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Non-fungible tokens (NFT) have been a topic in the Japanese crypto industry since early 2018. With the NFT craze in 2021, they have become increasingly popular and seen more mainstream adoption. It does, therefore, not come as a surprise that the Japan Cryptocurrency Business Association (JCBA) and Blockchain Contents Association (BCA), as two of the leading industry associations in Japan, issued NFT guidelines more recently.
In this article, we are taking a closer look at the state of the Japanese NFT market and the legal and regulatory environment for NFTs while considering the JCBA and the BCA guidelines.
| JCBA NFT-guidelines (April 2021, written in Japanese) https://cryptocurrency-association.org/dl/nft_guideline202104.pdf BCA NFT-guidelines (2nd edition) (December 2020, written in Japanese) https://eb3d626b-4b51-42f2-b2d4-0f682cc5645e.filesusr.com/ugd/e9a87a_2028e5c7115d4fcd933e9f55e6262762.pdf |
| We have been advising leading blockchain gaming companies on NFTs and other NFT-related matters since early 2018. In case you are looking for more information on blockchain games and crypto art, you might find the following two articles interesting. Blockchain Games and the Japanese Law (November 2018, written in Japanese) https://innovationlaw.jp/blockchain-games-under-japanese-laws/ Buyer Beware – Digital Art and Non-Fungible Tokens (NFT) https://innovationlaw.jp/en/buyer-beware-digital-art-and-non-fungible-tokens-nft/ |
I. The State of the Japanese NFT Market
1. Blockchain Games
Traditionally, items purchased in a game could only be used within the game and not be transferred to other players. This has changed with blockchain games, where game items are represented by NFTs. By allowing players to control the NFTs, they become able to buy, sell, exchange, and lend items represented by NFTs to other players – even outside of the game. According to the JCBA, the use of NFTs further ensures that the game assets do not disappear after the termination of the game. What is most likely meant is that the NFT does not cease to exist. Yet, it may lose its value as the represented asset might not be used anymore due to the termination of the game.
Popular blockchain games on the Japanese market include My Crypto Heroes, Crypto Spells, and Contract Servant.
| Traditional online games | Blockchain games |
|
|
Source: JCBA Guideline, page 4.
(1) My Crypto Heroes
My Crypto Heroes by double jump.tokyo was released in November 2018. The game is an RPG in which players can gather, build their character, and win items by completing challenges and fighting enemies. Both heroes and items are represented by NFTs and can be freely transferred peer-to-peer or traded on NFT markets.
My Crypto Heroes fast became the world’s number one blockchain game and still has the highest number of (active) users and transactions.
(2) Crypto Spells
Crypto Spells by Crypto Games is a card game in which players use cards represented by NFTs to fight with the computer and other players. There are several ways to acquire new cards, including battles and trading/exchanging them with other players within and outside the game.
(3) Contract Servant
Contract Servant by Axel Mark is a card game in which players have a deck of eight cards (servants). There are two types of servants – common servants and token servants, where the token servant is issued as an NFT. The tokens can then be traded among players through a market function. Players are further able to earn rewards from league battles each week.
(4) Other Notable Games
Other notable blockchain games in Japan are Crypton, Crypton Racing, and Brave Frontier Heroes. Further, double jump.toyko launched MCH+, a blockchain game development program that is based on the knowledge gained from My Crypto Heroes.
2. Crypto Art
In February 2021, Christies sold a Beeple artwork for JPY 7.5 billion. The artwork itself is stored on the InterPlanetary File System (IPFS) and represented by an NFT on the Ethereum blockchain. In Japan, a number of crypto art related services have been launched more recently. The major platforms are nanakusa, NFT Studio, and Token Link.
(1) nanakusa
In March 2021, Smart App released nanakusa – a marketplace for crypto art. nanakusa allows crypto artists to mint NFTs and sell crypto art via the platform. Purchasers of crypto art may further sell artworks – or more precisely, the NFT representing the artwork – via the trading platforms. From the information provided, it seems that royalties are paid to the crypto artists for all secondary sales.
(2) NFT Studio
In March 2021, CryptoGames released NFT studio. The platform allows artists to mint NFTs on Ethereum and Polygon for their crypto art. Similar to nanakusa, NFT studio includes features that allow artists to participate in the price for secondary sales.
(3) TOKEN LINK
In January 2021, Platinum Egg released Token Link, an NFT market for game items. Only a few months later, in April, Platinum Egg implemented an auction mechanism for crypto art.
3. NFT Market
(1) Coincheck NFT Market
In March 2021, Coincheck, the operator of one of the largest crypto exchanges in Japan, launched an NFT market. Currently, the only NFTs listed on the market are from Crypto Spells and The Sandbox. More NFTs will be listed in the future. The company has 2 million active users and hundreds of billions of yen in crypto assets under custody. As such, Coincheck will be an important partner for content providers and a gateway to the Japanese market for foreign projects.
When applying for listing, from our experience, projects must provide Coincheck with information about the blockchain used, the primary sale, IP content, and, where applicable, transaction volumes on other markets. As Coincheck is a member of the JCBA and a head of the NFT committee of the JCBA, it is also valuable to check JCBA guidelines in more detail.
(2) Participation by Major Companies
While Coincheck’s NFT market is the first of its kind in Japan, other major companies, including Mercari[1], LINE[2] and GMO Internet group[3] have announced that they are considering launching their NFT market. The entry of other major players is a clear sign that NFTs are gaining increasing mainstream traction on the Japanese market.
II. NFT Guidelines of Japanese Organizations
Currently, there are no laws and regulations that specifically deal with NFTs. Depending on their design, NFTs may, however, fall under the definition of crypto assets, prepaid payment instruments, or money orders under the Payment Services Act (PSA) or the Banking Act or constitute securities within the meaning of the Financial Instruments and Exchange Act (FIEA). Whether this is the case must be analyzed on a case-by-case basis. The guidelines prepared by the JCBA and the BCA aim to provide some more clarity in this regard.
(1) JCBA guidelines
The JCBA is one of the leading industry associations in Japan. Its members range from crypto-asset exchanges to other crypto asset service providers. The NFT committee of the JCBA issued NFT guidelines on April 26, 2021. The guidelines are meant to provide local and foreign NFT issuers with more clarity when applying for a listing on a Japanese NFT market.
| Matters covered by the JCBA guidelines |
| (1) Use cases of NFTs (2) Flowchart for determining whether NFTS fall under existing laws and regulations (3) Profit-sharing arrangements (4) Settlement (5) Gambling (6) Premiums and Representations Act (7) Anonymity and privacy (8) Security (9) User protection (10) Handling of new NFTs (type of NFT that requires careful handling) |
The following chart provides a good overview of the key considerations when determining the legal and regulatory environment for NFTs.
In the case of blockchain games, it is also necessary to consider gambling laws. According to Japanese criminal law, gambling is a criminal offense. It is defined as a game of chance where players can win monetary prizes, except for small gifts. While the definition is rather blurry, NFT issuers implementing mechanics similar to gatcha should consider gambling regulations carefully.
Blockchain games that include incentives for users, such as the free issuance of NFTs, must further comply with the Premiums and Representations Act. The Premiums and Representations Act regulates the free provision of goods and services by a business which aims to induce potential customers to buy the business’s products or services.
The Premiums and Representations Act stipulates limits for lotteries, competitions, etc. While the total amount differs, the following limits must generally be considered for lotteries and other competitions.
| Description | Examples | The maximum amount of premiums | |
| Premiums (general) | Premiums that are offered to anyone visiting a shop or anyone purchasing goods or services. | Gifts to all purchasers, gifts to all visitors, etc. | (1) If the transaction price is less than JPY 1,000, the premium must not exceed JPY 200. (2) If the transaction price is JPY 1,000 or more, the premium must not exceed 2/10 of the total transaction price. |
| Premiums and prices (game of luck and game of skill) | Premiums that are given to users as prices in a game of chance or skill. | Lotteries at the store. Quiz games and other games |
(1) If the transaction value is less than JPY 5,000, the maximum amount of the prize must not exceed 20x the transaction value. (2) If the transaction value is JPY 5,000 or more, the maximum amount of the prize must not exceed JPY 100,000. ※Both are capped at 2% of the total transaction value. |
Source: Prepared by our office based on the Consumer Affairs Agency website, etc.
The JCBA guidelines further provide that NFT issuers should implement measures that prevent users from using NFTs for money laundering and terrorist financing; consider security risks for storing NFTs and implement measures to deal with thefts or losses; properly explain to users that there is the risk that the NFT might become worthless if the service is terminated; and consider that NFTs are highly likely to be used for criminal purposes, including money laundering.
(2) BCA guidelines
The BCA was established by SNS and gaming companies and is involved in a number of initiatives aiming at the protection of minors and the elderly when using blockchain applications. On March 24, 2020, the BCA published the BCA guidelines on blockchain content (incl. NFTs) to protect consumers and promote self-regulation. A revised version of the paper was published on December 25, 2020.
| Matters covered by the BCA guidelines |
| (1) Gambling (2) Premiums and Representations Act (3) PSA (4) FIEA (5) Prevention of scams and other fraudulent practices |
The interpretation of the laws and regulations, including the PSA, FIEA, Gambling Laws, and Premiums and Representations Act, is largely in line with the interpretation by the JCBA.
With respect to gambling, the BCA guidelines hold that blockchain games should avoid or at least carefully consider implementing any of the following mechanics: (i) in-game gachas (vending machine type mechanics) that issue NFTs or other in-game items; (ii) collection of fees to participate in rewards.; (iii) randomized creation and burning of NFTs and other in-game items with monetary value; and (iv) collection of fees to participate in competitions where the collected fees are distributed to the participants depending on their ranking.
The BCA guidelines further include self-regulation for member companies that include (i) the prohibition of loss compensation, (ii) the prohibition of insider trading, (iii) the monitoring and prevention of market manipulation, and (iv) the obligation to disclose material information to all users.
In addition, the guidelines hold that the issuance of NFTs may involve scams and other fraudulent practices, such as the termination of services shortly after selling the NFTs. To prevent fraudulent practices, member organizations are advised to (i) provide all material information to their users, (ii) secure the necessary funds and resources to ensure that the content shown to the users is actually delivered, and (iii) conduct test sales of NFTs and extensive beta-testing to enable users to understand the content of the services and NFTs prior to the actual launch.
III. Future Issues
Given the fact that NFTs are a relatively new phenomenon that is still evolving, many issues are yet solved. The following explanations are meant to provide some guidance for matters not included in the BCA and JCBA guidelines but relevant for the industry.
(1) NFTs and External Services
In most cases, the data represented by NFTs is stored off-chain. This raises the question of how consumers can be protected from later changes to the service and what companies can do to avoid claims for damages. In the case of blockchain games, NFTs typically represent assets that are stored on the servers of the blockchain game company. If the company now decides to change its terms of use or to terminate its services, this may ultimately render the NFT worthless and, in some cases, non-functional. To ensure that the game company does not face any claims for damage, this scenario must sufficiently be covered in terms of use. The same applies to crypto art, where the artworks are stored on the servers of a marketplace. If the data is stored and subsequently deleted on the InterPlanetary File System (IPFS), the situation is much more unclear and requires further consideration.
(2) NFTs and IP
For NFTs that are used for crypto art or in blockchain games, it is necessary to consider the relationship between the content provider and the holder of the NFT carefully. Two aspects are of utmost importance. First, the rights that are represented by the NFT should be clearly stipulated in the sales documentation of the initial sale. This also includes the question of how the rights represented by the NFT are transferred. Second, the relationship between the off-chain data and the NFT, as well as the retention of the off-chain data, should be considered carefully to avoid potential actions for damages. In cases where the content provider participates in all further sales, this should be clearly indicated in the contract as well. In the future, it is possible to discuss what rights should be granted as best practices.
(3) Issues concerning the trading of NFTs
If not explicitly provided in the contract, it is unclear under Japanese laws whether the rights represented by an NFT – i.e., the economic substance – are transferred (i) if both parties agree to the transfer and the transfer is recorded on the blockchain or (i) by mere agreement. To increase legal certainty and to ensure that the data recorded on the blockchain accurately reflects reality, the terms of sale should clearly stipulate that transfers only become effective if it is recorded on the blockchain. While there is no legal precedent, we believe that this solution is most practical and reflects the parties’ intentions.
(4) Taxation of NFTs
The taxation of NFTs another issue to be considered. In February 2019, the Japan Cryptocurrency Tax Association (JCTA) found that the taxation of income from the sale of NFTs is “an issue that has not been clarified in tax law.” The document finds, however, that “NFTs have an independent value, and if income is generated from the sale or exchange of NFTs, it will generally be taxed as miscellaneous income.”
(5) Secondary distribution of NFTs and rewards for creators
For many projects, content creators are rewarded when a secondary sale takes place. Examples are the above-mentioned nanakusa and NFT Studio, who both pay royalties to the content creator for secondary sales. In other cases, the content creator might want to transfer all his IPs to achieve higher prices for the initial sale. It is likely that both models will exist side by side in the future, but best practices still have to evolve. Further discussions are necessary in that regard.
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 or investment in NFTs. This article provides merely a summary for discussion purposes. If you need legal advice on a specific topic, please feel free to contact us.
EOD
[1] On April 2, 2021, Mercari announced that it established a new company to plan and develop blockchain-related services, including NFTs.
[2] LINE tweeted recently that it is building an NFT platform. The tweet states that it intends to build services that make it easy to mint, buy, sell, and exchange NFTs.
[3] GMO announced developing a marketplace that allows users to buy and sell NFTs representing digital art and music from famous artists.
On March 19, 2021, the Financial Action Task Force (FATF) announced that it is updating its guidance for a risk-based approach to virtual assets and virtual asset service providers. The update is open for comments until April 20, 2021, and, if implemented as is, will have far-reaching implications for the DeFi space.
The Updates
The updates include the following areas and are meant to provide the public and private sector with more clarity:
- definition of virtual assets (VA) and virtual asset service providers (VASP)
- guidance on the implementation of the ‘travel rule’
- guidance on the risks and potential risk mitigants to P2P transactions
- guidance on the licensing and registration of VASP
- guidance on the application of the standards to stablecoins
- principles of information-sharing and cooperation amongst VASP supervisors
The focus of this post will be on item 1. The other areas will be covered in a separate post in the future.
The definition of VA and VASP
Virtual Assets
| “A virtual asset is a digital representation of value that can be digitally traded, or transferred, and can be used for payment or investment purposes. Virtual assets do not include digital representations of fiat currencies, securities and other financial assets that are already covered elsewhere in the FATF Recommendations.” Source: Glossary of the FATF Recommendations |
In the updated guidance, the FATF highlights that no asset should entirely fall outside the FATF standards. At the same time, no asset should be considered both a VA and a traditional financial asset. In cases where it is difficult to characterize an asset as a VA or a traditional financial asset, jurisdictions are required to decide which designation suits best to mitigate and manage the risk of the product.
So what is a VA according to the FATF?
A VA is not a traditional financial asset. The digital representation of fiat currencies, securities or other financial assets are therefore not covered by the definition. For an asset to be considered a VA, the asset must further be digitally traded or transferred and used for payment or investment purposes. The otherwise denied inherent value of cryptocurrencies is seen as a defining feature of VA.
While it is easy to see that cryptocurrencies, utility tokens and governance tokens are covered by the definition it is not clear whether non-fungible tokens (NFTs) are included as well. Given the fact that they have a similar risk profile with respect to cross-border transfers, their increasing popularity, and pseudonymity, it is however likely that the FATF wants to see these assets covered by the definition as well.
| “Assets should not be deemed uncovered by the FATF Recommendations because of the format in which they are offered and no asset should be interpreted as falling entirely outside the FATF Standards.“ Source: Draft updated Guidance for a risk-based approach to virtual assets and VASPs, para 40 |
To include NFTs representing digital art, collectibles or in-game items would however constitute a departure from the principle of financial markets regulation. After all other unique assets such as traditional arts, real estate, etc. are not covered by the definition of traditional financial assets as well which are fungible by definition – or in other words interchangeable with each other.
Virtual Asset Service Providers
| “Virtual asset service provider means any natural or legal person who is not covered elsewhere under the Recommendations, and as a business conducts one or more of the following activities or operations for or on behalf of another natural or legal person: i. exchange between virtual assets and fiat currencies; ii. exchange between one or more forms of virtual assets; iii. transfer of virtual assets; iv. safekeeping and/or administration of virtual assets or instruments enabling control over virtual assets; and v. participation in and provision of financial services related to an issuer’s offer and/or sale of a virtual asset.” Source: Glossary of the FATF Recommendations |
As with the definition of VA, the FATF highlights that the definition of VASP must be interpreted broadly. Without going into the details of what services are covered by item (i) to (iv), the focus of this post is on the question to which extent DeFi protocols are covered. The updated guidance provides more clarity on this which does, however, not necessarily mean that you will like it.
In short, it can be summarized as follows:
Software developers do not fall under the definition of VASP. But – according to the FATF there are hardly any cases where someone only provides a software solution.
So, let’s look at this in some more detail.
In the guidance, the FATF reiterates that it does not intend to regulate technology. The target of regulation are always natural or legal persons – in other words, individuals and legal entities. This point is important as it allows projects to assess whether they fall within the scope of VASP and, where necessary, make changes to their setup. As can be seen from the following statement, this will become increasingly difficult – yet not impossible – in the future.
| “The FATF takes an expansive view of the definitions of VA and VASP and considers most arrangements currently in operation, even if they self-categorize as P2P platforms, may have at least some party involved at some stage of the product’s development and launch that constitutes a VASP. Automating a process that has been designed to provide covered services does not relieve the controlling party of obligations.” Source: Draft updated Guidance for a risk-based approach to virtual assets and VASPs, para 75 |
According to the FATF, the expansive view is a conscious choice. Despite its commitment to innovation and not regulating software developers, this could still be the ultimate result. Similar to blockchain companies that were not meant to be excluded from traditional finance on a wholesale basis but still have a hard time opening bank accounts, the regulation of software developers might just be another collateral damage, and as such a conscious choice by the FATF.
So, if the regulatory environment was as strict as we claim here, how is it possible that projects like Uniswap allow users to exchange millions worth of dollars daily without being regulated?
First, the new guidance has not been finalized yet.
Second, the guidance has not been implemented into national law yet.
Third, even if it was implemented as is, law enforcement is still a different issue altogether.
The fact that the FATF intends to update its guidance on VAs and VASPs shows that the success of DeFi has not gone unnoticed. From the request for public comments, it is also clear that the overall direction is set – more regulation rather than less. The request only aims at removing potential ambiguities that could give countries room for interpretation and offer loopholes for DeFi projects and other innovations.
Getting back to Uniswap which was initially funded by venture capital, there is indeed the risk that it falls under the definition of VASP. The fact that the governance of Uniswap was largely distributed to the community by an airdrop last year, does not necessarily lead to a different result if other elements of the VASP definition remain in place.
Where the initiators of a protocol, for example, control the admin keys of the exchange’s smart contracts, the initiators may be considered a VASP. If transaction fees, on the other hand, are not distributed to the initiators of the protocol but the liquidity providers, this may lead to different results as the VASP – if existent – is not provided as a business.
Since there is no bright line test, there is always the possibility that DeFi protocols or the teams behind them are considered VASP. As the FATF wants its recommendations to be as broad as possible, it is highly likely that the teams behind DeFi protocols will initially be considered VASP unless active measures are taken, and proper structures implemented are implemented to further mitigate this risk.
Conclusion
The updated guidance shows that the FATF has been monitoring the DeFi space closely. If implemented as is, most projects will be covered as VASP under the new guidance. The growing regulatory burden has the potential to slow down innovation in the DeFi space. More likely than not, the industry will however find an appropriate answer which either includes increasing decentralization or the implementation of new solutions such as DeFi Compli from CipherTrace.
Besides all the criticism, the new regulations should also be considered as an opportunity for CeFi as it will most likely allow registered exchanges to implement DeFi solutions much more easily.
In 2019, Andreessen Horowitz predicted that in the not-too-distant future every company will be a FinTech company. Fast-forward to today, and most large companies embed financial services into their products to streamline the customer journey and increase their lifetime value.
Embedded finance typically covers the following services:
- payments
- card payments
- lending
- investments
- insurance
- banking
Generally speaking, there are three different types of entities involved in embedded finance – brands, enablers, and license holders.
| Brands | Non-financial services companies that embed financial services into their platforms and applications to improve the user experience and increase their lifetime value. |
| Enablers | Companies acting as the middle layer between brands and license holders. |
| License Holders | Financial services companies that are registered with or licensed by the Financial Services Agency (FSA) |
Historically, enablers and license holders have been largely identical in Japan. Yet, there is no particular reason why this should not change. In particular, the amended Act on the Provision of Financial Services is likely to bring new momentum to the FinTech industry as it allows financial intermediaries to provide services across different sectors with a single registration.
For brands the upcoming changes mean that they will be able to embed different types of financial services much easier, which in turn will drive demand for enablers connecting them smoothly with different license holders.
What type of license should the license holder hold?
The type of license depends on the kind of services the license holder intends to provide. In most cases one of the following licenses is required:
- banking services (including deposits, loans, and money transfers) » banking license
- money transfers (transmission of ≤ JPY 1 million) » money transmitter license
- lending services not including deposits » lending license
- securities and derivatives brokerage etc. » financial instruments business operator license
- insurance services » insurance company license
One example that might be different from other jurisdictions is to the provision of lending services in online shops. Depending on the type of lending services different licenses are needed. A careful analysis is therefore necessary.
If the license holder, for example, makes the payment on behalf of the buyer by granting an instalment loan, this is considered an ‘instalment sale’ which falls under the supervision of the Ministry of Economy, Trade and Industry. If the license holder, however, lends the money to the buyer, and the buyer uses that money to pay the shop, lending regulations apply, and the license holder falls under the supervision of the Financial Services Agency.
What type of license does a brand need?
A brand only needs a license if it acts as an intermediary for financial services. ‘Intermediation’ under Japanese laws is understood broadly and covers any act that furthers the execution of financial contracts. If a brand’s application, for example, seamlessly integrates financial products, this is generally considered an intermediation of financial services.
On the contrary, the introduction of financial products does generally not require a license. If a user is forwarded to the license holder’s website to purchase financial products, for example, the brand is not regulated.
Until this year, the intermediation of different kinds of financial services required different licenses. The intermediation of banking services required a banking agent license, the intermediation of securities services required an intermediation of financial instrument license and so on. For the intermediation of different types of financial products, the brand therefore needed different licenses. From mid of this year, this will change however, and a single license will be sufficient.
What type of license does an enabler need?
If an enabler provides intermediary service as described in the previous section, it has to apply for an intermediation license.
If an enabler, however, only provides a software solution connecting the brand with the license holder a license is not required.
Overview
Depending on the exact service, companies may or may not be subject to license requirements in Japan. At a very high level the regulatory environment is as follows:
- brands » license for intermediation of each financial product – from mid of this year a single license will be sufficient
- enablers » not necessarily subject to registration/license requirements
- license holders » subject to registration/license requirements.
A more detailed overview can be found in the following section.
Detailed overview of what licenses are necessary
As mentioned above, the license requirements differ considerably depending on what kind of service is carried out. A careful case-by-case analysis is therefore necessary.
EMBEDDED PAYMENTS
Instruction by brand
| brand | enabler | license holder | |
| service provided | brand instructs user’s bank to transmit money to brand’s account for purchasing goods or services | provides API for instruction | money transfer |
| applicable laws | not regulated | not regulated | Banking Act (BA) or Payment Services Act (PSA) |
| license/registration requirement | not regulated | not regulated | banking license under BA or money transmitter license under PSA |
Instruction by third party
| brand | enabler | license holder | |
| service provided | – | instructs user’s bank to transmit money to brand’s account | money transfer |
| applicable laws | – | BA or not regulated | BA or PSA |
| license/registration requirement | – | registration as electronic payment services provider under BA if instruction is given to bank not regulated if instruction is given to money transmitter | banking license under BA or money transmitter license under PSA |
Payment by third party (performance by user at the time enabler receives payment)
| brand | enabler | license holder | |
| service provided | entrusting the collection of payment to the enabler | receiving payment from user and making payment to brand (performance by user under the agreement with brand at the time enabler receives payment) | – |
| applicable laws | – | not regulated | – |
| license/registration requirement | – | not regulated | – |
Money transmission (not related to the purchase of goods or services)
| brand | enabler | license holder | |
| service provided | brand instructs user’s bank to transmit money to another person’s account | – | money transfer |
| applicable laws | BA or not regulated | – | BA or PSA |
| license/registration requirement | registration as electronic payment services provider under BA if instruction is given to bank not regulated if instruction is given to money transmitter. | – | banking license under BA or money transmitter license under PSA |
EMBEDDED LENDING
Inhouse instalments
| brand | enabler | license holder | |
| service provided | brand provides installment loan to user to finance purchases | – | – |
| applicable laws | Installment Sales Act | – | – |
| license/registration requirement | not regulated | – | – |
Credit purchase brokerage
| brand | enabler | license holder | |
| service provided | brand intermediates advance payment and installment payment from license holders | – | license holder makes advance payments to brand and receives installment payments from user |
| applicable laws | not regulated- | – | Installment Sales Act |
| license/registration requirement | not regulated | – | registration as credit purchase brokerage business and in cases where the amount is less than JPY 100,000 registration as small-amount credit brokerage business |
Loan affiliated sales
| brand | enabler | license holder | |
| service provided | brand intermediates loan and then jointly and severally guarantees the loan payment | – | license holder provides loan to user to finance purchase in brand’s online shop |
| applicable laws | Installment Sales Act, BA or Money Lending Business Act (MLBA) or Financial Services Act | – | BA or MLBA |
| license/registration requirement | brands must comply with some duties under the Installment Sales Act (no license/registration) intermediaries of loans must obtain a bank agency business license under BA or register as money lending business under the MLBA or as financial services intermediary under Financial Services Act | – | banking license under BA or registration as money lending business under MLBA |
Affiliated loan
| brand | enabler | license holder | |
| service provided | provides access to loan products in its online store | – | license holders provides loan to user to finance purchase in brand’s online shop |
| applicable laws | BA or MLBA or Financial Services Act | – | BA or MLBA |
| license/registration requirement | intermediaries of loans must obtain a bank agency business license under BA or register as money lending business under the MLBA or as financial services intermediary under Financial Services Act | – | banking license under BA or registration as money lending business under MLBA |
EMBEDDED INVESTMENTS
| brand | enabler | license holder | |
| service provided | provides interface for investments in securities through app | – | investment into securities |
| applicable laws | Financial Instruments and Exchange Act (FIEA) | – | FIEA |
| license/registration requirement | if brand is a financial institution, it must be registered as a financial institution engaging in the investment advisory and agency business; it is not allowed to use a financial services intermediary under the FIEA if the brand is not a financial institution, it can act under the investment advisory business or as a financial instruments intermediary business under the FIEA or a financial services intermediary business under the Financial Services Act | – | investment business under the FIEA |
EMBEDDED INSURANCE
| brand | enabler | license holder | |
| service provided | provides access to insurance products in its online store | – | provides insurance products |
| applicable laws | Insurance Business Act or Financial Services Act | – | Insurance Business Act |
| license/registration requirement | registration as insurance agent under Insurance Business Act or financial services intermediary under Financial Services Act | – | insurance business license or small insurance business license |
EMBEDDED BANKING
| brand | enabler | license holder | |
| service provided | provision of withdrawals and deposits through the app | – | deposit |
| applicable laws | BA or Financial Services Act | – | BA |
| license/registration requirement | permission for banking agency business under BA or registration as financial services intermediary business under Financial Services Act | – | banking license |
EMBEDDED CARD PAYMENTS
Debit cards issued by large companies
| brand | enabler | license holder | |
| service provided | issuance of debit cards linked to bank accounts | – | deposits |
| applicable laws | BA or Financial Services Act | – | BA |
| license/registration requirement | permission for banking agency business under BA or registration as financial services intermediary business under Financial Services Act | – | banking license |
Debit cards issued by money transmitters
| brand | enabler | license holder | |
| service provided | issuance debit cards linked to money transmitters | – | transfers |
| applicable laws | PSA | – | PSA |
| license/registration requirement | not regulated | – | registration as money transmitter under PSA |
EOD
Non-fungible tokens (NFTs) have become increasingly popular more recently. Starting with small blockchain games such as Crypto Kitties in 2017, they have entered public awareness with NBA Top Shot and the Christie’s auction raising USD 70 million for a digital art piece.
Given the recent success and increasing interest of mainstream media, it is time to take a closer look the mechanics and legal classification of NFTs. In many cases it is still unclear what NFTs legally represent, and poor technical implementation may render them worthless despite the buyer spending millions of dollars.
Definition
NFTs are commonly said to represent something unique. It may therefore come as a surprise that the content represented by the NFT can often be downloaded by anyone and duplicated freely. Take ‘Everydays: The First 5000 Days’ which was auctioned off by Christie’s recently. While you cannot simply download the high-resolution picture from Christie’s website directly, it is recorded on the Inter Planetary File System (IPFS) where it can be accessed and downloaded by anyone. The file stored on IPFS is the same file the buyer of the digital artwork will eventually receive.
Beeple (b. 1981), Everydays: The First 5000 Days – Sold for USD 69,346,250 by Christie’s
The high-resolution file is recorded on IPFS and can be accessed and downloaded by anyone. The size file is 326MB. It might therefore take some time to download.
So, if the content is not unique, what is it, then? In fact, it is the token itself. NFTs, unlike other tokens, are not interchangeable. Each NFT has unique features and given these features, a different economic value. While you can easily interchange ten ERC-20 tokens with ten ERC-20 tokens of the same kind, you cannot do this with NFTs as you will end up with tokens that have different features and a different economic value.
Implemented properly, NFTs inextricably link to the content which they represent. Depending on the design, they may represent digital ownership or some other rights and make the otherwise easily duplicable content scarce.
Common use cases
Common use cases of NFTs include digital art, digital collectibles, in-game items and worlds, domain names, event tickets, and fan tokens. The focus of this post will be on digital art.
The anatomy of NFTs and related problems
When dealing with NFTs it is important to understand why an NFT is unique, but more importantly, how it links to the content represented by it and where the content is stored.
On Ethereum, there are different token standards for NFTs – ERC-721 and ERC-1155. In the case of ERC-721, the NFT contains a mapping of unique identifiers with each identifier representing a single asset/content. In addition, it allows to track the owner of the token easily and creates a public trail of ownership. In the case of ERC-1155, the identifiers do not represent single assets but groups of assets. Tracking the provenance of single tokens is only possible if an ERC-721 superset is implemented. Given the possibility to track provenance, digital art typically uses the ERC-721 standard.
The metadata, which makes a token unique may either be on-chain or off-chain. Because of the costs for storing something on-chain, it is typically stored off-chain. In these cases, the NFT only contains a pointer to an external source which is typically an URL.
Once minted the data on the token becomes immutable and cannot be changed.[1] Depending on how the external content is stored the same is not necessarily true for the content. If the pointer in the NFT points to a URL that is controlled by a central entity or the artist himself, the artist may decide to replace the picture stored under the URL or to delete it completely. In addition, the link itself may be removed resulting in the NFT pointing to a 404 website.
Ultimately, this would leave the owner of the NFT in a very bad position as he still owns the NFT pointing to the URL where the digital art was originally stored. To draw attention to this issue, neitherconfirm replaced digital art with pictures showing rugs more recently.
To avoid this from happening and to ensure the data lives on forever, more recent projects including Beeple’s artwork on Christie’s use IPFS. Unlike current URLs, the IPFS creates unique URLs for files stored on the IPFS in a decentralized manner. If the file is changed, a new URL will be produced, meaning that the original file will always sit at the URL referenced in the NFT. Stated differently, the content and the token will become inextricably linked.
Legal issues
As important as the technical implementation is the question of what NFTs legally represent. This is important as it may limit what the creator or the buyer of an artwork can do, which again affects the price – both for primary and secondary sales. Other issues include the legal classification of NFTs under the Payment Services Act (PSA) and the Financial Instruments and Exchange Act (FIEA), their custody, and consumer protection laws.
Copyright and Ownership
Art, in general, involves a number of complex questions revolving around ownership and copyright. When creating an artwork, the creator generally becomes the first copyright owner. Registration at the copyright office is not necessary but may be advisable in some cases as it establishes a record of copyright ownership. For digital artworks, the same result can be achieved by signing the picture digitally, recording the corresponding NFT on the blockchain, and storing the high-resolution file on the IPFS.
But what does the NFT exactly represent? Digital ownership? Copyright? Or both?
This really depends on the artist as well as the platform the artist uses to sell his artworks. At an absolute minimum, an NFT represents digital ownership. The ownership of a digital artwork is transferred when transferring the NFT itself. The copyright, however, remains with the creator unless explicitly agreed otherwise.
As the first copyright owner, the artist has the exclusive right to make copies, sell and distribute the copies, prepare derivative works based on the copyrighted artworks and publicly display the artworks. In case you have been wondering how it is possible that some of the pictures in Beeple’s ‘Everydays: The First 5000 Days’had been sold in other auctions before but are still shown in his latest piece – this is the reason.
The copyright gives creators the following rights/protection:
- moral rights
- reproduction and distribution rights
- right to produce derivative works
- renting and lending rights
- right to communicate the work to the public
- profit rights
Compared to copyright, ownership rights are rather limited and, broadly speaking, restricted to non-commercial use.
If a creator wants to grant the owner the right to use the artwork for commercial purposes (merchandize, display, etc.), he may either transfer the copyright or grant the owner a license to use the artwork commercially.
It should be noted that some platforms require creators to give the platform a license to use the artwork for commercial and non-commercial purposes. In the case of Open Sea, for example, the creator grants the platform a worldwide, non-exclusive, royalty-free license to use the uploaded artworks for non-commercial and commercial purposes.
| “By submitting, posting or displaying Content on or through the Services, you grant us a worldwide, non-exclusive, royalty-free license (with the right to sublicense) to use, copy, reproduce, process, adapt, modify, publish, transmit, display and distribute such Content in any and all media or distribution methods (now known or later developed). This license authorizes us to make your Content available to the rest of the world and to let others do the same. You agree that this license includes the right for OpenSea to provide, promote, and improve the Services and to make Content submitted to or through the Services available to other companies, organizations or individuals for the distribution, promotion or publication of such Content on other media and services. Such additional uses by OpenSea, or other companies, organizations or individuals, may be made with no compensation paid to you with respect to the Content that you submit, post, transmit or otherwise make available through the Services.” OpenSea, Section 9 Terms of Service |
When selling digital artworks to users, the creator must therefore consider which rights he has already granted to the platform to avoid potential conflicts. If a creator has given the platform a non-exclusive license to use the artwork for commercial purposes, he cannot grant an exclusive license to the buyer anymore.
Hashmasks clearly distinguished between ownership and copyright as well. In its terms and conditions, Hashmasks states that the buyer of the NFT does not only become the owner of the artworks but also that he is granted an unlimited worldwide, exclusive license to use, copy and display the purchased art.
| “You Own the NFT. Each Hashmask is a NFT on the Ethereum blockchain. When you purchase a NFT, you own the underlying Hashmask, the Art, completely. Ownership of the NFT is mediated entirely by the Smart Contract and the Ethereum Network”Hashmask, Section 3.A.i. of the Terms and Conditions |
| “Subject to your continued compliance with these Terms, The Company grants you an unlimited, worldwide, exclusive, license to use, copy, and display the purchased Art for the purpose of creating derivative works based upon the Art (“Commercial Use”). Examples of such Commercial Use would e.g. be the use of the Art to produce and sell merchandise products (T-Shirts etc.) displaying copies of the Art.” Hashmask, Section 3.A.iii. of the Terms and Conditions |
Even where the creator and the buyer explicitly agree on the transfer of the copyright or the granting of a license, the token does not necessarily reflect the exact terms. Written in natural language, the terms do not become part of the code. To ensure that all parties are always fully aware of the rights represented by the NFT, it is advisable that the NFT points to the respective terms and to store the terms on the IPFS. In this case, the NFT would not only serve as a track record of ownership but also bring more clarity with respect to the rights represented by it.
Crypto regulations and custody
According to the Japanese Financial Services Agency (FSA), NFTs are generally not considered securities or crypto assets. Trading, intermediary services for the trading, as well as the provision of custody services is therefore not regulated and may be performed without a license.
If a platform accepts BTC, ETH, or some other crypto asset as payment and manages the funds on behalf of the artist, the platform would however have to register as a crypto asset service provider with the FSA as it would engage in regulated activities – here the provision of custodian services.
BTC, ETH, etc. can be used for payment. There are no legal or regulatory limitations.
Consumer protection
Consumer protection laws only apply if the artist sells his artworks as a business. This must be assessed on a case-by-case basis. Where the pictures are sold by a platform, consumer protection laws generally apply.
AML/CFT Regulations
Since art dealers are not regulated, they do not have to comply with AML/CFT regulations.
Tax
Gains from the sale of NFTs are classified as miscellaneous income under Japanese tax law. As such they are subject to a progressive tax rate of up to 45% plus a fixed local inhabitants’ tax of 10%.
[1] In many cases, it is still possible to change the metadata in the smart contract. It is therefore advisable to analyze each smart contract carefully.
It is one of the basic principles of capital and financial markets regulation that the same rules apply to the same business and the same risk. In the age of DeFi, this does not seem to be the case anymore. A second look shows, however, that nothing has changed but that the results have become far more difficult to predict.
To assess whether regulations apply, it is generally necessary to assess (1) whether the activities are regulated and (2) identify the entity/person engaging in such activities.
Until more recently, it has been relatively easy to identify both the regulated activities as well as the relevant actors. For DeFi protocols, the answer is not always that straight forward. In the absence of legal documents, it is often unclear how the services are structured (e.g. lending vs. investing). And even where it is possible to classify the respective activity, it is still necessary to analyze whether the activity is performed by a person (regulated) or a piece of software (unregulated).
This brings us to the question of when a project is sufficiently decentralized.
While there is no general answer to this question, there is a distinct set of factors that must be considered when answering the question. The most important factor is the degree of control the team retains over the project after it is launched. In many cases, the team retains admin rights to fix bugs or to upgrade the protocol. This alone may, however, not be enough to establish a sufficient link between the team and the regulated activity. In fact, a comparison with the traditional financial and capital markets shows that the regulations do not apply to the technology providers but those using the technology, in other words, banks, exchanges, and other financial intermediaries. Nasdaq, for example, is not only a registered exchange in the United States but also a software company providing its matching technology to more than 70 markets globally. This does, however, not make Nasdaq subject to regulations in all these markets. Instead, the regulated entities are those providing the marketplace.
If financial and capital markets regulations are meant to be interpreted technology-neutral as claimed by regulators around the globe, nothing different can apply to DeFi protocols. Just because the smart contracts are publicly available on the blockchain does not justify different results in the case of DeFi.
Something different applies, of course, if the team does not only develop and maintain the smart contract but also engages in the listing of tokens or provides the GUI for interacting with the protocol. In this case, there is a clear link between the regulated activity and the team, and registration becomes necessary.
If the GUI is provided by someone else, it is likely that this person becomes subject to regulation as this person opens the marketplace and facilitates trading, etc.
As can be seen from these examples, it is not always possible to draw a clear line. To avoid the risk of becoming subject to regulation, the best way is still full decentralization. In other words, the team must deploy smart contracts without admin rights or transfer the protocol’s governance to the community. While still untested, it is highly likely that this provides an effective shield against regulations.
The trade-off of this approach may, however, be a lack of institutional investment/usage. It is, therefore, necessary to consider the implications of a fully decentralized strategy holistically and not solely from a regulatory point of view. What works for one project might not necessarily be ideal for others.
We are proud to announce that So & Sato and Curvegrid are joining forces to deliver next-generation services at the intersection of finance, tech, and regulation.
With this first-of-its-kind partnership, we aim to address the key pain points that plague many businesses in the crypto industry and that have slowed down the development of the Japanese blockchain industry as a whole.
In many cases, these problems are of technical or legal nature. More often than not they are both. This adds further complexities to an already challenging environment which can neither be solved satisfactorily by law firms or tech companies on their own. Yet, many companies still follow this one-dimensional approach, which results in suboptimal solutions, delays, and wrong allocation of resources.
By combining the expertise of one of the leading law firms in the blockchain/crypto space with Curvegrid’s MultiBaas blockchain middleware and extensive technical knowhow, we are not only able to remove these inefficiencies but also to provide a one-stop solution for our clients, streamline communication with the regulators, assist with the launch of new products, and build solutions which are not only meeting the highest technical standards but which are also fully compliant.
Examples
- staking services (PoS)
- integration of DeFi protocols
- listing of new tokens
- communication with the FSA concerning non-custodial nature of wallets
Want to learn more? Feel free to contact us and arrange a meeting.
About Curvegrid
Curvegrid is a blockchain technology company based in Tokyo, Japan. Curvegrid’s MultiBaas blockchain middleware makes it fast, easy, and cost effective for companies to build on multiple blockchain platforms. Turnkey MultiBaas solutions are available for financial services, decentralized finance, online gaming, document management, logistics, and manufacturing that help companies get to market with blockchain faster than otherwise possible.
About So & Sato
So & Sato is a boutique law firm specializing in blockchain and crypto. Our partners are fully bilingual and have worked with leading law firms in the US, Singapore, and Japan for many years. Our firm has been at the forefront of Blockchain and Fintech ever since it was established in 2015. In 2020, our partner So Saito was ranked among the top 3 FinTech lawyers in Japan by Chambers and Best Lawyers. Combining years of experience in the field of capital markets and finance with an in-depth understanding of new technologies, So & Sato is uniquely positioned to develop innovative solutions for our clients in a highly complex and constantly changing legal and regulatory environment.
(1) SEC Chairman Jay ClaytonのICOレター (Dec. 11, 2017)
https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11
Statement on Cryptocurrencies and Initial Coin Offerings
(2) Dec. 11, 2017
Company Halts ICO After SEC Raises Registration Concerns
https://www.sec.gov/news/press-release/2017-227
Sample Questions for Investors Considering a Cryptocurrency or ICO Investment Opportunity
- Who exactly am I contracting with?
- Who is issuing and sponsoring the product, what are their backgrounds, and have they provided a full and complete description of the product? Do they have a clear written business plan that I understand?
- Who is promoting or marketing the product, what are their backgrounds, and are they licensed to sell the product? Have they been paid to promote the product?
- Where is the enterprise located?
- Where is my money going and what will be it be used for? Is my money going to be used to “cash out” others?
- What specific rights come with my investment?
- Are there financial statements? If so, are they audited, and by whom?
- Is there trading data? If so, is there some way to verify it?
- How, when, and at what cost can I sell my investment? For example, do I have a right to give the token or coin back to the company or to receive a refund? Can I resell the coin or token, and if so, are there any limitations on my ability to resell?
- If a digital wallet is involved, what happens if I lose the key? Will I still have access to my investment?
- If a blockchain is used, is the blockchain open and public? Has the code been published, and has there been an independent cybersecurity audit?
- Has the offering been structured to comply with the securities laws and, if not, what implications will that have for the stability of the enterprise and the value of my investment?
- What legal protections may or may not be available in the event of fraud, a hack, malware, or a downturn in business prospects? Who will be responsible for refunding my investment if something goes wrong?
- If I do have legal rights, can I effectively enforce them and will there be adequate funds to compensate me if my rights are violated?