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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:

(References)
Our previous Article on POS chain staking (in English)
・https://innovationlaw.jp/en/staking-restaking-under-japanese-law/
 
Our previous Articles on POS chain staking (in Japanese)
・Organizing Legal Issues on Staking 2020.3.17
・DeFi and the Law – LIDO and Liquid Staking Mechanisms and Japanese Law 2023.10.17
・EigenLayer and other Restaking Mechanisms and Japanese Law 2024.5.10

I. Overview of Legal Issues

(1) The Babylon mechanism itself does not appear to fall under the custody regulations under the Payment Services Act (PSA).
(2) The structure of Babylon is not considered to constitute a collective investment scheme (fund) under the Financial Instruments and Exchange Act (FIEA).
(3) If a liquid staking provider holds custody of a user’s BTC private key, such a provider may fall within the scope of custody regulations under the PSA. Legal classification should be assessed on a case-by-case basis depending on the structure.
(4) Japanese crypto asset exchanges are generally permitted to offer BTC staking services through Babylon under the current legal framework.
(5) One practical issue for Japanese crypto asset exchanges is that the rewards granted through the Babylon protocol may be altcoins that are not classified as “handled crypto assets” for that exchange. In such cases, the exchange is not permitted to custody these altcoins on behalf of users under current Japanese regulations. Accordingly, alternative measures must be considered, such as (i) transferring the altcoins to the user’s unhosted wallet, or (ii) selling or swapping them via a DEX or an overseas partner, and then crediting the user with BTC or Japanese yen.

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:

1 BTC is staked not to secure the Bitcoin network itself, but to secure other networks that rely on PoS-like economic security mechanisms, collectively referred to as Bitcoin-Secured Networks (BSNs).
2 Rewards are determined by the secured networks, typically in the form of their native tokens.
3 BTC can be used to secure multiple such networks simultaneously, potentially increasing yield (albeit with higher associated risks).
4 Staking does not require transferring the BTC private key; instead, it is conducted in a trustless and non-custodial manner using one-time signatures (EOTS: Extractable One-Time Signatures).

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:

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.

Risks Associated with Receiving Rewards in Other Tokens
• Price Volatility Risk of Reward Tokens
The reward tokens received from PoS networks generally have lower market capitalization and liquidity compared to BTC, making them more susceptible to price volatility.
Even if the nominal reward amount is high, a sharp decline in the token price could result in a significantly reduced effective yield.
 
• Liquidity and Redemption Risk
If the reward tokens are issued by a relatively niche or illiquid chain, they may be difficult to redeem on the open market, or suffer from large bid-ask spreads, reducing the actual profitability of staking.
 
• Continuity and Stability of Reward Design
If the PoS network changes its reward policy or reduces incentives in the future, the economic appeal of Bitcoin staking may diminish.
Moreover, if the chain’s operations are unstable, there is a risk that rewards may not be distributed properly or consistently.

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:

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:

1.The BTC staker selects a finality provider and generates the transaction data necessary to initiate staking.
2.The transaction includes the following conditional clauses:
(i) The designated BTC cannot be transferred for a fixed period (e.g., three days);
(ii) If certain predefined conditions arise during that period, the BTC will be sent to a predetermined address (typically a burn address);
(iii) However, the BTC staker retains the right to cancel (revoke) the transaction at any time before the fixed period ends, as long as no slashing condition has been triggered.
3.The “predefined conditions” referred to in (ii) generally correspond to slashing events—e.g., if the selected finality provider engages in dishonest behavior (such as submitting double signatures), the BTC will be forcibly sent to the burn address as a penalty.
4.The BTC staker finalizes the process by signing the transaction using a one-time EOTS (Extractable One-Time Signature), thereby proving BTC ownership and formally declaring their intent to participate in security provision.

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.

Method of Signature (Source: Babylon’s Litepaper
https://docs.babylonlabs.io/papers/btc_staking_litepaper%28EN%29.pdf?utm_source=chatgpt.com)

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:

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

 (Source: Babylon.docs  https://docs.babylonlabs.io/guides/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):

(2) Finality Providers

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

• Role:

• 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

Item Finality Provider (Babylon) General PoS Chain Validator
Block Generation ❌ Not performed ✅ Performed
Finality Observation ✅ Performed ❌ Typically not involved (finality is emergent)
Signature Type ✅ Signs finality data ✅ Signs blocks and voting messages
Slashing Risk ✅ Yes (for fraudulent finality signatures) ✅ Yes (for double signing, downtime, etc.)
Reward Mechanism ✅ Yes (based on submitted signatures) ✅ Yes (based on block production and delegation)

(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 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)

Function Description
Signature Verification Receives and verifies signatures from BTC stakers and finality providers.
Slashing Enforcement Executes slashing penalties when fraudulent or malicious signatures are detected.
Finality Recording Records the finality of blocks from PoS networks on Bitcoin (e.g., via timestamping).
Cross-Chain Relay Relays verified security information and signatures to other BSNs.

(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.

Key functions:
(i)Streamlining Operations
Since it is burdensome for BTC holders to individually generate signatures and monitor activity across multiple PoS networks, the protocol handles the following tasks:
・Selection of PoS networks for staking
・Automatic generation and management of EOTS signatures
・Collection and distribution of staking rewards
(ii) Issuance and Utilization of Liquid Staking Tokens (LSTs)
The protocol issues liquid staking tokens (e.g., stBTC) backed by the user’s staked BTC position. This allows the user to retain liquidity of their assets even while staking, enabling secondary use in DeFi and other ecosystems.
(iii) Complementary Use of Restaking
By carefully managing risk, the protocol may reuse the same BTC signature across multiple PoS networks (i.e., multi-staking), thereby maximizing yield.

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

Item Details
Token Name BABY (Native token of the Babylon Genesis Chain)
Means of Acquisition 1 Stake BABY and participate as a validator in block production and validation on the Babylon Genesis Chain
Means of Acquisition 2 Provide finality to the Babylon Genesis Chain using BTC as a finality provider
Primary Use Case 1 Staking collateral for validator participation
Primary Use Case 2 Governance (proposal creation and voting rights)
Primary Use Case 3 Network fees (planned in the future)
Additional Notes Rewards in other BSNs are typically paid in each BSN’s own native token, not BABY

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

Item Finality Provider Validator (Babylon Genesis Chain)
Staked Asset BTC (non-custodial) BABY token (non-custodial)
Primary Role Provide finality (submit signatures) to BSNs Block production and validation on Babylon Genesis Chain
Target Chain(s) Babylon Genesis Chain and other BSNs Only the Babylon Genesis Chain
Reward Token BABY or BSN-native token (depending on the chain) BABY token
Slashing Risk Signature invalidation and BTC burn (e.g., double signing) Slashing of staked BABY (e.g., double signing or downtime)
Staking Method Declaration of intent via BTC signature (held in a self-managed script; delegation also possible) On-chain BABY token staking (self-custodied; delegation also possible)

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:

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:

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:

(A)Covered Forms of Rights (any of the following):
1. Partnership agreement
2. Silent partnership agreement
3. Investment limited partnership agreement
4. Limited liability partnership agreement
5. Membership rights in a general incorporated association
6. Other similar rights (excluding those established under foreign laws)
Note: Items 1–5 are illustrative; “other rights” are interpreted broadly, regardless of legal form.
(B)Description of the Scheme (all of the following must be satisfied):
・Investors contribute cash or assets (including crypto assets, per Cabinet Order);
・The contributions are used in a business; and
・Investors have rights to receive dividends or a share in the property derived from that business.
(C)Exclusions:
The scheme does not apply where all investors are actively and substantially involved in the business (per Cabinet Order requirements); or
Where investors are entitled to returns only up to the amount they invested (limited liability form).
(D)Foreign Funds:
Similar rights based on foreign laws may also be regulated under separate provisions.

(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:

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)12, 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:

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:

 Staking Structure and Legal Framework Applicability of Crypto Asset Exchange Regulations / Fund Regulations as per Japanese Law
Service provider does not receive the user’s private key (only delegation) No applicable regulations

Service provider gets the user’s private key
Legal structure: “Custody” Crypto Asset Exchange regulations apply (registration as a Crypto Asset Exchange)
Legal structure: “Investment” Fund regulations apply (registration as a Type II Financial Instruments Business Operator)
Legal structure: “Lending” No applicable regulations

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) guideline3 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 keys4, 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 guideline5, “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.

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

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

Early Friendly Era
February 2014 MtGox, located in Shibuya, Tokyo, and the largest exchange in the world, went bankrupt.
March 2014 Japanese LDP (Liberal Democratic Party, a governing party in Japan) discussed with the government and decided not to regulate virtual currency at that stage but asked the industry to form a self-regulatory organization.
May 2016 Japan enacted the first virtual currency act in the world. The act was made as an amendment to the Payment Service Act (“PSA”). The act was friendly to startups and intended to foster the industry.
April 2017 The amended PSA stated above was enforced.
2017  There were ICO booms all over the world, and the price of crypto went up. The trading volume of Japanese exchanges became number 1 in the world. Many foreign players came to Japan to start their business.
Era of Stricter Regulation
February 2018 A massive hacking incident, under which approximately JPY 58 billion equivalent NEM was hacked, happened in Japan (Coincheck incident).
2018-2021 After the Coincheck incident, the Japanese government tightened the operation of the regulation. Many exchanges received business improvement orders and suspension orders, and the market became shrunk.
May 2020 The amended PSA and the amended FIEA were enforced.
Era that Web3 became a national strategy
2021- The Japanese government’s national growth strategy in 2021 includes the statement that Web3 became one of the national strategies. Under this strategy, the LDP’s Web3 project team has issued policy recommendations titled the Web3 White Paper5in order to foster Web3 every year since 2022.
June 2022 Japan enacted one of the world’s earliest stablecoin regulations. The act was made as an amendment of the PSA and the Banking Act.
2022 In 2002, there were collapses of Tera Luna, Three Arrows Capital, and the FTX Group. As a result, the global regulatory environment became stricter. However, Japan had already implemented stringent regulations, which proved effective. (*1) Therefore, Japan did not need to change its regulations even after these collapses.

(*1) Even in the FTX Group’s bankruptcy, the assets of FTX Japan’s customers were all preserved because the regulations required 100% of users’ assets to be segregated.
June 2023 Stablecoin regulation was enforced.
May 2024 DMM Bitcoin was hacked, resulting in a loss of approximately JPY 48.2 billion worth of Bitcoin. However, we have not seen any regulatory tightening in response to this incident at this stage.

II. Cryptoasset, NFT, and Stablecoin Regulation　

　1. Definition of Cryptoassets

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

(i) which is recorded by electronic means and can be transferred by using an electronic data processing system,
(ii) which can be used in relation to unspecified persons for the purpose of paying consideration for the purchase or leasing of goods, etc. or the receipt of provision of services and can also be purchased from and sold to unspecified persons acting as counterparties, and
(iii) excluding the Japanese currency, foreign currencies, currency-denominated assets, and Electronic Payment Instruments.
Electronic property value, which can be mutually exchanged with the above assets, also falls under the category of cryptoassets.

　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:

(i) sale and purchase of cryptoassets (i.e., exchange between cryptoassets and fiat currency) or exchange of cryptoassets into other cryptoassets;
(ii) intermediary, brokerage, or agency service for the acts described above (i);
(iii) management (custody) of fiat currency on behalf of the users/recipients in relation to the acts described above in (i) and (ii) and
(iv) management (custody) of cryptoassets on behalf of the users/recipients.
We hereafter call a cryptoasset exchange service provider as “CESP”.

(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.6

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 Kazakhstan7Regulation of mining in certain areas in Russia is also being discussed8. 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 field9. In May 2024, we published a Japanese article titled “Structure of Restaking Services such as EigenLayer and Japanese Law10.”
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.11restaked 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 points12.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:

DePIN, which stands for Decentralized Physical Infrastructure Networks, refers to networks that leverage blockchain technology to develop, maintain, and operate physical infrastructure in a decentralized manner. These networks use crypto tokens to incentivize individuals and organizations to contribute resources such as data storage, wireless connectivity, computing power, and energy.

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 article13.  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:

(1) Crypto Act
In Japan, when engaging in the “selling and buying,” “exchanging,” or “managing” of crypto as a business, regulations under the Crypto Act apply, and registration as a crypto exchange business is required. These regulations apply not only to crypto exchanges but also to ICOs and IEOs.

Regarding the relationship between DePIN and the “selling and buying” or “exchanging” of crypto, many projects have a mechanism where users receive tokens as a reward for contributing to DePIN. Even if these tokens are considered crypto, the provision of tokens as a reward for contributions to the project does not constitute “selling and buying” or “exchanging,” and therefore, the Crypto Act does not apply.

Concerning the relationship between DePIN and the “managing” of crypto, if tokens are granted to a user-owned address on the blockchain (where the user manages the private key), it is not considered that the DePIN operator is “managing” the crypto, and thus, the Crypto Act regulations do not apply. On the other hand, if the operator holds tokens granted to the user (the operator manages the private key), registration as a crypto exchange may be required. Therefore, to ensure that it is not considered as “managing” the crypto, it is necessary to send rewards to the user each time they occur. It is desirable to use a blockchain where even small rewards can be sent with low gas fees.

If usage fees are paid by credit card, resulting in tokens being burned and mined, this does not constitute the “selling and buying” of crypto.

In DePIN, it is common to list tokens granted as rewards to users to provide trading opportunities. In this case, for the exchange listing these tokens to sell crypto to Japanese residents, registration as a crypto exchange is required. On the other hand, there are no regulations that apply merely to users of the crypto exchange.
 
(2) Premiums and Representations Act
In Japan, attaching high-value premiums to the purchase of goods or services is regulated by the Premiums and Representations Act. For example, if premiums are uniformly provided to all purchasers, they are limited to 20% of the purchase price. If provided through a lottery, they are limited to the lesser of 20 times the purchase price or 100,000 yen, and also must not exceed 2% of total sales.

When users receive tokens as a reward for contributing to DePIN, these tokens are considered compensation for contributions and are not subject to the premium regulations under the Premiums and Representations Act.

(3) Act on Specified Commercial Transactions
Some DePIN projects require users to purchase specific equipment to participate in the project.

For businesses that involve (i) the sale of goods or the provision of services (including brokerage thereof), (ii) the inducement of users by presenting a business opportunity that provides rewards, and (iii) the imposition of the burden of purchasing necessary equipment for users to carry out the business, regulations such as the obligation to provide written documentation are imposed.

(4) Radio Act
Many of the devices used in DePIN are likely to emit radio waves for wireless communication.

To use these devices, a license under the Radio Act is required unless they bear a Technical Conformity Mark (GITEKI mark). It is effectively necessary to use general-purpose equipment that already has a GITEKI mark or to obtain the GITEKI mark for specific equipment.

(5) Telecommunications Business Act
For projects like Helium that involve setting up hotspots to connect to the internet and earn rewards, users may need to submit a notification under the Telecommunications Business Act. This requirement makes it difficult to carry out such DePIN in Japan.

(6) Other Laws Related to the Import and Sale of Equipment
When importing or selling specific equipment, laws such as the Electrical Appliances and Materials Safety Act, the Consumer Product Safety Act, the Household Goods Quality Labeling Act, and the Product Liability Act must be considered.

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.

Overview of the PicTrée Mechanism
1. Team Division: Users are divided into three teams: “Ampere,” “Volt,” and “Watt.”
2. Points: Users take photos of utility poles and manholes. Each time a user take photo of utility poles or manholes, the ownership of that utility poles or manholes can change to a different team. Additionally, by using game items to connect the utility pole or manhole to other utility poles or manholes of the same team, the team earns points.
3. Rewards: Users receive rewards based on their performance within the team, which can be in the form of Amazon gift cards or tokens. The winning team also receives team rewards.
4. TEPCO’s Benefit: Through these photos, Tokyo Electric Power Company can determine if maintenance or inspections are needed for the utility poles, thereby reducing maintenance costs.

Game Description and Source of Diagram: Digital Entertainment Asset Pte. Ltd. Press Release, March 4, 202414 (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

(1)  To analyze liquid staking, it is generally necessary to consider (1) the sales, purchase, and exchange regulations of the Payment Services Act (We call crypto regulation in the Payment Services Act the “Crypto Assets Act” after this), (2) the custody regulations of the Crypto Assets Act, and (3) the fund regulations of the Financial Instruments and Exchange Act, which is a kind of Japanese Security Act (the “FIEA”).
(2)  For staking, LIDO accepts staking of ETH and issues stETH in exchange for staked ETH. We believe that this conduct is not considered as “sales, purchase, or exchange of crypto asset” in the terms of the Crypto Assets Act. We believe stETH is just issued as proof of staking and not “exchange” under the Japanese Civil Code.
(3)  If the staking of ETH is considered a custody of crypto assets, the custody regulation of the Crypto Assets Act may apply. However, if the deposit is made against a smart contract and the protocol or node operator is technically incapable of transferring the ETH, etc., the custody regulation does not apply.
(4) The most controversial question should be whether the fund regulations of the FIEA would apply to liquid staking. LIDO’s mechanism might be considered as a fund because (i) ETH, etc., is contributed to the protocol by a user of LIDO, (ii) the node operator manages it, (iii) a portion of the staking fee is distributed to the user, (iv) the user seems to bear the penalty risk and thrashing risk of the staking, and (v) this mechanism seems to like a fund. However, we believe that we can argue that the fund regulation will not apply to LIDO because (i) staked ETH itself is not converted to anything, (ii) it is used for just a kind of collateral to compensation to penalty/slashing, and (iii)we can argue this mechanism is entirely different from usual funds.
(5) In addition to the above, we can argue that the Japanese financial regulation might not apply to DeFi if there is no “operator” because Japanese law just regulates persons and legal persons. However, this argument needs an actual fact analysis of the relevant liquid staking. Further, this argument cannot apply to a person or legal entity, if any, who intermediate Japanese residents to DeFi. Thus, the arguments from (1) to (4) above are important.

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:15

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).

Definition of the Funds under Japanese law
(A) (i) partnership contracts, (ii) silent partnership agreements, (iii) limited partnership agreements for investment, (iv) limited liability partnership agreements, (v) membership rights in incorporated associations, and (vi) other rights (excluding those under foreign laws and regulations).
(B) The Investor(s) receives the right to receive dividends of income or distribution of properties that arise from a business conducted by using money (including crypto assets) invested or contributed by the investor(s).
(C) None of the following
　(a) the case where all of the investors are involved in the business subject to the investment (in the way specified by a Cabinet Order)
　(b) the case where the investor(s) shall not receive dividends or principal redemption more than their investment
 
Funds under Foreign Law
(D) Rights under foreign laws that are similar to the above rights.

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.16, 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.

Required Factors to be considered as not regulated Crypto Asset but non-regulated NFTs
(i) the use as a means of payment to unspecified persons is prohibited, and (ii-a) the number of issued tokens is less than 1 million, or (ii-b) the transaction price is more than JPY 1,000.

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.

Definition of the Funds under Japanese law
(A) (i) partnership contracts, (ii) silent partnership agreements, (iii) limited partnership agreements for investment, (iv) limited liability partnership agreements, (v) membership rights in incorporated associations, and (vi) other rights (excluding those under foreign laws and regulations).
(B) The Investor(s) receives the right to receive dividends of income or distribution of properties that arise from a business conducted by using money (including crypto assets) invested or contributed by the investor(s).
(C) None of the following
　(a) the case where all of the investors are involved in the business subject to the investment (in the way specified by a Cabinet Order)
　(b) the case where the investor(s) shall not receive dividends or principal redemption more than their investment
 
(D) Funds under Foreign Law (rights under foreign laws that are similar to the above rights)

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

(1) You need to consider Japanese regulations when you sell DAO tokens to Japanese residents, even if you reside outside Japan.
(2) Regulations on DAO tokens differ depending on whether they are investment DAO tokens or community DAO tokens.
(3) Investment DAO tokens are generally considered “security.”  Their sale is usually regulated by the Financial Instrument and Exchange Act (FIEA).  The seller must obtain FIEA registration or delegate the sale’s activities to a licensed FIEA company.  Some exemptions exist, but they are not easy to use.
(4) Sales of community DAO tokens are either (i) unregulated, (ii) regulated by the Crypto Asset Exchange Business Law, or (iii) regulated by the FIEA, depending on the nature of the tokens.

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.

FSA’s revised guidelines
a)       The issuer must make it clear that the tokens are not intended to be used to pay for goods or services to an unspecified person.  For, example the terms and conditions provided by the issuer or business operator handling the product clearly prohibit the use of the product as a payment method, or the system is designed to prevent the use of the product as a payment method.
b)      Taking into consideration the price and quantity of the relevant property value, technical characteristics and specifications, and other factors as a whole, the tokens that can be used to reimburse an unspecified person for the price of the goods and so on must be limited.  For example, the tokens must have one of the following characteristics:
・The price per minimum transaction unit must be high enough not to be used as an ordinary means of settlement (JPY 1,000 or more).
・The issued number of tokens divided by the minimum trading unit (issued volume considered after divisibility) must be limited (1 million or less).

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

I. What is a Blockchain Game?

A blockchain game is a game that uses the blockchain and uses crypto assets, tokens or NFTs (Non-Fungible Tokens).

In a typical game the following occurs:
(1) user purchases game assets that belongs to the game operator rather than the user,
(2) such game assets cannot be freely transferred, sold, or lent out, and
(3) even time-consuming data disappears after game distribution ends.

Whereas in blockchain games, it is said that the following occurs:
(1) the user is the holder of the token (game asset),
(2) the token can be transferred, sold, or lent out to third parties,
(3) third parties can also use the token, and
(4) as long as the blockchain exists,17the recorded digital assets will exist in perpetuity.

Ⅱ. Laws to Consider and Conclusions

When providing a blockchain game to Japanese residents, the laws listed below should be taken into account. Here is a summary of the laws that pertains to this matter:

(1) Fund Settlement Law and Security Act
To issue and sell NFT itself is not regulated in Japan. Exception to it is (i) if tokens are deemed as crypto assets, such as fungible token which might be used as a payment method, they might be regulated under the Fund Settlement Law and (ii) if tokens are deemed as security, such as tokens including dividend feature, they might be regulated by the Financial Instrument Exchange Act.
(2) Act against Unjustifiable Premiums and Misleading Representations (hereinafter refer to Premiums Law or Premium and Representation Law)
Blockchain Game players might be given tokens, digital currencies, NFTs, digital assets or other gifts which have financial value when a user register, login, play a blockchain game. These gifts might be considered “premiums” or “free gifts” under the Premiums Regulations of the Premiums Law and the value of them are limited. 
If the Play to Earn games allow players to (a) purchase NFTs and (b) earn some reward (e.g., NFTs or tokens) by playing the game, the reward portion may be subject to the prize regulation. There is an argument that depending on the game design, the reward may not be considered an extra (premium) and may not be subject to the Premiums Law.

III. Legal Considerations

The following is a discussion of each legal issue.

1. Crypto Asset Law and Security Act

(a) Where is the problem?
Under blockchain games, the game operator frequently sells game characters, items, weapons, and land etc. as NFTs to users in exchange for ETH or other crypto assets.

Japanese law does not regulate sales of pure NFT, but regulate sales of crypto assets and sales of securities. Thus, whether sold tokens are not deemed as crypto assets or securities are crucial issue.

(b) What are crypto assets?
Under the Fund Settlement Act, the seller, Crypto Asset is defined as follows:

Definition of Crypto Assets (Article 2 Section 5 of the Fund Settlement Act
Definition of Type 1 Crypto Asset
A property value that is recorded in electronic record and transferred electrically, that can be used to pay for the purchase of goods or receive services to an unspecified person, and that can be purchased and sold to an unspecified person (excluding some stable coins and securities).
Definition of Type II Crypto Assets
Crypto Asset that is recorded in electronic record and transferred electrically which can be mutually exchanged with the Type I Crypto Asset with an unspecified party (excluding some stable coins and securities).

Selling or providing custody of crypto assets are highly regulated and must generally be handled by registered crypto asset exchange operator and also it is not feasible for a blockchain game operator to obtain registration.

At this moment, whether tokens are considered as crypto assets is determined by the number of issued tokens and whether the tokens can be used as some form of payment. NFTs are generally not considered as crypto assets, but if a game operator says it is an NFT, and the NFT has payment features etc., it may be considered a crypto asset.

(c) What are Securities?
Japanese Financial Instrument and Exchange Act (FIEA or Security Act) governs the issuance or sales of securities. Securities includes stocks, bonds, mutual funds, collective investment scheme etc. We have been often asked by blockchain game operators whether it is legal in Japan to sell NFTs, such as land, which generate “income” or “dividend”. If NFTs generate income without the participation of players, they may be classified as securities. Thus, when selling profit-generating tokens, the game should consider including features of players’ effort, such as editing land to attract customers.

2. Gambling offenses

(a) General Remarks
The crime of gambling under the Penal Code is established by (1) contesting the gain or loss of property profits by (2) winning or losing by chance. In addition, not only money but also “property interest” is considered to be the object of gambling, and rice, land, and debt collection are all considered to be “property interest” subject to the crime of gambling. Crypto assets are also considered to fall under the category of property interest.

Article 185 (Gambling)
A person who engages in gambling shall be punished with a fine of not more than 500,000 yen or a fine. However, this shall not apply when the betting is limited to betting on objects provided for temporary entertainment.

(b) Gacha (Loot Box), Reveal and Gambling Law
Some blockchain games have features of Gacha (loot box) and reveal. Users pay money or crypto assets to a gaming company and get NFTs randomly. For example, users pay 1ETH to get a game character NFT. Game characters may include Julius Caesar, Guanyu, Genghis Khan, Napoleon, George Washington etc, and those characters have different strength, powers, rarity etc, and what users can get is not revealed to users.
It was believed that these sales might be considered as gambling because (i) users pay property value, (ii) users receive property value which differs by chance, and (iii) there is winning or losing (of property value) by chance. However, in 2022, blockchain industries talked with a famous criminal law professor and some regulatory authorities and issued the guideline which states certain Gacha and reveal is not considered as gambling. Although the guidelines have no effect to police or criminal courts, the industry is now considering how following the guidelines may reduce the likelihood of criminal penalties.

The requirement is that the issuer and operator of games do not sell the same NFTs at different prices (for example, if the issuer sells NFTs that include Napoleon with 1ETH via Gacha, the issuer is not allowed to sell Napoleon NFT at a different price in another method), and do not buy back NFTs in a secondary market (for example, the issuer cannot buy back Napoleon NFT in 0.5ETH or 1.5ETH). In such cases, there is either winning or losing), and the issuer and operator shall not overstate the value of some NFTs in Gacha over other NFTs in Gacha.

(c) Synthesis
The same theory that applies to Gacha may apply to synthesis, but because synthesis is not discussed in the guidelines, we take a more cautious approach to synthesis.

3.Premiums and Premiums Law

(a)Initial Start
Developers often ask us of blockchain games if it is possible to give NFTs, game currency, crypto assets, other property to users free as a login bonuses, playing bonus and ranking bonuses etc. When conducting such distribution, it is necessary to consider the relationship with the Premiums and Representation Law.

(b) About the Premiums and Representation Law
The Premiums and Representation Law prohibits the offering of excessive premiums.
Premiums are (1) offered as a means of inducing customers, (2) offered incidental to a transaction, and (3) economic benefits such as goods or money. As the definition of economic benefits is broad, crypto assets, NFTs, in-game currencies, and other benefits might be considered as economic benefits.

Excessiveness will vary depending on whether the sweepstakes is general sweepstakes, joint sweepstakes, or all-inclusive sweepstakes, Still, it will be based on the following criteria to the extent that it is considered relevant to the game.

  Description Example Limits on Premium and Prizes
Total Prizes Offering prizes to anyone who uses the products or services or visits the store, not through sweepstakes. Gifts for all purchases, gifts for all visitors, etc. Transaction value less than 1,000 yen – Premiums up to 200 yen.
Transaction value is over 1,000 yen – Premiums are capped at 2/10ths of the transaction value

General Sweepstakes

 Offering prizes to users of goods or services by chance, such as lotteries, or by the superiority of specific actions. In-store raffles, quiz and game competitions. Transaction value less than 5,000 yen – 20 times the transaction value.
Transaction value of more than 5,000 yen – 100,000 yen.
(Both are capped at 2% of the total expected sales amount)

(c) Ranking Rewards and the Premiums and Representation Law
In traditional smart phone games, the top-ranking players frequently receive in-game currency. The economic value of in-game currency has been treated as zero or very low by game operating companies, and there is no issue under the Premiums and Representation Law.

In blockchain games, crypto assets and NFTs, which can be sold outside of the game might be given as prizes. In this case, the general sweepstakes restrictions apply. The transaction value determines the amount of the prize. Although it is difficult to determine how much the transaction value is, a reasonable approach would be to set the minimum charge as the transaction value and allow rewards of up to 20 times the minimum amount or 100,000 yen, whichever is lower.

(d) Play to Earn and the Premiums and Representation Law
If we consider a Play to Earn game as a game where players (a) purchase NFTs or game currency and (b) earn some reward (e.g., NFTs or game currency) by playing, the reward portion may be subject to the Premiums Regulation.

However, whether earned NFTs or game currencies will be considered “premium” is unknown. There is an argument that the Premiums Law does not apply to Play to Earn games because the rewards are not “extras (premiums),” but rather the purpose of purchasing NFTs and playing the game itself. Lottery winnings and game-play prizes, for example, are not considered “premiums,” but rather “the purpose” of the transaction itself (gambling law shall be discussed lottery winnings and game-play prizes). This issue has not been resolved in Japan, and careful deliberation is required.

Reserved Matters
The contents of this document have not been verified by the relevant authorities and are merely a description of arguments considered reasonable under the law. It is only the current thinking of our firm, and our firm’s thinking is subject to change.
This document does not recommend using blockchain games or purchasing NFTs.
This document is intended for blogging purposes only. Please consult your lawyer if you need legal advice on a specific case.

Introduction

Clients often ask us whether it is possible to structure a Decentralized Autonomous Organization (DAO) in Japan. Currently, Japan does not have regulations targeting DAOs, unlike Wyoming State or the Marshall Islands. So, we have written this article summarizing what is typically considered when forming a DAO in Japan.

1.DAO

1.1 What is DAO?

A decentralized autonomous organization (DAO) is a new legal structure with no central authority and members committed to acting in the organization’s best interests. DAOs are used to make decisions in a bottoms-up management style and have gained popularity among cryptocurrency enthusiasts and blockchain technology.

1.2 Classification of DAOs

There are several classifications of DAO described below:

1.     Investment DAO
 
Investment DAOs are for-profit DAOs aim at co-investing in a project. They are more likely to attract funds than Grant DAOs because they aim to generate profits mainly through “economic capital.”
Examples: Genesis DAO, The LAO, BitDAO, etc.
 
2.     Grant DAO
 
The community contributes monies to the grant pool and votes on funds allocation and distribution decisions in a Grant DAO. Innovative DeFi projects are funded using these DAOs, showing how decentralized communities are more flexible with funding than traditional organizations.
Examples: MolochDAO, MetaCarteDAO, Aave Protocol, Uniswap Grants, etc.
 
3.     Protocol DAO
 
When tokens serve as a voting metric for implementing any changes in the protocol, such a governance structure represents protocol DAOs. For instance, MakerDAO has revolutionized the DeFi space with its DAI stablecoin.
Examples: Maker, Compound, Uniswap, Aave, Yearn, Sushi, etc.
 
4.     Service DAO
 
A Service DAO is a decentralized working group. They can receive tokens as compensation for their projects.
Examples: RAID GUILD, DXdao, PartyDAO, etc…
 
5.     Social DAO
 
A Social DAO offers digital democracy where opinions are heard, and people can share common interests.
Example: Bored Apes (BAYC)
 
6.     Collector DAO
 
Artists who use nonfungible tokens (NFTs) to create art rely upon collector DAOs to establish ownership of their art.
Example: PleasrDAO
 
7.     Media DAO
 
Media DAOs allow product owners of content (i.e., readers) to contribute directly without involving advertisers for the native token as a reward in return for their contributions.
Example: Fore Front (FF), Bankless DAO, etc…

Source https://cointelegraph.com/daos-for-beginners/types-of-daos

1.3. Example of an Existing Overseas Law

A few places where DAOs are regulated are Wyoming State and the Marshall Islands. Below is a short description of forming a DAO in the Marshall Islands.

The Legal Form of a DAO on the Marshall Islands

Marshall Islands proposes a non-profit corporation (limited liability company) as a legal entity form for DAO, which stands out from the general practice to establish DAO as a foundation. Such a company is established in compliance with the general corporate law of the Marshall Islands with specific features that:
  • No part of the income or profit of the corporation is distributable to its members, directors, or officers; and
  • Members’ ownership of such a company may be defined in such a plain document as the register of members AND in the company’s smart contract.
  • You must clearly state the company’s purpose and connect it to the non-profit activity. The purpose will be furtherly indicated in the Certificate of Incorporation.

How does this work?

Generally speaking, such a company works as a limited liability company managed by its members. It has three essential constitutional documents: Certificate of Incorporation, Operating Agreement, and Charter of the Company.
The Operating Agreement should include the most crucial matters of your DAO management:
  • additional governing bodies;
  • voting and counting of votes of such governing bodies;
  • amendment of a smart contract;
  • creation and management of treasury.

You can amend any of these matters by the members’ decision in compliance with the procedure prescribed in the previous version of the Operating Agreement. 

Registering a Marshall Islands LLC for DAO


Here’s what the process of establishing a legal wrapper for DAO on the Marshall Islands looks like: 
  • You start by clearly defining the name and purpose of your DAO. Once again, the purpose of your DAO should indicate the non-profit element;
  • At least three founding members draft the Operating Agreement (you may amend the Operating Agreement at any time upon establishment of the company; therefore, it is a common practice to use the template at the first stage to speed up the process);
  • The founding members should pass the KYC process with the local regulator. Apart from the founders, anyone who holds 10% or more governance rights over the company must pass the KYC process
  • The founding members sign the drafted Operating Agreement, Certificate of Incorporation, and Foreign Business Investment License form and file these documents with the regulator;
  • If everything is alright with the documents, the regulator sends the Charter of the limited liability company to the founders.

The above is a reference from Taras Zharan Web 3 Virtual Legal Officer.

 https://legalnodes.com/article/marshall-islands-llc-as-a-dao-legal-wrapper

2. Financial Regulations on DAOs

2.1. Points to Consider

When structuring a DAO, one must consider the financial regulations and the legal form characteristics.

Here are several points to keep in mind:

1. Security regulation under the Financial Instrument and Exchange Act (“FIEA”) may apply when tokens have the possibility of dividends or redemption of the principal of more than 100% (dividends and redemption of the principal of more than 100% are from now on collectively referred to as “dividends, etc.”). As a general rule, token sales of such DAO must be conducted by a Type 1 Financial Instrument and Exchange Business Operator (“Type I license”) or by obtaining a Type 2 Financial Instrument Exchange Business Operator license (“Type II license”).

2. When selling Fungible Tokens without dividends, etc., it is necessary to have a Crypto Asset Exchange Operator conduct the sale or to obtain a Crypto Asset Exchange Operator license.

In contrast, these financial regulations generally do not apply when selling NFTs without dividends, etc.

3. You also need to consider the tax benefits. If you want to pursue tax advantages in an Investment DAO with dividends, etc., you can use a partnership or GK-TK scheme. If tax advantages are not particularly important, an association without rights, a general incorporated association, or a limited liability company can be considered a scheme to issue tokens. For the issuance of Fungible tokens or NFTs without dividends, etc., it may be better to have no particular legal structure.

2.2. Reference Table of Conclusions

The table below summarizes the legal scheme and financial regulations that should be considered in establishing a DAO.

The following regulations apply to token sales of Investment DAOs with dividends, etc. (assuming dividends or principal redemption of more than 100%).

Type of Member’s Rights Form under Japanese Law Free distribution of Tokens Token Sale Investment Management
DAO member’s rights as shareholders’ rights in Limited Liability Companies and Joint-stock Companies Tokenization of shareholders’ rights of limited liability companies, etc. Free distribution of the shareholders’ rights is not allowed under corporate law, etc.

Sales by a third party for an issuer need a Type I license. A Type II license is necessary for the self-offering of a limited liability company. No license is required in the case of self-offering of a joint-stock company.

In the case of solicitation of 50 or more people, there needs to be a submission of a registration statement regarding securities, etc.

 No regulation
DAO member’s rights (with dividends), not including shareholders’ rights TK investment, partnership investment, tokenization of rights that are difficult to classify into prescribed legal forms, etc. Unregulated

Sales by a third party for an issuer need a Type I license.

Self-offering needs a Type II license.

In the case of solicitation of 50 or more people, there needs to be a submission of a registration statement regarding securities, etc.

No regulation

(Possibility of Investment Management Business license in the case of securities investment)

On the other hand, a DAO without dividends, etc., is also possible. Its regulations are as follows:

Tokens/NFT Free Token Distribution Sale of Tokens Investment Management(Assuming no dividend)
Utility Tokens No regulation Crypto Asset Exchange Business regulation No regulation
NFT No regulation No regulation No regulation

With respect to possible legal forms for DAOs, the following comparisons can be made:

Status Legal Form Limited Liability Is it possible to distribute? Avoid Double Taxation Others, Comprehensive Evaluation
No Legal Entity Status Association without rights +Tokens with unclear rights 〇? 〇 ×

△~〇 High degree of freedom. A good scheme if there is no problem with double taxation.
Civil Law Partnership + Partnership Equity Token × 〇 〇

△~〇 High degree of freedom. A good scheme if there is no problem with limited liability.
Investment Business Limited Liability Partnership + partnership Equity Token 〇 〇 〇

× Although other points are reasonable, there are restrictions on investment destinations and businesses, such as not being able to purchase NFTs. It’s usually hard to use this scheme as DAO.
Limited Liability Partnership + Partnership Equity Token 〇 〇 〇

× There are valid points; however, to use as a DAO is problematic because of the need to register the name of the union member.
DAO has Legal Entity Status

Corporation (*1) + Tokenization of Anonymous Partnership (e.g., TK-GK scheme)

 〇 〇 〇 △ It is necessary to operate in accordance with the Companies Act and the General Incorporated Associations Act. It should be noted that TK holders do not have the right to instruction. The good point is that there is no double taxation and limited liability.

Corporation (*1) + Token with unknown rights

 〇?  〇 × △ ~ 〇 It is necessary to operate under the Companies Act and the General Incorporated Associations Act. Besides that, it has a high degree of freedom and is a good scheme if you don’t mind the double taxation problem.

Corporations (*1) + Tokenization of shareholders rights (*2)

  〇  〇(× For general incorporated associations) ×

× Is there a low degree of freedom due to the need to operate per the Companies Act and the General Incorporated Associations Act? For example, it is necessary to manage members as shareholders.

*1 Legal entities include limited liability companies, stock companies, and general incorporated associations. LLCs are generally easier to establish and operate than joint-stock companies. If you want to have a more public image, use a general incorporated association.
*2 Membership rights of a limited liability company, stocks of a stock company, membership rights of a general incorporated association.

2.3 Tokenization of Rights

Tokenization of rights of funds or partnership, where there is an investment of funds (including money and crypto assets), investment management, dividends, or redemption of the principal of more than 100%, would be broadly considered a collective investment scheme (fund) under Japanese law. Below is the summary of the Definition of a Collective Investment Scheme.

Summary of Definition of Collective Investment Scheme
Rights that satisfy the following (i) to (iv)
(i) Rights under a partnership agreement as defined in Article 667(1) of the Civil Code, a silent partnership agreement as defined in Article 535 of the Commercial Code, an investment limited partnership agreement as defined in Article 3(1) of the Act on Limited Liability Partnership Agreement for Investment Business, or a limited liability partnership agreement as defined in Article 3(1) of the Act on Limited Liability Partnership Agreement for Investment
(ii) The existence of a business (the “Invested Business”) in which money (including cryptographic assets) contributed or contributed by the person who has such rights (the “Investor”) is allocated to the Invested Business;
(iii) The investors are entitled to receive dividends of profit generated from the invested business or distribution of assets related to the invested business;
(iv) There are no exceptional circumstances, such as all investors being constantly involved in the business.

The revised Financial Instruments and Exchange Act, which came into effect on May 1, 2020, created the legal concept of Electronic Record Transfer Rights. The rights of tokenized collective investment schemes usually fall under the Electronic Record Transfer Rights below.

Outline of Definition of Electronically Recorded Transfer Rights
Rights that satisfy the following (i) to (iii) but exclude (iv) (Article 2, Paragraph 3 of the FIEA):
(i) Rights listed in each item of Article 2, Paragraph 2 of the FIEA (funds, trust beneficiary rights, members’ rights of general partnerships, limited partnerships, limited liability partnerships, etc.);
(ii) When they are expressed in property values that can be transferred through an electronic data processing system;
(iii) When recorded in electronic devices or other objects by electronic means;
(iv) Cases provided in the Cabinet Office Ordinance have considered the nature of distribution and other circumstances.

The sale of this electronic record transfer right requires a Type 1 Financial Business registration. If soliciting more than 50 people, it will be a public offering (Article 2, Paragraph 3 of the Financial Instruments and Exchange Act), and a securities registration statement must be submitted based on Article 5 of the FIEA.

If the sale is limited to qualified institutional investors or wealthy people of 49 or less, and even if there is resale, there are technical restrictions so that other people cannot become DAO token holders.

When the Investment DAO is formed, it can be sold in such a limited form at first, and after it grows, it can be sold to the general public while complying with increased regulations.

2.4 Tokenization of Company Membership Rights and Financial Registration Regulations

Regarding tokenization of company membership rights, a Type I FIBO license is necessary when a third party sells the rights, and Type II is essential in the case of self-solicitation. In the case of tokenization of company membership rights (shareholders rights) of a joint stock company, a Type I license is necessary in the case of solicitation by a third party, and no license is required in the case of self-solicitation.

2.5 Regulations on Public Offerings, etc.

 If any of the following applies, it becomes a public offering. In principle, it is necessary to submit a securities registration statement.

(i) When soliciting the acquisition of securities from 50 or more persons (excluding Qualified Institutional Investors (QII) in the case there are restrictions on resale other than QII);

(ii) When it does not fall under any of the following categories: Private Placement for QII, Private Placement for Professional Investors, and Private Placement for Small Groups.

2.6 Financial Regulations for DAOs without Dividends

If DAOs have no dividends, etc., they are not considered securities, but different financial regulations may apply.

Tokens/NFTs Free token distribution Token Sales Investment Management (Assumption without dividends)
Utility Tokens Unregulated Crypto Asset Exchange Business License Unregulated
NFTs Unregulated Unregulated Unregulated

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 DAO. This article provides merely a summary for discussion purposes. If you need legal advice on a specific topic, please feel free to contact us.

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