Introduction to Crypto Assets (Virtual Currencies)
First, what exactly are crypto assets?
Under Japan’s Payment Services Act, crypto assets are defined as (Article 2, Paragraph 5):
Property value with all the following characteristics:
- Usable as payment to unspecified parties and exchangeable with fiat currencies.
- Electronically recordable and transferable.
- Not legal tender or assets denominated in fiat.
- Exchangeable with unspecified parties for the above property value.
- Excludes securities tokens classified as Electronic Record Transfer Rights under the Financial Instruments and Exchange Act.
Crypto assets serve dual roles:
- Payment method: Regulated under the Payment Services Act.
- Investment vehicle: Governed by the Financial Instruments and Exchange Act.
Understanding Crypto Asset Custody Business
Custody in finance refers to safeguarding assets like securities. For crypto assets, it involves managing holdings on behalf of clients, including wallet services.
Under Japan’s 2020 revised Payment Services Act, custody is classified as part of Crypto Asset Exchange Services, defined as (Article 2, Paragraph 7):
- Buying/selling or exchanging crypto assets.
- Brokering or intermediating such transactions.
- Managing client funds related to these activities.
- Custody: Managing crypto assets for others.
Thus, custody providers must register as crypto asset exchanges and comply with stringent regulations.
Key Regulations for Crypto Asset Exchange Operators
Even custody-focused businesses must adhere to these rules:
1. Advertising and Promotion Rules
Operators must disclose in ads (Payment Services Act Article 63-9-2):
- Business name, registration number, and status as a registered exchange.
- Clarification that crypto assets are not legal tender.
- Risks of value fluctuations and loss potential.
- Usage limited to payments only if the recipient agrees.
Prohibited practices (Article 63-9-3):
- Misleading claims about crypto assets’ nature.
- Encouraging speculative investment over utility as payment.
- Actions undermining user protection or operational integrity.
2. User Protection Measures
Exchanges must:
- Educate users on crypto asset risks and contract terms.
- Implement safeguards to ensure fair operations (Article 63-10).
3. Safeguarding Client Assets
To mitigate risks like insolvency, exchanges must:
A. Trust Deposits for Client Funds
- Segregate and entrust client funds with a trust company (Article 63-11).
B. Segregation of Crypto Assets
- Store client crypto separately from corporate holdings.
- Use high-security methods like cold wallets (offline storage) for 95% of assets.
- Up to 5% may be held in hot wallets (online) for liquidity (Article 63-11).
C. Reserve Requirement
- Hold matching "fulfillment guarantee crypto assets" to cover hot-wallet holdings (Article 63-11-2).
D. Priority Repayment Rights
- Clients gain priority claims over segregated assets in case of default (Article 63-11-2).
Additional Obligations
Anti-Money Laundering (AML):
- Verify user identities and report suspicious transactions.
- Maintain transaction records per the Crime Proceeds Transfer Prevention Act.
Can Custody Providers Avoid Exchange Registration?
Yes, if the business model avoids "managing crypto assets for others" per regulatory interpretations:
- Partial Private Key Control: If the custodian holds only part of the keys needed to transfer assets, they may bypass registration (Financial Services Agency guidance).
- Encrypted Keys: If keys are encrypted and the custodian lacks decryption access, it may not qualify as custody.
👉 Explore compliant custody solutions
FAQs
Q1: Must all wallet services register as exchanges?
A: Only those enabling full asset transfers via their keys. Non-custodial wallets are exempt.
Q2: What’s the penalty for non-compliance?
A: Unregistered operations face fines, suspension, or criminal charges under Japanese law.
Q3: How are cold wallets more secure?
A: Offline storage prevents remote hacking, unlike internet-connected hot wallets.
Q4: Can exchanges use client crypto for investments?
A: No—commingling client assets is prohibited unless explicitly authorized under strict conditions.
Conclusion
Crypto custody providers must navigate complex regulations unless they design systems limiting key control. Strategic structuring can exempt businesses from exchange registration.
For tailored legal advice on custody models or exchange compliance, consult a crypto-specialized law firm.