables truly trustless staking, eliminating the need for traditional asset transfers or reliance on custodians.

(1) What It Means Not to Transfer the Private Key

In conventional staking and DeFi use cases, utilizing crypto assets typically requires one of the following actions:

• Wrapping the original asset (e.g., BTC) into a token that can be used on another chain (e.g., wBTC)
• Locking the asset into a third-party custodian or smart contract as collateral

Both methods effectively require giving up control of the private key, at least temporarily, which introduces risks such as asset leakage or loss due to smart contract vulnerabilities.

Babylon avoids these risks by enabling signature-based staking mechanism. This allows BTC holders to retain full control over their assets while still participating in economic security provision.

(2) Technical Mechanism: Declaration of Staking Intent via One-Time Signature (EOTS)

Babylon utilizes a cryptographic technique known as Extractable One-Time Signatures (EOTS) to allow BTC stakers to both prove their ownership of BTC and explicitly accept responsibility for contributing to the security of a PoS-based system.

The basic flow of this mechanism is as follows:

This design enables PoS networks to receive a security guarantee backed by BTC, a highly liquid external asset, while the Babylon protocol itself provides a comprehensive framework for detecting malicious behavior and executing slashing penalties.

7 Significance and Limitations of Trustless Design

The BTC staking mechanism enabled by Babylon is characterized by a trustless and non-custodial architecture, in the following respects:

• BTC remains in the user’s self-managed script and is never transferred to a third party.
• The intention to provide collateral can be expressed solely through a cryptographic signature (digital proof), without relying on centralized intermediaries or smart contracts.
• Participation in security provision and the receipt of rewards are possible based solely on that signature.

This structure, which minimizes the need for trust in third parties, is closely aligned with Bitcoin’s foundational principles of self-custody and decentralization.

However, it is important to note that the system is not entirely “trustless.”

Certain functions—such as verifying signatures, executing slashing, and distributing rewards—are handled by the Babylon Genesis Chain, described below.

In other words, while BTC itself is never directly deposited or locked up, a degree of “protocol trust” is still required—specifically, trust in the legitimate operation and correct implementation of the Babylon protocol, including the Babylon Genesis Chain.

III. Important Entities in the Babylon Ecosystem

The entities involved in the Babylon ecosystem are diverse, but some of the key participants include following:

1 Important Entities about Babylon

Figure: Babylon Overview

(1) Bitcoin-Secured Networks (BSNs)

• Summary:
Bitcoin-Secured Networks (BSNs) refer to a category of networks (or chains) that enhance their security by integrating Bitcoin’s economic security via Babylon. These networks typically operate on PoS or PoS-like systems and utilize BTC as external collateral to strengthen their security infrastructure.

• Role:
PoS networks, particularly in their early stages, often face security challenges due to a small or overly centralized validator set and insufficient economic collateral. By incorporating BTC through Babylon, BSNs can achieve the following:

1. Enhanced Security with BTC
   By leveraging BTC—a highly liquid and trusted external asset—PoS networks can strengthen their resilience against network attacks (currently focused on mitigating double-signing risks).
2. Improved Finality Guarantees
   BSNs can obtain “external finality” for their blocks through cryptographic signatures submitted by Babylon’s finality providers, further strengthening consensus assurance.
3. Incentive Design to Attract BTC Stakers
   By offering rewards in their native tokens or stablecoins, BSNs can economically incentivize BTC stakers to participate in securing the network, offsetting the cost of enhanced security.

• Typical Use Cases (Examples):

• Emerging app chains built with the Cosmos SDK
• PoS networks with volatile or weak native token economics
• Ethereum Layer 2 chains
• Gaming chains, DePIN networks, AI chains, and other specialized blockchain applications
• In theory, Babylon can provide security to all PoS networks.

(2) Finality Providers

• Summary:
Entities that observe and verify block finality on PoS networks secured by Babylon, and submit cryptographic finality signatures accordingly.

• Role:

• Generate and submit finality signatures to the Babylon protocol
• Ensure honest behavior, as fraudulent signatures may trigger slashing penalties

• Note:
Finality providers differ from traditional validators in other chains. Their core responsibility is to observe the finality of blocks on the target PoS network and report that information to the Babylon chain.
However, they play a somewhat validator-like role in that they create and submit cryptographic signatures, earn rewards for doing so, and are subject to slashing in case of misconduct.

Comparison of Finality Providers and General PoS Validators

(3) Bitcoin Stakers

• Role:
Hold BTC and contribute to the security of PoS networks by submitting off-chain cryptographic signatures to Babylon.

• Reward:
Receive staking rewards from the PoS networks in return for providing BTC as collateral via Babylon.

• Key Characteristics:

• BTC stakers do not need to transfer their BTC or private keys to any third party.
• They retain full control over their assets while participating in staking.
• The process is non-custodial and trustless by design.

BTC stakers can also delegate their staking to finality providers.
Even in such cases, no BTC or private key is transferred, and the delegation is completed through a non-custodial mechanism.

(4) Babylon Genesis Chain (one of the BSNs)

• The Babylon Genesis Chain is a Cosmos SDK-based PoS Layer 1 blockchain designed to operate the Babylon protocol.
• Although it is one of the Bitcoin-Secured Networks (BSNs), it plays a central role within the Babylon ecosystem, serving as its foundational coordination layer.

• If you participate as a finality provider securing the Babylon Genesis Chain, you will receive the chain’s native token, “BABY,” as a reward.

(5) Liquid Staking Protocol (not shown in the figure above)

A protocol that facilitates BTC staking via Babylon on behalf of BTC holders, aiming to improve operational efficiency, usability, and liquidity. While the main focus is on liquid staking, a hybrid model that combines restaking (reuse of the same BTC for multiple networks) may also be adopted where appropriate.

2 Supplement: Relationship Between the Babylon Ecosystem and the Babylon Genesis Chain

The relationship between the Babylon ecosystem and the Babylon Genesis Chain is nuanced and may require clarification.

The Babylon Genesis Chain is a PoS Layer 1 blockchain that plays a central role within the Babylon ecosystem. However, it is not synonymous with the ecosystem itself.

The Babylon protocol refers to a broader framework encompassing multiple Bitcoin-Secured Networks (BSNs) that utilize Bitcoin-based economic security via Babylon.

If a participant joins Babylon as a finality provider and provides finality to the Babylon Genesis Chain, they receive “BABY”, the native token, as a reward.

Finality providers currently serve the Babylon Genesis Chain, where they contribute to finality and receive BABY, the native token, as compensation. Although the Babylon protocol is designed to be extendable to other Bitcoin-Secured Networks (BSNs), finality provisioning beyond the Genesis Chain has not yet been implemented. In the future, other BSNs may adopt the Babylon finality mechanism and offer their own tokens as rewards to finality providers.

In addition, the Babylon Genesis Chain has its own set of validators, who stake BABY and participate in block production and consensus. These validators are also rewarded in BABY for their contributions to the network’s operation.

1 Overview of BABY Token: Acquisition Methods and Utility

2 Comparison: Finality Providers vs. Validators (on the Babylon Genesis Chain)

IV. Bitcoin Staking and Japanese Law

Based on the above assumptions, this section outlines the key legal issues related to providing or using a Bitcoin staking service such as Babylon.

In particular, the analysis focuses on two core questions:

• Whether the custody regulations under the Payment Services Act (資金決済法) apply, and
• Whether the fund regulations under the Financial Instruments and Exchange Act (FIEA, 金融商品取引法) are triggered.

1 Babylon and the Custody Regulation of Crypto Assets

In the context of BTC staking via Babylon, a key legal issue is whether the provision of BTC as economic security constitutes the “management” or “custody” of crypto assets under Japanese law.

Under custody regulations based on the Payment Services Act, the primary legal criterion is generally understood to be whether the service provider holds the private key required to transfer the user’s crypto assets.

This interpretation is supported by an official public comment issued in connection with the 2019 amendments to the Act:

“If a business operator does not possess any of the private keys necessary to transfer the cryptographic assets of a user, the business operator is not considered to be in a position to proactively transfer the cryptographic assets of the user, and therefore, basically, is not considered to fall under the category of ‘managing cryptographic assets for others’ as stipulated in Article 2, Paragraph 7, Item 4 of the Payment Services Act.”

In this regard, the private key required to transfer BTC is never shared with or transferred to any entity, including the Babylon Genesis Chain or finality providers.

The technical structure of the system is as follows:

• The BTC staker selects a finality provider and generates the necessary transaction data to initiate staking.
• The transaction includes a conditional instruction, such as:
  (i) the BTC will be locked for a specified period; and
  (ii) if a slashing event occurs, the BTC will be transferred to a predefined burn address.
• The BTC staker signs this transaction using a one-time EOTS (Extractable One-Time Signature), thereby proving ownership and expressing intent to participate in staking.

This design enables BTC to serve as economic security without transferring control of the private key, ensuring that the BTC remains in the staker’s custody unless slashing conditions are triggered.

Accordingly, Babylon and finality providers would generally not be considered to fall under custody regulations under the Payment Services Act.

However, it should be noted that certain Liquid Staking Protocols may offer services that involve taking custody of users’ private keys. In such cases, those entities may indeed be subject to custody regulations, and a case-by-case legal assessment would be required.

2 Babylon and the FIEA Regulations

In Babylon, BTC is provided as economic security, and BTC stakers receive compensation while bearing certain risks such as slashing. From this structure, a legal question arises as to whether Babylon might be classified as a “fund” (collective investment scheme) under Japanese law.

(1) Definition of “Fund (Collective Investment Scheme)” under Japanese Law

Article 2, Paragraph 2, Items 5 and 6 of the Financial Instruments and Exchange Act (“FIEA”) broadly define a “fund” (collective investment scheme) as follows:

(2) Applicability of Fund Regulations to the Babylon Protocol

While Babylon might fall within the category of “other similar rights” in (A) above and does not appear to meet the exclusions under (C), it is unlikely to satisfy all of the conditions under (B). Accordingly, it may not constitute a fund under the FIEA, for the following reasons:

• The BTC provided by the staker is positioned as economic collateral, not as a capital contribution or investment to Babylon’s operating entity.
• The staking rewards are not dividends from Babylon’s business, but rather token-based rewards issued by the PoS networks that benefit from the staker’s security provision.
• The BTC staker does not entrust assets to any centralized management entity but simply interacts with the protocol by signing a transaction; the assets remain in self-custody unless slashed.

From these perspectives, Babylon’s BTC staking mechanism does not appear to meet the definition of a fund under the FIEA.

(3) Applicability of Fund Regulations to Finality Providers and Liquid Staking Protocols

Babylon allows BTC stakers to delegate their staking authority to finality providers. However, since this process does not involve the transfer of private keys, such delegation is not likely to fall under a fund regulation.

On the other hand, certain Liquid Staking Protocols may offer services that involve taking custody of users’ private keys. In such cases, a careful legal analysis is required to determine whether such schemes meet the definition of a fund under the FIEA, particularly in light of the structure of asset control and contribution.

V. Crypto Asset Exchanges and Babylon Staking

This section examines the legal and operational issues that may arise when a Japanese crypto asset exchange operator performs BTC staking via the Babylon protocol using assets deposited by users.

1 Position of Staking within Crypto Asset Exchange Business

Many crypto asset exchanges in Japan provide staking services as part of their business operations.

To our understanding, as long as users do not bear the risk of slashing (i.e., potential loss)¹⁵¹⁶, such services are generally treated as part of the core business of “receiving deposits of crypto assets” as defined in Article 2, Paragraph 15, Item 4 of the Payment Services Act.

This legal interpretation should remain applicable even when Babylon is used as the underlying protocol—no special legal treatment or additional licensing is expected to be required.

2 Compatibility with Cold Wallet Regulations

Under Article 60-11, Paragraph 2 of the Payment Services Act and Article 27, Paragraph 3, Item 1 of the Cabinet Office Ordinance on Crypto Asset Exchange Services, crypto asset exchanges in Japan are required to segregate users’ crypto assets from their own assets and hold them in cold wallets.

In most PoS staking systems, private keys used for asset transfers do not need to be moved; rather, a separate validator key is used. This practice is generally considered not to conflict with cold wallet requirements.

In Babylon, there is no concept of a validator key. Instead, staking is performed via cryptographic signatures called Extractable One-Time Signatures (EOTS). Importantly, the private key for BTC remains in the possession of the BTC staker—in this case, the exchange operator—and is never transferred or exposed to third parties.

Therefore, since the exchange does not move or manage private keys externally, Babylon staking is not expected to conflict with cold wallet custody obligations.

3 Handling of Altcoin Rewards in Babylon

A unique practical issue with Babylon staking is that while BTC is used as the staked asset, the rewards are typically paid in the native tokens (i.e., altcoins) of the target PoS network, rather than in BTC itself.

For example, when staking ETH, both the staked asset and the reward are ETH, which poses no legal or operational issues for exchanges that have already registered ETH as a “handled crypto asset” with the Financial Services Agency (FSA).

In contrast, when staking BTC via Babylon, the resulting rewards may be in the form of tokens such as BABY or other native tokens of PoS networks that are not registered as handled crypto assets. This presents a compliance challenge under the Payment Services Act.

Several operational approaches can be considered:

(1) Custody of Altcoins by the Exchange and Grant to Users

In this approach, the exchange holds the altcoins it receives as rewards and allocates them to users.

While it may be possible to register certain major tokens (e.g., BABY) as handled crypto assets, and some tokens associated with Babylon partner networks (e.g., ATOM, SUI) are already listed in Japan, it is not realistic to file individual registrations for every potential reward token.

(2) Direct Delivery of Altcoins to Users’ Self-Managed Wallets

Here, the exchange does not custody the reward tokens but transfers them directly to each user’s self-managed wallet. This bypasses the need to register the tokens as handled crypto assets.

However, this approach presents practical challenges: requiring users to manage wallets for a wide range of altcoins is burdensome from both a UX and operational support perspective. It also introduces potential transaction costs and operational risks.

(3) Sale or Exchange of Altcoins, and Payment of Rewards in BTC or JPY

Under this method, the exchange converts the reward altcoins into BTC or JPY (e.g., via a DEX or an overseas partner), and then distributes those converted assets to users as rewards.

While this may raise concerns that the exchange is engaging in crypto asset exchange services involving unregistered crypto assets, such risks may be mitigated through appropriate contractual arrangements.

Specifically, if the agreement with the user clearly states that:

• The user deposits BTC for staking, and
• The exchange will return rewards in BTC or JPY (not altcoins),

then the exchange’s sale or swap of the altcoins can be viewed as part of its internal process for sourcing rewards, rather than as a crypto asset exchange activity involving third parties.

In this structure, the exchange merely acquires and disposes of unregistered tokens on its own account, which is generally not considered a regulated activity under current law.

(4) Conclusion

In light of the above, under the current regulatory framework, it appears that the most realistic and effective approach for crypto asset exchanges is to structure their operations based on scheme (3).

That said, from the perspective of BSNs, there are concerns about potential ongoing selling pressure caused by continuous liquidation of reward tokens. Therefore, the sustainability of the system as a whole should also be carefully considered in future discussions.

Acknowledgments

In preparing this article, I received valuable input from the teams at Kudasai Inc. and Next Finance Tech Inc., both of whom are well-versed in Babylon staking. I also benefited from informal yet insightful suggestions from individuals involved with the Babylon protocol.

However, any remaining errors or interpretations are entirely my own and do not represent the official views of any specific entity

Disclaimer

The content of this document has not been reviewed by any regulatory authority and represents a general legal analysis based on interpretations currently considered reasonable under applicable Japanese law. The views expressed herein reflect the current thinking of our firm and are subject to change without notice.

This document does not constitute an endorsement of any specific staking mechanism, including Bitcoin staking, the Babylon protocol, liquid staking services, or any related technologies or platforms.

This material is provided solely for informational and blog purposes. It does not constitute legal advice, nor is it intended to be a substitute for legal counsel. For advice tailored to your specific circumstances, please consult with a qualified attorney.

1．Introduction

As seen in Ethereum network, staking—the process of locking a certain amount of crypto assets on a blockchain for a set period to contribute to transaction validation (Proof of Stake), earning rewards in return—is gaining traction globally as well as in Japan. Major Japanese crypto asset exchanges now offer staking services, contributing to its expansion. This paper outlines key legal issues related to staking under Japanese law and briefly addresses the concept of restaking, which is a mechanism in which existing staked crypto assets or staking rewards are staked again to earn additional rewards, with the aim of enhancing network security and enabling new services.

2．Legal Issues Related to Staking Under Japanese Law

Regulatory applicability depends on the manner in which staking is conducted and its legal framework. Relevant regulations include those governing Crypto Asset Exchanges and Funds as referenced and further explained below.Staking one’s own crypto assets remains unregulated under such regulations, therefore, this discussion focuses on cases where a service provider stakes on behalf of users. To summarize the key conclusions in advance:

Custody, Investment, and Lending are key legal classifications in the regulatory framework for staking services. While details will be discussed later, these terms can be briefly defined as follows:
✓Custody refers to the management of crypto assets on behalf of users. Possession of private keys is a key factor in determining regulatory applicability of Custody. If structured as Custody, it falls under Crypto Asset Exchange regulations under the Payment Services Act (PSA).

✓Investment refers to a scheme where users contribute funds (including crypto assets) to a service provider, which then utilizes them for business operations (e.g., staking) and distributes profits to the users. If structured as Investment, it falls under Fund regulations governed by the Financial Instruments and Exchange Act (FIEA).

✓Lending refers to an arrangement where users lend their crypto assets to a service provider, which manages the crypto assets at its discretion and returns them after a specified period. If recognized as a Lending agreement, it is generally not subject to PSA or FIEA regulations.

3．A Short Introduction to Crypto Asset Exchange Regulations and Financial Regulations

Under Japanese law, Crypto Asset Exchange regulations under the PSA, Article 2, Paragraph 15, apply to the following activities:

1. Buying, selling, or exchanging crypto assets.
2. Intermediating, brokering, or acting as an agent for these activities.
3. Managing users’ funds related to 1 and 2.
4. Managing crypto assets on behalf of others.

Among these, staking is particularly relevant to Item 4., which refers to the Custody services.

Regarding “managing crypto assets on behalf of others” (hereinafter referred to as “Custody”), the Financial Services Agency (FSA) guideline¹⁷ states:

“[…] in a case where the business operator is in a state in which the business operator is able to proactively transfer a Crypto-Asset of a user, such as a case where the business operator holds a secret key [Author’s Note: referring to a private key] sufficient to enable the business operator to transfer the Crypto-Asset of the user without any involvement of the user, either alone or in cooperation of an affiliated business operator, such a case falls under the management of Crypto-Assets.”

This indicates that possession of private keys is a key factor in determining regulatory applicability of Custody.

Additionally, staking may also be subject to Fund regulations governed by FIEA (Article 2, Paragraph 2, Item 5). This FIEA applies where users contribute funds (including crypto assets) to a service provider, which then utilizes them for business operations and distributes profits to the users.

(a) Case where the service provider does not hold the user’s private key

If a service provider only receives delegation from users without holding their private keys¹⁸, it does not qualify as a Custody activity under the FSA guideline as quoted above and is not subject to Crypto Asset Exchange regulations under the PSA.Additionally, in this case, since users do not contribute funds to the service provider —given that the service provider cannot transfer the crypto assets for business operations without possessing the private key— it does not constitute an “Investment” and therefore, Fund regulations under the FIEA do not apply either.

(b) Case where the service provider holds the user’s private key

If a service provider holds the user’s private key, it may be classified as a Custody activity under the PSA. Additionally, depending on the legal structure of the arrangement, the user’s contribution could be considered an “Investment,” making it subject to Fund regulations under the FIEA.

First, if the arrangement is structured as a “Custody,” the provider is deemed to be managing the user’s crypto assets on their behalf. This qualifies as a Custody activity under Crypto Asset Exchange regulations and falls under the Payment Services Act (Article 2, Paragraph 15, Item 4).

If the legal structure is such that the provider receives “Investment” of crypto assets from users, it does not meet the Custody regulation requirement of “managing crypto assets on behalf of others,” as the assets are received for business use rather than for custodial management on behalf of users. Therefore, Custody regulations under the PSA do not apply. However, since the provider uses the contributed funds to operate a business (staking) and distributes the revenue to users, it is likely subject to Fund regulations under FIEA.

If the arrangement is structured as Lending, where the user lends crypto assets to the service provider, which manages them at its discretion and returns them after a specified period, rather than making a Custody (where assets are held and managed on behalf of the user) or an Investment (where assets are contributed with an expectation of return), no specific regulations apply. However, according to the aforementioned FSA guideline¹⁹, “The borrowing of Crypto-Assets […] falls under the management of Crypto-Assets […] if a business operator substantially manages a Crypto-Asset on behalf of another person under the name of the borrowing of a Crypto-Asset such that the user can receive the return of the Crypto-Asset borrowed at any time at the request of the user. “

Therefore, regulatory authorities may classify such circumvention schemes as a Custody activity, making them subject to Custody regulations under the PSA.

Thus, even when a service provider holds the user’s private key and conducts staking, the applicable regulations vary depending on the legal structure of the arrangement. However, in practical business operations, the distinction between “Custody”, “Investment” and “Lending” is not always clear. To determine the applicable regulations, it is useful to analyze the staking scheme based on the following factors:

1. Whether the rewards are received by the service provider and then distributed to the user, or are they directly distributed to the user.
2. If the service provider receives the rewards first and then distributes them to the user, and whether the distribution is fixed or linked to revenue.
3. Whether the slashing risk, which refers to the risk of staked assets being partially or fully slashed if a validator violates network rules or engages in misconduct, is borne by the service provider or the user.

Based on these factors, the conclusions for typical cases are summarized as follows. However, if a case does not fit within these typical scenarios, determining whether it qualifies as Custody service or a Fund Investment can be challenging.

• If the amount of rewards paid by the service provider to the user is predetermined and the user does not bear the slashing risk: Custody regulations (i.e. PSA) apply.
• If the amount of rewards paid by the service provider to the user is linked to the staking rewards earned by the service provider, and the user bears part of the slashing risk (i.e., there is no principal guarantee): Fund regulations (i.e. FIEA) apply.
• If the arrangement is structured as a crypto assets Lending agreement, and in substance, it is recognized as a Lending rather than a demand payment or similar arrangement (i.e., one where users can request repayment at any time, meaning the service provider cannot manage the crypto assets at its discretion for a specified period, thereby lacking a key element of Lending): Neither PSA or FIEA apply.

The licenses required for service providers under each scheme are summarized as follows:

• If classified as a Custody activity, registration as a Crypto Asset Exchange is required.
• If classified as a Fund, registration as a Type II Financial Instruments Business operator is required.
• If classified as Lending, no registration is required. However, if a financial instruments business operator engages in a Lending business, approval for ancillary business under the FIEA is required.

4．Legal Issues Related to Restaking Under Japanese Law

(1) Structure of Restaking

Restaking is a scheme where crypto assets that have already been staked are staked again in another protocol.

The demand for restaking arises from two key factors: enhance security of certain decentralized finance (DeFi) protocols and similar services and enabling users to obtain higher yields.

If a DeFi service uses its own Proof of Stake token for validation of transactions and hence its security, its effectiveness may be limited due to low token value or poor distribution and can be open to security vulnerabilities through holding a significant number of the related tokens. Restaking solves this by reusing staked crypto assets (e.g., ETH) to provide the security of major public blockchains like Ethereum.

 In return, DeFi services share rewards with crypto assets holders, who also bear slashing risks. This allows holders to earn additional rewards on top of their staking returns, boosting overall yields.

(2) Legal Issues Related to Staking Under Japanese Law

The key legal issues related to restaking under Japanese law include:

1. Whether the holding of users’ crypto assets by a restaking service qualifies as a “Custody” service, potentially making them subject to custody regulations (i.e. PSA).
2. Whether the distribution of rewards to users, along with their exposure to slashing risk, could fall under Fund regulations (i.e. FIEA).

Regarding Custody regulations, the applicability of Custody regulations depends on the structure of the restaking service. However, based on the previously mentioned stance of the FSA on Custody, if the  crypto assets are managed by a smart contract and the restaking service provider does not have the technical ability to transfer the crypto assets, Custody regulations would not apply.

Regarding Fund regulations, the application of Fund regulations requires that the contributed assets be used to conduct a business. In the case of restaking, if crypto assets are merely locked as a form of collateral to cover potential penalties from slashing, rather than being allocated for business operations, it would not meet the legal definition of an Investment. Therefore, Fund regulations would not apply.

Note that, as with staking, the applicable regulations may vary depending on the specific structure of the restaking scheme.

I. Introduction

Japan has enacted and improved crypto regulations since 2017. Japan was once one of the most crypto-friendly nations in the world, but after 2018, it adopted a stricter regulatory stance. It is, however, now becoming more friendly to the Web3 industry again, with an intention to attract foreign investment.

This article provides an overview of cryptoasset regulations in Japan in 2024.

History of Cryptoasset Regulations in Japan

II. Cryptoasset, NFT, and Stablecoin Regulation　

　1. Definition of Cryptoassets

The PSA defines cryptoassets as property value with the following elements:

　2. Cryptoasset Exchange Services

(1) Definition

Under the PSA, the Cryptoasset Exchange Service means any of the following acts carried out in the course of trade:

(2) Meaning of “in the course of trade”

Sales and purchases of cryptoassets to Japanese residents are not subject to the regulation unless they are conducted “in the course of trade (gyo to shite)”. An act in the course of trade is generally understood to be a repetitive and continuous act vis-à-vis the public. For example, trading in cryptoassets for one’s own investment purposes or taking custody of cryptoassets of a wholly owned subsidiary are not considered acts in the course of trade.

It should be noted that just because your clients are only institutional investors is not considered as it is not in the course of trade.

(3) Solicitation to Japanese Residents

Whether or not a CESP solicits Japanese residents is also considered an important factor in determining the regulation’s application. The determination of whether solicitation towards residents of Japan is being conducted is made on a case-by-case basis. For instance, actions such as not blocking access to a website from Japan, providing information in Japanese, or introducing products at events in Japan could be considered factors that indicate solicitation towards residents of Japan.

(4) Management of Cryptoassets

The custodian of cryptoassets shall take the CESP license. According to the FSA guidelines, whether each service constitutes the management of cryptoassets should be determined based on its actual circumstances. Generally, if a service provider can technically transfer its users’ cryptoassets, it falls under the category of the management of cryptoassets. If a service provider does not possess any of the private keys necessary to transfer its users’ cryptoassets, the service provider is basically not considered to manage cryptoassets.

Accordingly, wallet services, such as non-custodial wallets, where the users manage the private key on their own, are not considered to constitute the management of cryptoassets.

(5) Intermediary, Brokerage, or Agency Service

An intermediary generally means a factual act that involves efforts to conclude a legal act between two others. Brokerage or agency service means to perform a legal act in one’s own name and for the account or on behalf of another person.
With respect to a purchase and sale agreement of cryptoassets between third parties, the acts of (i) soliciting the signing of the agreement, (ii)explaining the product for the purpose of solicitation, and (iii) negotiating the terms and conditions fall, in principle, under the category of an intermediary.
The mere distribution of product information papers, etc., may not fall under the category of an intermediary and should be considered on a case-by-case basis.

(6) Requirements for the License and Cost

The PSA requires minimum capital, financial requirements, a physical office, a sufficient number of personnel on staff, segregation of assets, an annual audit, a customer identity verification system, accountability to users, protection of person/s’ information, including sensitive information, and, if outsourced, must retain authority. The service provider must be equipped with the systems for adequate operation and legal compliance deemed necessary to operate a Cryptoasset Exchange Service appropriately and securely. Although the applicant must have a minimum capital base of at least JPY 10 million, and it must not be in negative assets, from our experience, the cost of obtaining the license and starting the internet exchange business can be more than JPY 1 billion.

(7) Exchange M&A

We are often asked by companies interested in entering the Japanese crypto market whether they can start their business by acquiring an already licensed CESP rather than obtaining a new license. The answer is Yes. Regulatory speaking, change of major shareholders is done just ex-post notification and you can start your business after purchasing the already licensed CESP.

The major issue here is that the purchased CESP shall satisfy the governance and compliance levels, which are similar to those a new licensed exchange shall achieve. If one purchases a cheap CESP, which is just having a license but has not done a business actively, to reach these levels might be difficult and time-consuming. Furthermore, if you wish to change the business model or system of the purchased CESP, you must provide an explanation to and obtain approval from the FSA. The cost of purchasing the licensed CESP, combined  with this additional expense, can sometimes be comparable to the cost of obtaining a new license. Therefore, careful consideration is necessary.

　3. Crypto Exchange’s Obligations

(1) Management of Users’ Property

The PSA requires the users’ cryptoassets to be segregated from the CESP. Further, the CESP shall keep (i) at least 95% of the users’ cryptoassets in cold wallets and (ii) equivalent to 100% minus those kept in the left column of its own cryptoassets in cold wallets. Thus, as a consequence, the CESP shall hold the equivalent of 100% of users’ cryptoassets in cold wallets.

With respect to fiat currency, the CESP shall deposit its users’ fiat currency in a bank account under a different name from where the CESP deposits its own funds.

A CESP must undergo an annual audit of its financial statements and segregation of assets.

(2) Anti Money laundering

Anti Money Laundering law requires CESPs to conduct a know-your-customer of users. Stricter regulations for anti-money laundering came into effect on June 1, 2023. According to the new Travel Rules, when assets over a certain amount are sent by a user, the receiving and sending CESPs must share information about the users. The lack of interoperability in such information-sharing systems has prevented users from sending and receiving cryptoassets between some CESPs.

　4. DEX

The regulations applicable to decentralized exchanges (DEX) are not clear. There is an argument that the regulations do not apply to exchanges that are completely decentralized and have no administrator at all, as there is no entity subject to crypto regulations. However, it is necessary to carefully consider whether there is truly no administrator. Further, entities that provide access software to a DEX may be subject to the regulations for being intermediaries.

As stated later in section III. 1, the sale of cryptoassets issued by oneself is subject to crypto regulations. Providing liquidity to a DEX for cryptoassets issued by oneself may also be considered as engaging in the sales of the cryptoassets.

　5. NFT

Pure NFTs, such as trading cards and in-game items recorded on blockchains that do not function as payment instruments, are not considered cryptoassets. The FSA states that the distinction between cryptoassets and pure NFTs is as follows:

(i) the issuer of the NFTs prohibits its use as a payment instrument by technical feature or by agreement
(ii) the quantity and price of the NFTs are not suitable as a payment instrument (specifically, one NFT costs more than ¥1,000 or the total number of the NFTs issued is less than 1 million).

Generally speaking, pure NFTs are not regulated in Japan. Please, however, note that whether NFTs are considered as “pure” NFTs needs careful discussion. For example, if an NFT gives some dividend or economic benefit, it might be considered as a security. Further, an NFT, which is linked to real-world assets, might require a discussion of whether regulation of real assets may apply.

　6. Stablecoins

Japan was one of the first countries in the world to establish stablecoin regulations. Stablecoins pegged to fiat currency are defined as electronic payment instruments and require a license different from CESP to offer the related service.

Other stablecoins that adjust their value through algorithms could be regulated as cryptoassets or securities. Stablecoins classified as cryptoassets are subject to crypto regulations, while stablecoins classified as securities are subject to securities regulations (FIEA).

III. Crypto Financing

　1. ICO, IE

ICO (Initial Coin Offering) is an act of issuing and selling tokens to raise fiat currency or crypto assets from the public. ICO is regulated in Japan. The applicable regulations depend on the legal nature of the issued tokens. If the tokens are considered securities, the token issuance will be regulated by the FIEA. If the tokens are considered cryptoassets, the token issuance will be regulated by the PSA.

The issuance of new cryptoasset-type tokens in Japan is generally done by IEO (Initial Exchange Offering). IEO is an act of raising fiat currency or cryptoassets by an entity entrusting the sales of tokens to a licensed CESP. In the case of IEO, if the issuer itself does not conduct sales activity, the issuer does not need to take the crypto exchange license. If, however, the issuer itself wants to conduct sales activity for its new tokens, it needs to have a crypto exchange license, which requires significant cost and time compared to IEO. Several IEO projects have already been launched in Japan.

The IEO process requires examinations by the exchange, JVCEA, a Japanese self-regulatory organization, and the FSA. The examination checks the feasibility of the project for which the funds will be used, the financial soundness of the issuer, and other factors.

　2. SAFT, SAFE

SAFT (Simple Agreement for Future Tokens) is a way to raise funds in exchange for the right to purchase tokens to be issued in the future. SFAT targeting Japanese residents is considered to be subject to fund regulation or crypto regulation, depending on the legal nature of the agreement. However, both regulations do not apply unless the act is done in the course of trade, so we may argue that entering into a SAFT with limited numbers of specific persons, such as business partners who will contribute to developing projects, should not be regulated.

SAFE (Simple Agreement for Future Equity) with token warrant is subject to general equity investment regulations, depending on the attributes of involved entities and investors.

Japanese entities sometimes use J-KISS, a Japanese convertible equity, with a side letter that provides tokens.

IV. Crypto Staking

Generally speaking, we believe staking service for POS tokens is not regulated in Japan. For example, staking one’s own cryptoassets or becoming a validator for ETH is not regulated in Japan.

Not all staking services, however, are exempted from the regulation. If service providers manage the private keys of users’ cryptoassets (we understand some exchanges provide those services), custody regulation may apply. In addition to managing private keys, if the service providers distribute rewards as well as slashing penalties to the users, fund regulations might apply.

We understand that there are some NFT projects that say that they sell NFTs for crypto, and purchasers can stake NFTs, and can get rewards. We understand fund regulation might apply to such cases, especially in cases where staking does not have any actual usage for providing security.

V. Crypto Lending

In crypto lending services, a service provider borrows cryptoassets from users for a certain period of time and pays a lending fee in exchange. No regulation applies to that lending because the Money Lending Business Act regulates money lending, but it does not deem cryptoassets as money.²⁰

It should be noted that crypto custody regulations may apply in cases where the service is considered as custody, not lending, even if a service is titled as crypto lending. One factor that distinguishes lending and custody is whether users can withdraw their assets at any time (deposit) or whether there is a specific required time of non-withdrawal (lending).

VI. Crypto Mining

Mining cryptoassets requires large amounts of electricity. Thus, mining appears to be regulated in some countries, such as Kazakhstan²¹Regulation of mining in certain areas in Russia is also being discussed²². In Japan, mining itself is not regulated.

A business that collects money from the public to conduct mining operations and then distributes the proceeds from mining to the customers may be regulated under the FIEA as a fund.

Schemes that one sell mining machines, accept deposits of the machines, and promise to pay fees for the mining results may also be regulated under the Act on Deposit Transactions. If the Act on Deposit Transactions is applied, the business must obtain confirmation from the Prime Minister, but it is said that to get such confirmation is nearly impossible. Creating a scheme to avoid such regulation is important.

VII. Crypto Taxation

　1. Tax on Individuals

principle, classified as miscellaneous income. Miscellaneous income is income that is neither interest income, dividend income, real estate income, business income, employment income, retirement income, forestry income, transfer income, or temporary income. The tax rate for miscellaneous income ranges from 5% to 45%, depending on the amount of total income. The maximum tax rate is about 55% when we calculate income tax as well as residential tax and special reconstruction income tax.

　2. Tax on Corporations

Profit generated by cryptoassets transactions is subject to corporate tax which is about 30% depending on the amount of income and how big a company is.
Cryptoassets for which there is an active market must be valued using the mark-to-market method at the end of the fiscal year and are taxable even if companies do not sell them.
This unrealized gain tax treatment became a huge issue in Japan, and many Web3 companies left Japan.

In 2022, the Japanese government decided to reform this unrealized gain tax, and now the tax is not levied if an issuing company of tokens continues to hold its tokens with certain technical transfer restrictions.

In 2023, another tax reform was proposed and approved by the government. Under the reform, an unrealized gain tax is not applied if a company holds tokens with a certain transfer restriction, even in the case that tokens are issued by other entities (including Bitcoin and Ether etc.)

Disclaimer

The content of this article has not been verified by the relevant authorities or organizations mentioned herein and represents only a reasonable interpretation of their statements. Our interpretation of laws and regulations reflects our current understanding and may change in the future. This article is not intended to be legal advice and provides a summary for discussion purposes only. If you need legal advice on a specific topic, please feel free to contact us.

EOD

This article discusses the structure of EigenLayer, which has recently gained rapid attention in the DeFi space, and the applicable regulation on it under Japanese law.
Our firm is a law firm well-versed in the Web3 domain, and we have published numerous articles in both Japanese and English on legal issues related to the Web3 field²³. In May 2024, we published a Japanese article titled “Structure of Restaking Services such as EigenLayer and Japanese Law²⁴.”
While the Japanese version of the article provides a more detailed analysis, this article summarizes the conclusions of the Japanese version to facilitate easy understanding for overseas entities considering offering restaking services in Japan.

I Overview of EigenLayer

The Structure of Restaking in EigenLayer

EigenLayer is a service designed to ensure secure execution for programs running outside of the Ethereum Virtual Machine (EVM) by using ETH.
For instance, when a DeFi application that uses the Ethereum blockchain consists of parts that operate within the EVM and parts that do not, the security for the EVM parts is guaranteed by the Ethereum blockchain. However, the parts that run outside the EVM are not covered by the security of the Ethereum blockchain, making them vulnerable. The traditional approach to this issue has been to issue native tokens for that application, but this comes with several problems:

1. If the native tokens have low value, the threat of “slashing” is less effective.
2. If the native tokens are not widely distributed (e.g., if the initial developers hold many tokens), the system may not function effectively.
3. There is little incentive for users to purchase native tokens.

EigenLayer aims to provide a solution to these problems.
In simple terms, EigenLayer “reuses” ETH that is already staked on Ethereum to provide security to services built on EigenLayer (Actively Validated Services, or AVS). For example, consider an AVS that periodically surveys numerous crypto exchanges and DeFi protocols to collect token price information and calculate their average values. In this case:

1. Only those who have staked a certain amount of ETH can act as “operators” and provide price information.
2. If false information is provided, the ETH, etc.²⁵restaked by the operator on EigenLayer will be slashed.
3. Operators are rewarded by the AVS for providing accurate information.

A key feature is that ETH staked for the regular Proof of Stake mechanism on Ethereum can also be used as collateral for multiple AVS, allowing operators to earn additional rewards. Furthermore, users who are not operators can deposit their ETH, etc. into EigenLayer, restake it through selected operators, and receive a share of the rewards that operators earn from the AVS. The advantage for users is that they can earn multiple layers of rewards through EigenLayer restaking compared to simple ETH staking.

Liquid Restaking

In addition, external entities offer a service related to EigenLayer known as Liquid Restaking. This service involves users depositing their ETH with a liquid restaking provider, who then stakes the ETH on Ethereum and restakes it through EigenLayer once the minimum staking unit of 32 ETH is accumulated. In this case, users only interact with the liquid restaking provider, while the provider handles transactions with EigenLayer. This arrangement frees users from the responsibility of selecting operators. Liquid restaking services thus play an important role in providing users with the opportunity to generate revenue through EigenLayer.

II Laws to Consider and Conclusions

Restaking and Japanese Law

(1) Legal Considerations for Restaking services such as EigenLayer

When considering restaking services such as EigenLayer under Japanese law, it is primarily necessary to evaluate the applicability of:

1. Custody regulations under the Crypto Act (a subset of the Payment Services Act);
2. Fund regulations under the Financial Instruments and Exchange Act (FIEA);
3. Regulations under the Act against Unjustifiable Premiums and Misleading Representations (UPMR).

(2) Custody Regulations under the Crypto Act

If the act of depositing ETH, etc. into EigenLayer is viewed as the entrustment of crypto, the custody regulations under the Crypto Act may apply. However, if the deposit is made to a smart contract and the smart contract technically prevents EigenLayer, the AVS, the operators and other people except for users to transfer the ETH, etc., we believe the custody regulations would not apply.

(3) Fund Regulations under the Financial Instruments and Exchange Act

FIEA regulates funds that collect money, use such money for some kinds of investment or some business activities, and distribute the profits to investors. There is a concern about whether the fund regulations under the FIEA apply to the mechanism where EigenLayer receives deposits of ETH, etc., operators provide security to the AVS in return for rewards, and a portion of these rewards is distributed to users, who also bear the risk of penalties such as slashing. However, if the deposited ETH, etc. is not used for investment or business activities but merely locked in a smart contract as a form of collateral to address penalties like slashing, we believe that the fund regulations under the FIEA would not apply.

(4) Regulations under the Act against Unjustifiable Premiums and Misleading Representations

In restaking services such as EigenLayer, users may receive points²⁶.as rewards. These points might lead to future airdrops. The potential applicability of the UPMR, which prohibits excessive premiums provided in connection with transactions of goods and services, needs to be considered. Under UPMR, premiums refer to (1) economic benefits such as goods or money that are provided (2) as a means to attract customers, and (3) in connection with transactions. In this respect, users of restaking services likely view these points as part of the rewards associated with restaking, and the high yields might incentivize them to restake. Therefore, these points can be seen as part of the primary transaction, not as “premiums” provided in connection with the transaction, implying that the UPMR might not apply.

Liquid Restaking and Japanese Law

(5) Legal Considerations for Liquid Restaking Providers

Liquid restaking providers, being external entities, likely operate under various structure. It is necessary to evaluate the applicability of:

1. Custody regulations under the Crypto Act;
2. Trading regulations under the Crypto Act;
3. Fund regulations under the FIEA;

(6) Custody Regulations under the Crypto Act

If the act of depositing ETH for liquid restaking is deemed as custody, the custody regulation under the Crypto Act may apply. Whether liquid restaking providers manage private keys is a critical issue. We believe, however, it seems that most liquid restaking providers do not own private keys and thus the custody regulation do not apply.

(7) Exchange Regulations under the Crypto Act

There is a concern about whether issuing Liquid Restaking Tokens upon depositing ETH constitutes crypto exchange. Legally, if tokens are issued as proof of deposit, it would not be considered trading or exchange under the Crypto Act, and thus, the trading and exchange regulations would not apply.

(8) Fund Regulations under the Financial Instruments and Exchange Act

Fund regulations must also be considered for liquid restaking providers. Key considerations include how private keys are managed. If the smart contract ensures that the deposited ETH is used solely as collateral and cannot be otherwise utilized, we believe the operation may not be classified as a fund. Conversely, if the smart contract is not properly set up and allows the provider to use the private keys and crypto assets, the operation may be subject to fund regulations.

Disclaimer
The content of this article has not been confirmed by the relevant authorities or organizations mentioned in the article but merely reflects a reasonable interpretation of their statements. The interpretation of the laws and regulations reflects our current understanding and may, therefore, change in the future. This article does not recommend the use of staking, liquid staking, liquid restaking, EigenLayer or LIDO, etc.. This article provides merely a summary for discussion purposes. If you need legal advice on a specific topic, please feel free to contact us.

I  DePIN

DePIN (pronounced ‘dee-pin’) stands for Decentralized Physical Infrastructure Network. While there is no definitive conclusion on what DePIN exactly is, according to ChatGPT, it can be described as follows:

In recent years, DePIN has become a major topic in the Web3 industry, with globally renowned projects such as Hivemapper, Helium, and Filecoin. In Japan, the number of Hivemapper users is increasing, and the country’s largest power company, Tokyo Electric Power Company, has launched a DePIN game called PicTrée, further highlighting the growing interest in DePIN. A summary of this game is provided for reference in section III below.

Our firm is a law office well-versed in Web3 and has addressed various legal issues related to Web3 under Japanese law in numerous articles written in Japanese. Although DePIN has recently garnered attention in Japan, it seems that adequate legal scrutiny has not yet been conducted. Therefore, to support the business development of DePIN in Japan, we have compiled the Japanese article²⁷.  While the Japanese article contains a more detailed analysis than this English article, this English article is designed for overseas businesses considering offering DePIN in Japan. It summarizes the conclusions of the Japanese article to facilitate easy understanding of the discussion

II  Laws to Consider and Conclusions

There are various types of DePIN projects. Therefore, the laws potentially applicable when introducing DePIN to residents of Japan may vary depending on the project. Here, we considered the introduction of the current major DePIN projects listed in section I for residents of Japan.

In conclusion, for these projects, it is necessary to consider the following regulations:

1. The crypto regulation part of the “Payment Services Act,” which establishes regulations related to crypto exchange registration, (hereinafter referred to as the “Crypto Act”).

2. The Act against Unjustifiable Premiums and Misleading Representations (hereinafter referred to as the “Premiums and Representations Act”), which regulates the provision of premiums attached to the purchase of goods or services.

3. The Act on Specified Commercial Transactions, which regulates transactions that induce consumers to purchase equipment by offering benefits such as business opportunities.

4. The Radio Act.

5. The Telecommunications Business Act.

6. Other laws related to the import and sale of equipment.

The summary of our current analysis is as follows:

III  PicTrée (Demonstration Experiment by DEA and TEPCO Group)

In April 2024, “PicTrée,” a GameFi demonstration experiment by the Singapore-based GameFi company Digital Entertainment Asset (DEA) and Tokyo Electric Power Company Power Grid Inc., was launched.

“PicTrée” is a GameFi project where game users receive rewards for taking photos of utility poles and manholes. Utility poles and manholes require continuous maintenance and inspections, which incur significant costs. In this experiment, game players take photos of the current state of utility poles and manholes. Based on these images, the power company determines whether inspections or repairs are necessary, aiming to reduce costs while maintaining safety.

Similar to Hivemapper, this DePIN project allows participants to contribute to society by taking photos and receiving rewards. It is a more accessible DePIN project, as it can be participated in using one’s smartphone and a free app.

Game Description and Source of Diagram: Digital Entertainment Asset Pte. Ltd. Press Release, March 4, 2024²⁸ (Translated by So & Sato Law Offices)

Disclaimer
The content of this article has not been confirmed by the relevant authorities or organizations mentioned in the article but merely reflects a reasonable interpretation of their statements. The interpretation of the laws and regulations reflects our current understanding and may, therefore, change in the future. This article does not recommend the use of DePIN or the purchase of DePIN equipment. This article provides merely a summary for discussion purposes. If you need legal advice on a specific topic, please feel free to contact us.

This article describes the structure of and applicable Japanese law to liquid staking, which has been expanding rapidly in recent years, and its most significant protocol, LIDO.

I. A Summary of Legal Analysis

II Basic Overview of Liquid Staking, ETH Staking, and LIDO

1 Liquid Staking

Liquid staking is a DeFi (decentralized finance) mechanism whereby a person receives a staking fee for a crypto asset while receiving an additional alternative asset (a staking-proof token) and can invest said alternative asset in another DeFi.

2 Proof of Stake and Staking

Proof of Stake (POS) is the authentication mechanism of the blockchain by a person who has a certain level of involvement (stake) in the crypto asset.

Unlike the Proof of Work (POW) mechanism used in Bitcoin and other cryptocurrencies, authentication can be performed without requiring a large amount of calculations, thus reducing electricity consumption and making it more environmentally friendly.

3 ETH Staking

Ethereum has been structured using POS instead of POW from ETH 2.0. In Ethereum staking, (1) you can become a validator by depositing 32 ETH, (2) the validator authenticates each transaction on Ethereum and thereby receives a certain amount of ETH as a reward, and (3) if the validator intentionally provides false information, he/she will be penalized by forfeiting a part of the deposited ETH (thrashing), (4) a validator is always required to be online, and if they are down, they will also be penalized to a certain extent.

4 How LIDO Works

LIDO is the world’s largest protocol for Liquid Staking. At present, it is estimated that more than 30% of the staking volume of Ethereum is done via LIDO. LIDO is supposed to work as follows:²⁹

Prepared by So&Sato Law Offices from published materials

①LIDO allows users to stake ETH without maintaining their staking infrastructure and without economically locking up their assets.

②When a user wants to stake ETH to LIDO, the user should send ETH to LIDO’s smart contract. In response, the user receives a 1:1 token called stETH.

③stETH is a token that represents the deposit of ETH to LIDO for staking, and when a user sends stETH to LIDO to burn stETH, the user will receive ETH. stETH can be freely bought and sold, and if there is another DeFi that accepts stETH, the user can earn double rewards by using stETH on another DeFi (however, DeFi protocols that accept stETH still seem to be limited).

④LIDO will use ETH received through the smart contract to perform staking. LIDO will receive 10% of the reward obtained from staking, which will be distributed to the person in charge of the staking (node operator) and the LIDO DAO. The remaining 90% will be distributed to the users. The distribution to the users is made by adding the number of stETH in the address of stETH, and the number of ETH managed by LIDO is always the same as the number of stETH.

⑤LIDO uses multiple node operators. Node operator candidates apply to LIDO, stating that they wish to become node operators, their experience and technical capabilities, etc., and are then voted on by the DAO, which is composed of LIDO token holders, the LIDO’s governance tokens, to determine whether they are eligible to become node operators.

⑥Note that ETH has thrashing risks and penalties. LIDO hedges against such risks by using a large number of node operators. LIDO also manages some ETH separately and uses it as insurance against thrashing risk.

⑦LIDO is an open-source, peer-to-peer protocol and is not operated by a single operator, etc., as the LIDO DAO makes the decision on its operation.

III Liquid Staking and Japanese Law

When offering liquid staking like LIDO, it is necessary to consider whether the trading and custody regulations of the Crypto Assets Act apply and whether the fund regulations of the FIEA apply.

1 Regulation of the Issuance of Crypto Assets

When a user contributes ETH to LIDO, the user will receive stETH, and conversely, when a user sends stETH to LIDO, the user will receive ETH.

The question arises as to whether this action constitutes an exchange of ETH for stETH. If it is considered an exchange of crypto assets, the regulations of the crypto asset exchange services might apply.

StETH, however, is issued to prove the deposit of ETH, and we believe the issuance of such stETH does not constitute a sale or exchange under civil law and thus does not constitute an exchange of crypto assets (and vice versa).

2 Custody Regulation of Crypto Assets

The contribution of ETH to LIDO might be considered a deposit of crypto assets to LIDO and raises the issue of whether the custody regulations of the Crypto Assets Act apply to LIDO.

However, it appears that the contribution to LIDO is a contribution to a smart contract, and LIDO cannot use said ETH except for staking (i.e., it does not control the private key) due to the structure of the smart contract.

Under the Japanese custody regulations, “If a business operator does not possess any of the private keys necessary to transfer the crypto assets of a user, the business operator is not considered to be in a position to proactively transfer the crypto assets of the user. In such case, the business operator is basically not considered to fall under the category of “managing crypto assets for others” as defined in Article 2.7.4 of the Payment Services Act. (Result of Public Comment No. 9 on the Draft Cabinet Order and Cabinet Office Ordinance Concerning Amendment to the Payment Services Act, etc. of 2019). If the smart contracts can technically prevent the free transfer of ETH by people related to LIDO, we believe LIDO is not considered to be subject to the custody regulations under the Crypto Assets Act.

3 FIEA Regulations

The question arises whether LIDO or liquid staking is considered a fund (collective investment scheme), given the mechanism of receiving ETH contributions, the node operator managing it, distributing a portion of staking fees to users, and users bearing the risk of thrashing and other penalty risks.

The definition of a fund under Japanese law is generally as follows (Article 2, Paragraph 2, Items 5 and 6 of the FIEA). If a fund investor’s right is tokenized, the tokens are considered electronically recorded transferable rights (Article 2, Paragraph 3, Pillar 1 of the same law).

If the issuer itself is offering or private offering the tokens, registration as a Type 2 Financial Instruments Business is required (Article 2, Paragraph 8, Item 7, (g), Article 28, Paragraph 2, Item 1, and Article 29 of the same law, Article 1-9-2, Item 2 of the Order for Enforcement of the FIEA), and if the third party is offering or private offering the tokens, registration as a Type 1 Financial Instruments Business is required (Article 28, Paragraph 1, Item 1 and Article 29 of the FIEA).

The concept of “other rights” in (A) above is very broad, and it is said that (i) through (v) are merely an enumeration of examples, regardless of the legal form. It can be argued that tokens issued in fully decentralized finance are not “rights” because they are not considered “rights” in the usual legal interpretation, but there is currently a prevailing view that some rights are recognized for Bitcoin, etc.³⁰, and in relation to this article, we assume that some kind of right is recognized even for smart contracts.

Nor does it fall under any of the exceptions in (C) above.

The main issue is the interpretation of (B) above, which states “dividends of income or distribution of properties that arise from a business conducted by using money” and “invested or contributed.” If we simply take the point that ETH is sent to the smart contract, it is used in the business of the POS, and the award from staking ETH is distributed to users, it would seem to satisfy both the “dividends of income or distribution of properties that arise from a business conducted by using money,” and “invested or contributed” requirement.

However, liquid staking is very different from ordinary funds in the following respects, and, arguably, liquid staking is not a fund to which the FIEA applies.

(1)In the case of a regular fund, the money and other assets contributed are fully owned by the fund operator, and the fund operator can technically use them in various ways, although they are contractually bound. In the case of liquid staking, the ETH contribution is made to the smart contract, and LIDO or node operators are not free to use it; ownership (ownership-like rights) over ETH is always considered to be held by the user,

(2)In the case of a regular fund, the money received is used to purchase shares, fund a business, etc., and changes from money to shares, etc. In LIDO staking, the ETH sent to the smart contract is not specifically changed into anything else but is maintained as it is.

(3)The only reason ETH is locked is to ensure that there is no thrashing in the event of fraudulent reporting in the validation process or penalties if a node goes offline.

(4)Based on (1) through (3) above, if we compare the legal nature of staking to a traditional economic act, it can be thought that the user is merely locking ETH into a smart contract as a kind of collateral to secure default liability and is merely receiving compensation for providing third party collateral. The provision of such collateral and the receipt of compensation do not satisfy the requirements of “dividends of income or distribution of properties that arise from a business conducted by using money” and “invested or contributed,” as referred to in the fund.

4 Argument that the Operator Does Not Exist and Therefore Is Not Subject to Regulation

In the case of DeFi, it could be argued that the operator does not exist in the first place and is not subject to regulation. Japanese law is a legal system that regulates persons and legal entities, such as operators. A completely decentralized financing scheme would not be subject to regulation. However, we need to carefully consider whether there really is no operator for DeFi. In general, DeFi aims for the operator to be non-existent, but even so, it is unclear whether many DeFi are truly completely operatorless.

Further, if the scheme is subject to financial regulations under the law, assuming there is an operator, the intermediary for the scheme could be subject to regulations even if there is no operator for DeFi itself. It would prevent, for example, an unlicensed Japanese company from sending customers to the DeFi.

Therefore, when examining the legal issues of DeFi, it is necessary to consider two issues: (i) if there is an operator, whether it is subject to legal regulation, and (ii) whether an operator exists.

However, it is unclear from the published documents whether the LIDO DAO is truly decentralized, so this article mainly discusses (i) above.

Disclaimer
The content of this article has not been confirmed by the relevant authorities or organizations mentioned in the article but merely reflects a reasonable interpretation of their statements. The interpretation of the laws and regulations reflects our current understanding and may, therefore, change in the future. This article does not recommend the investment in LIDO or liquid staking. This article provides merely a summary for discussion purposes. If you need legal advice on a specific topic, please feel free to contact us.

Ⅰ Introduction

Recently, Web3 companies often ask us whether they can issue and sell tokens linked to ownership or value of real world assets (“RWA tokens”) in Japan. The types of linked real assets include artwork, real estate, whiskey, vintage cars, government bonds, securities, gold, etc.

Applicable Japanese regulations to RWA tokens vary depending on the types of tokenized assets and the scheme. We will provide an overview of the applicable regulations to RWA tokens and then substantive legal issues of RWA tokens.

Ⅱ Crypto Regulation

Japanese law differentiates crypto assets, which are regulated, and NFTs, which are not regulated, and most RWA tokens are structured as NFTs.

If RWA tokens fall under the category of crypto assets, selling and purchasing the tokens as a business requires a crypto asset exchange license. For example, Zipang Coins, which are RWA tokens representing gold and issued by a Japanese major trading company group, are structured as crypto assets, and only licensed exchanges can sell them as a business.

On the other hand, most RWA tokens are structured as NFTs. From the legal viewpoint, the difference between crypto assets and NFTs is whether they can be used as a payment method. FSA has submitted a guideline and answers to public comments and stated that if tokens satisfy the following requirements, they are not crypto assets and are not regulated under the Payment Service Act.

Ⅲ Fund Regulation

If RWA tokens are considered securities, to sell and purchase the tokens as a business requires a financial instruments business operator license. If the token holder has the right to receive a dividend or more than 100% principal redemption, they are generally considered securities. The definition of the collective investment scheme (fund) in Japan is as follows. As the definition covers “all rights” that can receive a dividend or more than 100% principal redemption, you should carefully analyze whether the tokens are considered securities when its structure includes a profit distribution element.

Ⅳ Goods Deposit Transaction Regulation

Another regulation that is related to RWA tokens is the Goods Deposit Transaction regulation. In Japan, there have been some controversial transactions in which (i) a merchant sells some goods to buyers, (ii) the merchant accepts deposits of the sold goods from the buyers for more than 3 months, and (iii) the merchant promises to pay some fee such as a rental fee to the buyers or promises to buy-back the sold products more than the sales price. These kinds of transactions were often used as financial investments without regulation. The Goods Deposit Transaction regulation now regulates these kinds of transactions. The regulation requires an explanation to buyers if the transaction involves the above (ii) and (iii) elements and requires approval from the government if the transaction involves the above (i), (ii), and (iii) elements. Please note that there has been no case the approval was obtained yet, and, thus, no one knows the difficulty of obtaining the approval.

We are often asked the way to give economic benefit to RWA token holders. Simply giving the economic in principle causes the issues of both or either of fund regulations and goods deposit transaction regulation and makes token issuance not feasible.

Ⅴ Prepaid Payment Instruments

There are RWA tokens that give a right to acquire products or use products such as hotel rooms, etc. Issuance of tokens linked to the right to acquire or use real assets is, in principle, subject to prepaid payment instrument regulation under the Payment Services Act. Some RWA tokens give those rights to holders and are subject to the regulation. For example, Not A Hotel NFT, which gives a holder to stay in a luxury residence, is subject to the regulation.

There are two types of prepaid payment instruments. The first type is the private-type prepaid payment instrument, which can be used only against the issuer or its closely related persons. The issuer of the private prepaid instrument shall file a notification to the Finance Bureau and deposit half amount of the unused amount, except for the case when the issuer only issues instruments that have less than 6 months’ expiration date or the unused balance at a certain reference date is 10 million yen or less.

The second type is the third-party type prepaid payment instrument, which can be used against other than the issuer or its closely related persons. The issuer of the third-party type prepaid payment instruments shall register with the Finance Bureau, except for the case when the issuer only issues instruments that have less than 6 months’ expiration date.

Ⅵ Secondhand Goods Business Regulation

A business that sells, purchases, or exchanges once-used goods such as used cars, used bags, used jewelry, and published artwork is, in principle, subject to the secondhand goods business regulation. A person who conducts the secondhand goods sales and purchase business shall file a notification to the police agency and shall conduct KYC of its customers. It is conceivable, however, that this regulation would not apply to the division and sale of the right of secondhand goods, and thus RWA tokens, which related to the divided right of real goods, are exempted from the regulation.

Ⅶ Other Regulation

In addition to the above, sales, etc., of assets might require consideration of asset-specific regulations. For example, to sell alcohol needs an alcohol sale license, and the seller of RWA tokens UniCask, which relates to a barrel of whiskey, takes the alcohol sale license.

Ⅷ Substantive Legal Issues

Compared to a simple sale of real world assets, RWA tokens require more careful consideration of what rights will be transferred and how to perfect the transfer. Holding RWA tokens does not necessarily mean having ownership of real assets, and transferring RWA tokens does not necessarily mean automatically transferring the ownership of the real assets.

For example, when you transfer real estate, you need to file a real estate transfer registration, and without it, you cannot insist that you are the owner of the real estate to third parties, and just transferring tokens on a blockchain may not suffice this requirement. To transfer tangible property in Japan might be possible just by transferring tokens, but careful consideration is necessary. The law regarding the transfer and perfection of real assets may vary in different jurisdictions, and generally, the laws in the country where the real asset is located apply.

Disclaimer
The content of this article has not been confirmed by the relevant authorities or organizations mentioned in the article but merely reflects a reasonable interpretation of their statements. The interpretation of the laws and regulations reflects our current understanding and may, therefore, change in the future. This article does not recommend investment in RWA tokens. This article provides merely a summary for discussion purposes. If you need legal advice on a specific topic, please feel free to contact us.

1 What is DAO?

A DAO is a decentralized autonomous organization that drives a business or project forward using smart contracts without a specific owner or manager. Overseas clients sometimes ask our firm whether they can sell DAO tokens in Japan.

2 Summary of regulation on sales of DAO tokens to Japanese residents

Below is a chart you need to consider before selling DAO tokens to Japanese residents.

<Chart to be considered>

3 Community DAOs and financial regulation

Community DAOs often issue governance tokens.

To consider the financial regulation of sales of DAO tokens in Japan, we must look at (a) whether the DAO provides some kind of dividend or more than 100% redemption of the principal (“Dividend, Etc.”), (b) whether the DAO has any legal entity nature that is similar to a joint stock company or LLC and whether the tokens represent nature similar to shareholders rights, and (c) whether DAO tokens can be used as a payment method.

3.1 DAO tokens that distribute Dividend, Etc.

Tokens in most community DAO do not have any dividend feature or profit distribution feature for token holders.  If there are such features, the regulation on investment DAO tokens will be applied.  Please see item 4 below.

3.2 DAO tokens issued by a company

If a DAO is structured in the form of a company, which happens rarely, and the DAO token awards member rights of the company to token holders, the right might be deemed as securities.  Type 1 Financial Instruments Business Registration is required for the sale of those tokens.

3.3 DAO tokens issued by non-company

In general, many DAOs are formed without clarification of the legal form.  Some DAOs just use a smart contract and do not have any form of legal entity.  Under Japanese law, such DAOs may be classified as partnerships or “associations without a juridical person.”  The rights of partnerships and associations without juridical persons do not fall under securities unless there are Dividend, Etc.

The sale of DAO tokens without Dividend, Etc. and so on issued by an organization other than a company should be classified as a crypto asset or NFT.

If the tokens fall under the definition of crypto asset, their sale shall be made by a licensed crypto asset exchange business operator.

However, if the DAO token is considered an NFT, there are no restrictions on its sale.

The distinction between a crypto asset (FT) and an NFT

In 2023, the Financial Services Agency (FSA) issued guidelines stating the distinction between a crypto asset (FT) and an NFT: (https://www.fsa.go.jp/news/r4/sonota/20221216-2/20221216-2.html).

The guideline states that if the asset does not have “means of payment” characteristics, it is not a crypto asset and that having “means of payment” characteristics can be determined by the following criteria: In general, if (a) DAO tokens cannot be used as a payment method, and (b-1) the price of the token is more than JPY 1,000 or (b-2) the issued number of tokens is less than 1M, the tokens are considered NFTs, and their sale is not regulated.

4 Investment DAOs and Financial Regulation

4.1 Investment DAO tokens are generally considered securities and regulated by FIEA

Under the FIEA, DAO tokens that pay Dividend, Etc. generally fall under the category of “electronically recorded transfer rights.”  Thus, in order to sell electronically recorded transfer rights, you must either register as a Type 1 Financial Instruments Exchange Business Operator (Type 1 FIEBO) and conduct the sales yourself or have a Type 1 FIEBO do it for you.  Furthermore, when soliciting 50 or more persons and issuing 100 million yen or more, the solicitation of the tokens becomes a public offering (Article 2, Paragraph 3 of the FIEA), which requires the submission of complex offering documents and continuous disclosure.

4.2 Exemption from FIEA might apply to some tokens, but it is not easy to use

As an exception, if sales are made only to qualified institutional investors (QIIs, professional investors) or wealthy individuals (with financial assets of JPY 100 million or more) who are 49 or younger, and if technical restrictions are in place to prevent other individuals from becoming DAO token holders through resale, then the sale falls under the exception category called “special business for qualified institutions, etc.,” and self-offering only requires a simple notification under Article 63 of FIEA.

We have heard that many investment DAOs in the US are issued to QIIs, and many investment DAOs limit their sales to avoid US security regulations.  The problem in Japan is that the definition of “professional investors” is much narrower than in the US.  In Japan, one criterion for becoming QII is that corporations and individuals must have at least JPY 1 billion in securities.  In the US, a person who has more than USD200,000 annual income can become a QII, and in the EU, a person who has more than EUR500,000 in financial assets (in addition to satisfying other requirements) can be a QII.  These requirements are much easier to satisfy than the requirements in Japan.

Japan also has a narrower exception to submit offering documents.  In Japan, offering documents are required for offerings exceeding JPY 100 million.  In contrast, exemptions apply for offerings less than USD6 million in the US (sales by Reg A Tier 1) and less than EUR5 million in some countries in the EU.

In light of the above, the issuance of investment DAOs is not popular in Japan but is still possible if you obey Japanese regulations.

EOD