Can the FSA Support the Cryptocurrency Market While Protecting Customers?

More than 2 months has passed since the virtual currency exchange Coincheck lost more than 500 million dollars' worth of cryptocurrency in a suspected hack.

In its wake, Coincheck announced on April 16th that it will be bought by major online brokerage Monex Group.

The incident has forced the Financial Services Agency to take exceptional measures to protect the customers affected, while also supporting development of the cryptocurrency market.

Just one week after the alleged theft, FSA officials raided Coincheck offices in Tokyo's Shibuya Ward on February 2nd. It was a highly unusual move for the FSA just 4 days after it had issued an order to the company to reform its business.

The financial watchdog had swiftly gathered inspectors specialized in administrative systems and money laundering for the unprecedented on-site investigation.

Confirming ability to pay

The main reason for the raid was to confirm whether Coincheck had enough resources to compensate customers for their losses. The company had announced it would repay the roughly 260,000 people whose NEM currency had disappeared.

Doubting Coincheck's claim it had sufficient funds to do so, the FSA decided to investigate before receiving the company's report on reforms. The agency also stationed an FSA auditor at the site to monitor the firm's every move.

A sense of urgency

Why did the FSA take such a hard line?

They were worried about criticism of the agency if the customers affected were not repaid. Legal revisions were enacted in April 2017 approving virtual currencies as a form of payment and requiring cryptocurrency exchanges to register with the Japanese government. A world first, this regulation aimed to protect consumers while developing the cryptocurrency market.

However, the move was regarded as a certification of virtual currencies, spurring a sudden boom in trading. Then the Coincheck theft took place. To prevent a panic, the FSA had to determine whether the company was able to reimburse its customers, and what action to take if it could not.

The FSA audit revealed that Coincheck was raking in profits. Their main profit was not from commissions brokering trades between customers, but from fees charged to customers buying cryptocurrency from Coincheck.

The total value of trades handled by Coincheck during last December was just over 3.8 trillion yen, or about 35 billion dollars. The company says about 20 percent of that value was in cryptocurrency sales, securing hundreds of millions of dollars in fees in just a single month.

The FSA determined that Coincheck could, in fact, afford to reimburse customers for their losses. The audit also revealed that the company had made it a priority to expand its business while lacking adequate security to protect customers. The FSA viewed this behavior as a sign that existing management had to go.

Registration hangs in the balance

The FSA considered refusing Coincheck's application to register as a virtual currency exchange. The company was already operating before the new regulations, and was still awaiting registration approval. But refusing to register Coincheck would put them out of business and possibly delay compensation of the more than 260,000 victims, causing panic.

After much discussion, the FSA decided to continue auditing them to ensure they repaid their customers.

Heavy homework for Coincheck

The FSA demanded "drastic reform of the management system" at Coincheck in a second order issued on March 8th. It was a final warning for the firm's president, Koichiro Wada, and Chief Operating Officer Yusuke Otsuka, the majority shareholders. If they wanted the business to continue, they had to restructure management and ownership and establish new administrative and security systems.

Sources say Coincheck accelerated negotiations with several IT and financial firms, hoping to find a buyer that could satisfy FSA requirements.

It decided to become a subsidiary of major online brokerage Monex Group and continue in the virtual currency business.

Monex would buy all the firm's shares and appoint their own management team, including a president. Wada and Otsuka would step down from their positions, but stay on as executives.

Wada told a news conference on April 6th that he would resign as president, taking responsibility for the loss of funds.

Monex President Oki Matsumoto said he would formally register the firm as an exchange and fully resume services in about 2 months.

Lessons Learned

Should the FSA have grasped the situation of virtual currency trading earlier, and demanded reforms? After the Coincheck incident, the agency inspected other exchanges, issuing orders for reform to some and suspending others.

Numerous unregistered exchanges didn't hold up under the enhanced regulations and chose to close their doors. However, enthusiasm for cryptocurrency trading remains strong, mainly among the younger generation, and more than 100 firms are awaiting FSA registration.