Japanese crypto-exchange operators unexpectedly faced major problems last year due to the unprecedented hack in late January of Tokyo-based Coincheck Inc., which lost digital tokens estimated at the time to be worth ¥58 billion and caused commotion across the industry.
This has prompted the country’s regulatory watchdog to scrutinize exchange companies, which in turn led to the revelation that problematic operations were being conducted by many of them.
During 2018, the Financial Services Agency (FSA) did not approve any new exchange operators.
Now that 2019 has begun, where do things go from here?
Several experts and industry sources interviewed by The Japan Times say uncertain times are likely to end for operators.
This year more firms will be allowed to enter the exchange market after undergoing stricter scrutiny by authorities, which is likely to reinvigorate the crypto-exchange industry, they said.
Also, the government is set to implement additional regulations that will give consumers a stronger sense of security regarding their virtual currency investments, they added.
“The groundwork to reinforce the foundation of the crypto-industry in Japan was laid out” last year, so 2019 will be “a year to make a firm step forward,” said Pina Hirano, who heads the Blockchain Collaborative Consortium, a Tokyo-based organization promoting the use of blockchain, a key technology behind virtual currencies, which retains digital records of all past transactions.
Because of the Coincheck heist, all major players in Japan’s cryptocurrency industry were forced to spend much of last year redesigning and rechecking their security systems.
They were also urged to have internal control and management systems robust enough to enable them to run a financial business smoothly.
The Coincheck shock hit Japan’s crypto-sector just 10 months after the country introduced regulations for virtual currency exchanges. At the time, Japan was considered to be ahead of other nations when it came to virtual currency regulations.
The rules require operators to register with the government and submit annual reports, as well as to confirm the identities of customers to prevent crypto-assets from being used for money laundering or terrorism.
But the hacking of the Tokyo-based startup exposed the fact that many exchange firms were focused more on raking in profits through speculative trading by customers than properly following the rules, FSA officials said.
Currency values spiked in the second half of 2017, followed by explosive growth in trading volumes and the number of market participants. The FSA disclosed last August that the total asset value of 17 exchanges, including cryptocurrencies that customers are keeping in those companies’ accounts, rose to about ¥700 billion, a sixfold jump from the previous business year.
However, 75 percent of exchange operators had fewer than 20 employees at that time.
The FSA said those apparently understaffed firms were often too busy to handle the increasing number of customers, and some didn’t even confirm the identity of their clients.
Last year the FSA conducted on-site inspections of all crypto-exchanges. The authority found grave problems in the operations of eight registered operators, issuing an administrative order to each of them to correct those problems, such as not implementing stringent enough measures to prevent money laundering.
The FSA then faced harsh criticism for its apparent lack of effective regulations.
The regulatory body says it did not expect violent price fluctuations caused by speculative traders, which left existing financial regulations unfit to deal with the massive amount of trading caused by “bubble” spikes in their values.
As a result, the higher prices of virtual currencies in recent years have shaped the image of cryptocurrencies as speculative assets rather than as a futuristic monetary tool.
This prompted many players, such as exchange operators, investors and so-called miners — who use powerful computers to verify transactions, earning digital coins in the process — to prioritize turning a profit.
When legislation to implement the regulations was enacted by the Diet in 2016, the value of digital coins was much lower and only a few early adopters saw the new currencies as the future of money.
Currently the FSA is more carefully scrutinizing applicants who want to get into the exchange business. As a result, 13 of the tentatively approved exchange providers have given up plans to become registered operators because they were unable to meet the high standards demanded by the watchdog.
Since the regulatory watchdog found itself too busy to be able to inspect all existing exchanges, the screening process for newcomers had until recently come to a standstill.
The FSA on Friday gave final approval for the resumption of operations at Coincheck, which has become a group firm of Monex Group Inc., a major online brokerage, so it can improve its internal control and management system.
“Only those companies that can meet the standards and follow regulations will be eligible to run crypto-exchange businesses … we will see more responsible firms entering the market this year, which will energize the industry,” said Hirano.
Moreover, regulations will be updated this year to reflect some of the lessons learned from the Coincheck debacle, which was followed by another hacking attack on Osaka-based Tech Bureau Corp. in September last year.
According to a report compiled by a panel of experts under the FSA’s auspices in December, one of the new rules under consideration is to require exchange operators to set aside assets matching the values of currencies held by customers in their online accounts.
Cryptocurrencies held online could be vulnerable to cyberattacks. Thus, securing assets equal in value to the online accounts will enable exchange operators to compensate investors in the event accounts are hacked and money stolen.
Tech Bureau lost bitcoins and other digital currencies said at the time to be worth about ¥7 billion, and the firm was unable to compensate those who lost their investments.
Because of this, the firm was forced to close and it handed over its business operations to another exchange operator that had promised to reimburse the customers.
Among other possible new regulations are requirements for cryptocurrency wallet providers to confirm the identity of their users, banning ads to promote cryptocurrencies as speculative assets and capping leverage for margin trading.
However, a raft of stricter regulations will set the bar higher for new startups hoping to make a foray into the business. This could contradict to the FSA’s initial policy to foster the new industry by striking a good balance of regulations and freedom.
But Kazuyuki Shiba, principal economist who watches the crypto-industry at the Institute for International Monetary Affairs, a Tokyo-based think tank, said the stricter rules are necessary, given massive cyberattacks against exchange operators in the past.
New regulations “would be the first step for healthy growth of the market,” he said.
Another urgent item on the agenda for exchange service providers is to create new services with real value other than simple trading for speculative profit-making, people in the industry said.
The FSA appears to be determined to help the industry “provide value and convenience to users other than trading,” said Junichi Kanda, who heads Money Forward Financial Inc. a Tokyo-based fintech firm that plans to start a crypto-business.
Kanda said some major IT firms are also waiting to join the market and are likely to introduce some new crypto-services. They include services using new currencies that would have less volatility in terms of value because such coins are more convenient as a means of settlement.
According to the FSA, about 190 firms are either applying for or are interested in becoming registered crypto-exchange service providers. Major firms such as Line Corp., Mercari Inc. and MUFJ Bank are believed to be among the names on the list.
Experts warn shifting away from speculative, profit-first trading is key for the industry to achieve long-term growth.
“They have to show the merits of cryptocurrencies other than the rise of value. For instance, people can send digital coins to users in other countries for a really low fee in a few hours rather than some days,” said Shiba at the Institute for International Monetary Affairs.
“It’s important that crypto-players think and demonstrate how cryptocurrency can benefit society as a whole. … They will be tested on whether they can do that (this) year,” he added.
Shiba also added that the government has an incentive to push efforts to make a healthy crypto-business environment and improved consumer protection, as the country will host this year’s Group of 20 summit in June.
Other countries are generally behind in terms of implementing regulations on cryptocurrencies, such as checking customers’ identifications, so Japan is probably aiming to put the crypto-rules on the table at G20, said Shiba.
As for the value of cryptocurrencies, which continued to fall last year, Hirano of the Blockchain Collaborative Consortium said the lower prices have inflicted damage on the industry.
Bitcoin prices were around ¥100,000 at the beginning of 2017 but shot up to over ¥1 million in November and to ¥2 million in December of that year. But it plummeted by 50 percent in January and has been declining ever since. As of Thursday night, a bitcoin was being traded at around ¥410,000, according to bitFlyer, Japan’s leading exchange operator.
When the cryptocurrency market was booming in 2017, many new players emerged and employment opportunities increased, with more engineers wanting to work in the industry, said Hirano.
“But it is hard for some businesses to survive because prices of cryptocurrencies have fallen considerably,” he said.
“The bubble period hypnotized a lot of people into thinking that they have to do some business related to cryptocurrencies … but the boom faded out last year and so did many companies,” said Hirano, adding he hopes that more people come back to the industry this year.