YIELD FARMING AND LIQUIDITY MINING
DeFi Lending from a Regulatory Perspective
27/07/2020

By So Saito & Joerg Schmidt

YIELD FARMING AND LIQUIDITY MINING
Mostly unrecognized by mainstream media, DeFi has gained increasing
traction over the last few months. Large parts of its growth can be
attributed to lending platforms such as Compound, Maker, and Aave,
just to name a few. Broadly speaking, users of these platforms receive
some form of interest in exchange for locking their assets into a smart
contract, which in turn lends them to (other) users. Together withextrinsic rewards paid by these platforms, yields of up to 100 percent
are currently possible. The process of optimizing yield through a
combination of leverage and rewards is commonly referred to as yield
farming and liquidity mining.
In this article, we will discuss the regulatory treatment of lending
platforms under Japanese laws. Restrictions for users do not exist. In
our next article, we will focus on the opportunities, Compound andother platforms provide to crypto asset exchanges in Japan, whichcurrently face fierce competition and pressure under the newregulations.

Total Value Locked (USD) in DeFi1
The following chart includes data from DEX, lending, derivatives, payments, and assets platforms.

1 DeFi Pulse, retrieved from https://defipulse.com/ (accessed 10 July 2020).

1. The Concept
The basic concept of yield farming and liquidity mining is to generatepassive income from crypto assets. Yield farmers and liquidity miners
generally try to put their assets to maximum use by utilizing a combinationof lending and borrowing techniques on one or more lending platforms.
Apps such as Instadapp help users to bridge different protocols and toleverage the full potential of DeFi by automating large parts of the lending
and borrowing activities.
To explain how yield farming and liquidity mining work, we will use
Compound, one of the biggest and currently most used platforms, as anexample.2

1.1 Lending
In order to earn a yield on Compound, users must lock their assets in asmart contract. In turn, the smart contract issues new tokens (cTokens) ata predefined exchange rate. These tokens allow the user to earn a yieldover time and to use them as collateral when borrowing funds via theplatform.
cTokens do not provide recurring revenue to their holders. Instead, theyrepresent a share in a pool of assets that constantly grows due toborrowers’ interest payments. With the price of cTokens increasing
relative to the locked assets, cTokens generate a yield when used towithdraw the locked assets. The actual amount depends on thecompound interests calculated by the protocol based on market dynamics,
namely supply and demand.
In addition to the compound yield, lenders currently receive COMP tokens.
These tokens allow their holders to propose and vote on changes to theprotocol and are actively traded on exchanges. Only with COMP tokens,the current yields are possible at all.

2 According to DeFi Pulse, 28.03 percent of the USD 2.51 billion total value locked in DeFI is currently locked inCompound, DeFi Pulse, retrieved from https://defipulse.com/ (accessed on 10 July 2020).

Exchange rate of cUSDC to USDC over time3

1.2 Borrowing
When borrowing funds via Compound, a user must deposit cTokens ascollateral. The maximum amount a user can borrow depends on thecollateral factor of the deposited asset. This factor is set by COMP token
holders. The collateral factor is generally higher for liquid, high-cap assets
and lower for illiquid, small-cap assets. The collateral factor of ETH, forexample, is currently set at 0.7. A user supplying ETH 100 to the protocol,
would therefore be able to borrow up ETH 70 worth of assets via
Compound.4
Where a user’s borrowing balance exceeds his borrowing capacity due tooutstanding interests, the value of collateral falling or the borrowed
assets increasing in price, the collateral will be liquidated automatically ata discount to the current market price.
Like lenders, borrowers currently receive an external reward in the formof COMP tokens for using the Compound platform. Every day,approximately 2,880 COMP are distributed – 50 percent to lenders and50 percent to borrowers.

3 Compound, retrieved from https://compound.finance/ctokens (accessed on 10 July 2020).
4 It is worth noting that a user’s collateral would immediately be liquidated to a certain extent with the first interestpayment becoming due.

2. Regulatory Environment
When analyzing the legal and regulatory environment for DeFi lending
activities, it is necessary to break down the lending model into differentcomponents. First, it is necessary to analyze the tokens required for theprotocol to work. In a second step, the activities involving each of thetokens must be analyzed in more detail. It should be noted, however, that
it is not possible to view tokens and activities as separate components,
but that it is necessary to consider the interaction between both for theanalysis.

2.1 Legal Classification of the Tokens
Compound and other lending platforms involve a number of different
tokens. In the case of Compound, these tokens are (i) ETH and ERC-20
tokens supplied to the protocol, (ii) cTokens which are issued in exchange
for the tokens supplied, and (iii) COMP which is issued as a reward andwhich constitutes the protocol’s governance token.
Under Japanese laws, tokens may either constitute crypto assets under
the Payment Services Act (PSA) or electronically recorded transfer rights
under the Financial Instruments and Exchange Act (FIEA). Tokens neither
covered by the definition of crypto assets nor electronically recordedtransfer rights may not be regulated at all.
Crypto assets

The PSA distinguishes between type I crypto assets and type II crypto
assets. Type I crypto assets are proprietary values that can (i) be used forpurchasing goods and services from unspecified persons, (ii) purchasedfrom and sold to unspecified persons acting as counterparties, (iii) andtransferred electronically.
Type II crypto assets are property values that can (i) be mutually
exchanged with unspecified persons for type I crypto assets and (ii)transferred electronically. Currency denominated assets such as fiat
currencies and electronically recorded transfer rights are explicitly
excluded from the definition of both type I and type II crypto assets.

Electronicallyrecorded transferrights

The definition of electronically recorded transfer rights was added to theFIEA with the latest amendment. It covers electronically recorded values
that represent type II securities which can be transferred electronically,
and which do not have liquidity constraints.

2.1.1 ETH and ERC-20 Tokens
Currently, most platforms, including Compound, allow users to deposit
ETH, certain ERC-20 utility tokens5, and different kinds of stable coins.
ETH is a typical type I crypto asset. ERC-20 utility tokens generally
constitute type II crypto assets as they can easily be exchanged with type
I crypto assets. The same most likely applies to wrapped bitcoin as they
are currently not used for payment and can only be exchanged with type
I crypto assets.
For stable coins, the legal classification depends on their exact featuresand underlying model. The most prominent stable coins, such as USDTand USDC, are based on an IOU model. Each token is backed by one USD.6
As a result, they are likely to fall under the definition of currency
denominated assets and are thus excluded from the definition of crypto
assets under the PSA. For more information on the classification ofdifferent stable coins, click here.

2.1.2 cTokens
cTokens represent a user’s balance in the Compound protocol. As themarket earns interest, the tokens become convertible into an increasing
amount of the underlying assets. This raises questions as to whethercTokens represent beneficiary certificates in a money market fund (MMF)or interests in a collective investment scheme and therefore constituteelectronically recorded transfer rights.
Beneficiary Certificates in an MMF
Key features of anMMF

Traditionally MMFs are used as cash management vehicles for retail andinstitutional investors. Defining features are the payment of dividends,
the fact that investors can redeem their certificates at any time, and thefact that MMFs seek to maintain a stable net asset value. The redemptionof a substantial amount of beneficiary certificates may, however, result ina loss of liquidity and negatively affect the remaining certificates’ price.
The risk of illiquidity also exists in the case of Compound and other DeFi

5 For this paper, utility tokens are understood as tokens that give token holders access to an application or a service

and which serve as a platform-internal currency.
6 For USDT, the accounts have not been properly audited so far.

protocols. As the following graphic shows, it may be even more
pronounced than for traditional MMFs.

Illiquidity Events in Compound’s SAI Markets7
The green line indicates the total amount of SAI supplied, the red line the total amount of SAI
borrowed, and the grey line the utilization ratio.
Economic nature ofcTokens and sharesin an MMF isfundamentallydifferent

The difference between Compound and traditional MMFs is that a user’s
yield is independent of profits generated by the protocol. Rather thancalculating the yield after repayment of the borrowed loans, the protocol
uses the prevailing interest rate for each interval when calculating thecompound interest rate. Whether a loan is fully paid back at any point intime or not, is irrelevant.
No legal entity

It is further worth noting that the Compound protocol does not constitutea legal entity that could act as a trust. The protocol is also not controlled

7 Alethic, Illiquidity and Bank Run Risk in DeFi, retrieved from https://medium.com/alethio/overlooked-risk-illiquidity-

and-bank-runs-on-compound-finance-5d6fc3922d0d (accessed 10 July 2020).

by a legal entity that may otherwise be seen as a principal.
Interests in a Collective Investment Scheme
Economic nature ofcTokens and units
in a collective
investment scheme
is fundamentallydifferent

The definition of collective investment schemes in the FIEA 8 isintentionally broad and covers various arrangements that are used to poolmoney for investment purposes. Investors in a collective investment
scheme are entitled to participate in the earnings a scheme generates but
bear a business risk at the same time. If the scheme suffers a loss,
investors in the scheme suffer a loss as well.
The argument that Compound and other DeFi platforms do not pay
dividends can also be used with regard to collective investment schemes.
Unlike investors in a collective investment scheme, holders of cTokens
earn a yield irrespective of profits generated by the platform. The yieldsolely depends on the accrued interests over time and is calculated byusing the interest rate on the respective markets for each block.
While there is an illiquidity risk, lenders should generally not make a loss
when using Compound. This is due to the over-collateralization and autoliquidation of loans where the balance of the collateral is insufficient tosupport the loan. If this promise holds true, the situation is fundamentallydifferent from collective investment schemes where investors may
actually suffer a loss.

cTokens do not
represent rights

It may further be argued that cTokens do not fall under the definition ofinterests in a collective investment scheme as they do not represent rights.
Rights, by definition, require a counterparty. In the case of DeFi, acounterparty does not exist. Instead, assets are collected and distributed
via smart contracts according to predefined rules on a factual basis.
Whether the regulator will follow this argument remains to be seen. Yet,
we believe that there is plenty of room to argue that cTokens and similararrangements do not fall under the definition of collective investment
schemes and do, therefore, not constitute electronically recordedtransfer rights under the FIEA.
Type II Crypto Assets

cTokens as type II
crypto assets

Since cTokens can be transferred electronically and exchanged with othertokens, they represent type II crypto assets under the PSA. The fact thatthe tokens become convertible into an increasing amount of the8 Article 2(2)(v) FIEA.

underlying asset does not lead to different results. This is because theirvalue is only driven by market forces, namely supply and demand. The
protocol merely ensures that the value of cTokens does not decrease
relative to the underlying asset over time.

2.1.3 Governance Tokens
COMP as type II
crypto assets

Governance tokens issued by the Compound protocol constitute type II
crypto assets. They can be exchanged with other crypto assets but are notused for payment. The fact that governance tokens provide the user withvoting rights is irrelevant for the legal classification in the absence of otherfeatures.

2.2 Legal Classification of Activities
2.2.1 Lending and Borrowing of Crypto Assets
Crypto lending not
regulated

The lending and borrowing of crypto assets are not regulated underJapanese laws. A banking license or money lending license is therefore notrequired.

2.2.2 Exchange with cTokens
The exchange of crypto assets is generally considered a crypto asset
exchange business in Japan. This applies irrespective of whether theexchange is facilitated by a centralized exchange, a decentralizedexchange (DEX), or another smart contract if there is a controller.
Whether the issuance of cTokens in exchange for the supply of othertokens constitutes an exchange within the meaning of the PSA is not clear.
Neither the PSA nor any subsidiary legislation contains a definition ofexchange. Yet, there are good reasons to doubt that the issuance ofcTokens in exchange for the supply of other tokens constitutes anexchange within the meaning of the PSA and must, therefore, beregistered with the Financial Services Agency (FSA).

Issuance ofcTokens inexchange for othercrypto assets
fundamentallydifferent fromtraditionalexchange activities

cTokens are issued when a user supplies other tokens to the protocol.
While this might look typical exchange of crypto assets, there is afundamental difference. The user does not lose control over the initialamount deposited. cTokens more or less serve as a key to unlock the initialamount deposit and can be used at any time to do so – provided of course,
there is sufficient liquidity. For typical exchanges, this possibility does notexist. The same applies to the exchange of cTokens for other crypto assets.

2.2.3 Issuance of Governance Tokens
Issuance of COMP
not comparablewith ICO

The issuance of governance tokens is not an exchange business as well.
While the issuance of tokens in exchange for liquidity, is sometimes
compared with ICOs the key difference is that there is no payment ofconsideration for receiving the tokens. Instead, the tokens are issued as a
subsidy by the platform without additional consideration. It is therefore
more akin to an airdrop where an issuer aims to promote his platform.
Also, in these cases, it is not necessary to register as a crypto asset
exchange.

2.2.4 Locking of Tokens into Smart Contract
Protocol does notprovide custody
services

The definition of crypto asset exchange services also includes custodybusiness. When tokens are locked into a smart contract, this may
generally be considered custody under the PSA. It may however beargued that this does not apply where the smart contract creator does
not have control over the contract. In these cases, only the user is able tounlock the supplied amount by transferring cTokens to the smart contract
and to release the funds. The automatic liquidation function does notchange this result as the protocol creator does not have control over thefunds at any point of time.

Conclusion
While DeFi has become increasingly popular over the last few months, it
has not been on the radar of Japanese regulators so far. The good news isthat certain protocols and tokens will most likely not fall under the FIEA.
This will hopefully allow DeFi to get some more traction on the Japanesemarket and allow exchanges to add DeFi to their services.

As so often, the devil is in the detail. Much depends on the structure ofthe overall arrangement and the token design. Existing projects thatintend to enter the Japanese market are therefore well advised to analyze
their protocol and token design carefully. 9 The same applies to crypto
asset exchanges that intend to add further services in the future to
become more attractive in an increasingly competitive market.
We will analyze the possibilities resulting from DeFi and PoS for exchanges
in our next article. Stay with us.

CONTACT
So Saito10
Partners.saito@innovationlaw.jp
Joerg Schmidt11
Foreign Associatej.schmidt@innovationlaw.jp

DISCLAIMER
The DeFi protocols mentioned in this article, in particular Compound, are used for illustrative purposes
only. Given the format of the article, not all details of the protocol and token design have been
considered comprehensively, so that the results of the assessment may deviate from the results by
the regulator or a legal opinion prepared for the respective project. By no means, the explanations
should be understood as a legal opinion regarding DeFi protocols mentioned in this article.

9 DeFi, by definition, does not necessarily involve a central entity controlling the project. It may, therefore, be difficult

for the regulator to get hold of the persons behind the project. If a project aims to get more traction in the regulated
space, there is however no way to cut some corners or to circumvent regulation altogether.
10 Admitted in Japan and New York.
11 Admitted in Germany (not registered in Japan).