Coincheck Inc Chief Operating Officer Yusuke Otsuka speaks to the media in Tokyo on Tuesday. Photo: REUTERS/Toru Hanai
business

Coincheck heist sheds light on Japan's rush to create cryptocurrency rules

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By Thomas Wilson and Takahiko Wada

After the MtGox cryptocurrency exchange was stung by a half-billion dollar theft in 2014, Japanese regulators swung into action.

Their goal was to craft rules that both protected traders and allowed a promising sector to flourish. By last April, thought they had arrived at a set of guidelines that did just that.

Japan's national system to oversee cryptocurrency trading was the world's first, rolled out even as policymakers elsewhere grappled with how to deal with the sector. Under the Japanese framework, some exchanges would be allowed to operate - even though they hadn't yet won regulatory approval.

One of those was Coincheck Inc. Last month, hackers stole about $530 million from the Tokyo-based exchange, a theft rivalling Mt. Gox's as one of the biggest ever for digital currency.

The Coincheck heist exposed flaws in Japan's system. And for some experts, it raised questions over the country's dash to regulate the industry - a sharp contrast to clampdowns by countries like South Korea and China.

Interviews with a dozen government officials, lawmakers and cryptocurrency industry leaders depict a regulator that opted for relatively loose rules to help nurture an industry largely populated by start-ups.

Japan's Financial Services Agency declined to comment.

But proponents of its regulatory approach say the system and the hack were not connected.

"It's too much to say that the FSA or institutional design was lax because there was one hack," said former information technology vice-minister Mineyuki Fukuda, previously a supporter in parliament of promoting and regulating cryptocurrencies.

In the wake of the MtGox bankruptcy, Japan didn't know what to make of bitcoin - or even who should be in charge.

"It's not money," Finance Minister Taro Aso told reporters days after the exchange collapsed. "Does the Financial Services Agency have jurisdiction? The Finance Ministry? The Consumer Affairs Agency? The Ministry of Economy, Trade and Industry?"

Amid the vacuum of oversight, the governing Liberal Democratic Party, seeing the fintech sector as a way to stimulate growth, initially called for the cryptocurrency industry to form a body to regulate itself.

That led to the formation of the Japan Authority of Digital Assets (JADA), comprising blockchain and cryptocurrency start-ups and entrepreneurs.

When the FSA was later tasked with creating regulations for cryptocurrencies, it turned to JADA for help. The group lobbied for rules friendly to start-ups, like low capital requirements.

"We had constant discussions with the FSA, giving technical information and ideas," said So Saito, a founding member of JADA and now general counsel of its successor, the Japan Blockchain Association (JBA).

The FSA's rules required exchanges to register, operate robust computer systems and address risk management.

But they left the storage of assets to a set of non-binding guidelines. Exchanges should keep the encrypted keys needed to access digital money in "cold wallets" - for example, USB drives not connected to the internet - only if doing so didn't overly inconvenience customers, the guidelines said.

In effect, the clause left no obstacle to Coincheck's holding $530 million worth of NEM crypto-coins in an online "hot wallet" - essentially a digital folder stored on a server - from which the funds were stolen.

"The FSA was quite relaxed on protecting consumers on things like cold wallets and hot wallets," said the chief financial officer of a major Japanese cryptocurrency exchange.

Policymakers across the world have grappled with how to deal with cryptocurrencies. Most have been skeptical about trade in digital assets.

U.S. regulators may ask Congress to legislate more oversight of digital money, the head of the Securities and Exchange Commission said this month.

In Asia, South Korea is embracing strong oversight of cryptocurrency trading, at one point saying it might shut down local exchanges. China, concerned about financial stability, last year ordered some exchanges to close. India this month vowed to stamp out use of cryptocurrencies altogether.

Statistics on cryptocurrencies are patchy because their trading is unregulated in most countries. But Japan accounts for between a third and half of all global bitcoin trade, exchange operators say - a share of the market that has grown as other jurisdictions have cracked down.

As Japan's rules came into effect last April, exchanges were given six months to register.

But even those that registered but weren't approved could continue to operate.

Coincheck was among the exchanges that didn't win approval. By the time it filed its application in mid-September, bitcoin was surging towards a record high of $19,458, which it hit in December.

The exchange had grown to one of Japan's biggest amid a sharp increase in trading, moving to a new headquarters from a dingy backstreet office. Its share of domestic bitcoin trades soared to 55 percent in December from only 7 percent a year earlier, data from Jpbitcoin.com show.

In an interview with Reuters last year, Kaga Kawabata, Coincheck's business development manager, was dismissive of the FSA's oversight, even as the exchange prepared to register."They have no knowledge. Every year someone moves, and it's a big pain to educate them," he said.

The FSA said last week it didn't approve Coincheck partly because of worries about weaknesses in the exchange's systems, declining to give further details. It allowed Coincheck to continue operating, calling for improvements without a specific timeline.

The regulator was in a bind, industry insiders said: Coincheck had grown so big that the FSA couldn't reject its application.

"Consumers would be upset. It was politically difficult to close down Coincheck," said Masakazu Masujima, a lawyer and adviser to the Japan Cryptocurrency Business Association, an industry body. "So they kept requesting it to improve its systems."

© (c) Copyright Thomson Reuters 2018.

©2018 GPlusMedia Inc.

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But proponents of its regulatory approach say the system and the hack were not connected.

"It's too much to say that the FSA or institutional design was lax because there was one hack," said former information technology vice-minister Mineyuki Fukuda, previously a supporter in parliament of promoting and regulating cryptocurrencies.

One hack is all that it took to steal another half-a-billion dollars, and just how many other hacks or attempted hacks have not been reported?

If the system and the hack were not connected, then who or what is to blame?

1 ( +2 / -1 )

As the guy in the article says, the FSA wouldn’t have a clue. They are a bunch of career bureaucrats, they aren’t the ones who innovate and think new ideas, they aren’t experts in cryptocurrency. If they were they would be the ones starting up the new businesses, not the ones forced to pretend that its old school and they know exactly how best to regulate it.

This stuff is new. People who risk their own money are risking THEIR OWN MONEY. They are they ones taking the risk, don’t expect tax payer funded FSA regulators to get it all right first time around.

Let’s be pragmatic. Early adopters may get burned. That’s part of the risk, and it’s a free choice.

0 ( +2 / -2 )

China, India, and S Korea will play catch up later, (Don't understand it so ban it) as the world becomes more aware of digital currencies, the digital industry is in its infancy. Email vs Writing a letter to mom, see how email wins that? Mobile devices have changed when, where, and how we transact with our finances, we no longer have to enter a brick and mortar establishment, someone in a field in AFRICA could just go online and boom do what they need and continue to work a few minutes later.

We already do the majority of or banking on line digitally, the value of digital currency will show its worth when the next Global Financial Crisis arrives, Gold and other precious Metals were once the hedge, I've the feeling that Digital currencies will be the hedge of choice. A cashless society is approaching but I've the feeling its not gonna be quite the way the ROTHCHILDS planned it!

0 ( +0 / -0 )

At least they admit it was about politics in the end, "consumers would be upset and it was politically difficult". Must have been some nice payoffs involved! I think consumers are a lot more upset now that their assets are frozen and they can now only take out their cash on a "first come first serve basis".

I do think that regulation should be from within, for example the group in charge of a crypto should determine rules which an exchange has to abide by in order to allow trading. For example, the NEM foundation kept warning Coincheck about their lax security measures and CC just ignored it (which is why NEM decided not to take a hard fork and invalidate the stolen coins, it was 100% preventable and was not a fault of the coin).

3 ( +3 / -0 )

Hmmm....  The notion of the JFSA "swinging in to action" is risible.  over 3 years and nothing.  Plus regulation will not prevent these bucket shop exchanges being hacked.

0 ( +0 / -0 )

Email vs Writing a letter to mom, see how email wins that? 

Email? Old school! Don't the kids just use FaceBook Snapchat and Instagram now?

Gold and other precious Metals were once the hedge

I don't think digital assets have surplanted them at all, yet. You can't even wear bitcoins. When the Indians and Chinese all dump their gold for cryptocurrencies, then I will believe that times have changed.

I've the feeling that Digital currencies will be the hedge of choice.

I think they can be useful in basket case economies like Venezuela or when central banks shutdown the system (like in Cyrpus a few years back), because even if the value fluctuates wildly, it is still doing better than the local currency. 

It's relative. 

Prefer bitcoins to Venezuelan bolivars? Yes. But To any of the major dollars? No, not right now thanks. But if the Japanese authorities shutdown the banking system here then sure, bitcoins would be nice to own then. Certainly easier to get bitcoins through customs than it is gold.

I do think that regulation should be from within, for example the group in charge of a crypto should determine rules which an exchange has to abide by in order to allow trading.

Definitely a role for self-regulation. And one for government regulation too. But I don't think anyone knows what the perfect set of rules looks like yet.

regulation will not prevent these bucket shop exchanges being hacked.

Certainly hackers will forever try to hack :)

I was impressed though that this NEM coin was designed in such a way that the stolen ones could be marked. You sure can't melt down cryptocurrency and re-mold it like could be done with precious metals.

1 ( +1 / -0 )

 Don't the kids just use FaceBook Snapchat and Instagram now?

Kids here rarely use FB, that's for Mom and Dad. Snapchat, Twitter, Instagram, and a few others are the preferred method of communicating.

0 ( +0 / -0 )

fxgai, good post - except owners of precious metals don't cart them around any more than you cart around your dollar holdings in wads of benjimans. Gold, due to its relative stable supply, is quite similar to Bitcoin (though it also has immensely valuable practical applications, whereas Bitcoin is fiat). Watching how virtual currencies evolve is fascinating, and anyone who states with certainty where all this is headed is lying or foolish. A true global cryptocurrency could be in its infancy. Perhaps what emerges will be regulated by "the machines," not human actions (not necessarily a bad thing, but potentially catostraphic - imagine an "I'm sorry, Dave" on either an individual or macroeconomic level). It is a lotta fun, though, and thanks for your post!

0 ( +0 / -0 )

anyone here buy any goods or services with cryptocurrency? Anybody here sell any goods or services for it?

What goods or services, and why would you?

0 ( +0 / -0 )

"Crypto" is Amway for people who don't want to push bad soap and stale snacks on their friends and relatives

0 ( +0 / -0 )

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