POS AND YIELD FARMING
A new revenue stream for Japanese crypto exchanges
06/08/2020
By So Saito & Joerg Schmidt

POS AND YIELD FARMING
With 24 registered crypto asset exchanges, the Japanese market has
become increasingly competitive over the last few years. Constrained byregulations, Japanese exchanges have further only been able to list afraction of the tokens traded elsewhere. At the same time, newrestrictions on margin trading and additional license requirements forcrypto derivatives have made it increasingly difficult to competeinternationally.
The latest market developments, namely the shift from proof-of-work to
proof-of-stake consensus mechanisms and the increasing popularity ofyield farming, provide an excellent opportunity to exchanges, however,to add further services and to exploit additional revenue streams.
In this article, we analyze the regulatory environment for exchanges thatwant to use their customers’ funds for staking and yield farming services,highlight potential pitfalls, and provide some legal considerations for
implementing these services.
For more information on the regulatory environment for DeFi lending
platforms, please visit our previous article.

Key Findings
Registered exchanges can generally provide staking and yield
farming services in Japan if they remain in control over the staked
funds and do not transfer the economic risk resulting from the newservices to their users.

DEFINITIONSProof-of-Stake (PoS)
Blockchains depend on some form of consensus mechanism. Themechanism ensures that all nodes in the network agree on a single state
and that the transaction history becomes immutable. The proof-of-work(PoW) consensus mechanism was the first successfully deployed. Given
its high energy consumption and low transaction throughput, newPage 1 of 8

consensus mechanisms have evolved. The most prominent is the proofof-stake (PoS) consensus mechanism.
PoS generally uses a pseudo-random selection process to select a node
as a validator. Selection criteria vary from platform to platform andinclude, among others, a node’s wealth, staking age, or other factors.
The validator of a block generally receives a block reward together withtransaction fees paid by the users of a network. According tostakingrewards.com, the staking rewards for the bigger platforms are
typically between 3-9 percent of the staked amount.1
While the Ethereum community has discussed the transition from a PoW
to a PoS consensus mechanism for some time, other platforms havepressed ahead. Current forms range from pure PoS to different types ofdelegated PoS (DPoS). For the latter, a user does not directly participate
in the validation of transactions but delegates this activity to others, thedelegates.

Table 1: Overview of different consensus mechanisms using some form of PoS
consensus

funds controlled

directmechanismby user

distribution topenalties

userEthereum

PoS

yes, but

2.0

yes

yesyesyesnonotemporarily
locked in a smart
contract

tezos

liquidbakingyes, but locked inPoS(PoS)a smart contract
as a bonddelegating

yes, different(DPoS)

keys fortransactions andstaking

1 Staking Rewards, Trusted Data. Stakeable Assets., retrieved from https://www.stakingrewards.com/proof-of-stake(accessed on 03/08/2020).

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EOS

DPoS

yes, but

not necessarily

temporarily

any distribution

locked in a smart

to delegators

nocontract
Algorandpure PoS

yes

yes

noLISK

DPoS

yes, butno

only lock-up for

temporarily

an extended

lockedperiod

Yield Farming
Yield farming allows token holders to generate passive income from theircrypto holdings as well. Instead of participating in staking, yield farming
requires users to lock their funds into a lending protocol such as
Compound or MakerDAO, which in turn allows others to borrow fromthe pooled funds at a certain interest rate.
Many of the lending protocols currently involve an additional type oftoken, which is used as an incentive for both lenders and borrowers.
Together with these incentives, annual yields of up to 100 percent werepossible until last month. More recently, the price of most governancetokens dropped, however, and brought the yield for lenders down tomore realistic levels.
Currently, most DeFi lending activities focus on the Ethereum blockchain.
Since Ethereum still uses the PoW, yield farming and staking do notcompete directly. However, this will change with the roll-out of
Ethereum 2.0 over the next five to ten years.

LEGAL CONSIDERATIONSRegistered exchanges in Japan can engage in the exchange of crypto
assets and the management of their users’ funds – all, of course, within
the boundaries set by the Payment Services Act (PSA) and subsidiarylegislation.

Crypto Asset Exchange Services
The definition of crypto asset exchange services in the PSA does not only
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lay out the services subject to registration. It also determines the scopeof regulated services a registered exchange may provide.
According to Section 2(5) PSA, the following services are considered
crypto asset exchange services:(1) the purchase and sale of crypto assets or exchange of crypto assets(2) intermediary, brokerage, or agency services for the purchase, sale,and exchange of crypto assets(3) the management of a user’s funds in relation to the purchase, sale,and exchange of crypto assets(4) the management of crypto assets on behalf of another person
Since all exchanges in Japan are centralized exchanges, they provide
exchange and custody services.2 Accordingly, they must also follow therules for crypto custodians when providing staking or yield farming
services.

Custody Services
Under the new regulations, exchanges are generally required to hold 95
percent of their users’ funds in a cold wallet or secure them by means
which provide a similar level of security. The remaining 5 percent can be
stored in a hot wallet but must be fully backed by an exchange’s ownfunds.
It should be noted that in both cases, the exchange remains in full control
over its users' funds. A user is, therefore, generally able to withdraw hisfunds at any time. This even applies in cases similar to a bank run andmust be borne in mind when preparing the terms and conditions for yield
farming and staking services.

POS UNDER THE PSA
As shown above, PoS mechanisms come in different shapes and sizes. Itis, therefore, necessary to analyze the design carefully when assessing
the admissibility of staking services.
As much as the admissibility depends on the design of the respective
consensus mechanism, it depends on the contractual arrangements in2

Unlike decentralized exchanges, centralized exchanges require users to transfer their funds to an address
controlled by the exchange. The user does not have any control over the funds until he instructs theexchange to transfer the funds to an address specified by him.
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place. Both components and their interaction with each other must,therefore, be analyzed comprehensively. This applies in particular
because the right contractual arrangements may neutralize some of thenegative effects resulting from design choices.

Control Over Funds
The first thing to consider is who controls the staked funds. If it is theuser, which is highly unlikely if not impossible in case of centralizedexchanges, there are no concerns. The same is true if the funds arecontrolled and remain under the control of the exchange after being
used for staking.

PoS
In most PoS models, a user must lock his tokens in a smart contract forstaking. While the tokens are temporarily locked in the smart contract,i.e. the time they are used for staking and in some cases an additional
period, they can generally be unlocked at any time.
The only one who can unlock the funds from the smart contract is theperson controlling the private key corresponding to the address that wasinitially used to lock the funds in the smart contract. Except for slashing
staked funds in case of misbehavior or excessive downtimes, the smart
contract does not control the staked amount. In particular, it is not able
to transfer the funds independently.
Since the funds remain under the control of an exchange, the situation is
not different from any other situation where the funds are associatedwith an address controlled by an exchange.

DPoS
In the case of DPoS, the situation is generally not different from thesituation described above. An exchange using funds for delegation
services does not lose control over the funds at any time. This applies
even if the funds are locked in a smart contract for delegation.
In some cases, namely the liquid PoS by tezos, the exchange must noteven send a users’ funds to a smart contract. Instead, there are two keys
– one for controlling the funds and another one for delegation. Unlike inother PoS models, it is therefore not even necessary to send the funds toa smart contract and withdraw them when a user wants to withdraw hisPage 5 of 8

funds from the exchange.

Hot Wallet VS Cold Wallet
Since the smart contracts used for staking do generally not control thelocked funds, the situation is comparable to the situation where thefunds are associated with an address controlled by the exchange. In bothcases, the funds can only be transferred by the person controlling theprivate keys. If these keys are stored offline, the level of security isgenerally the same for funds locked in the smart contract and funds
associated with an ordinary address. That being said, there is no reason
to treat the two situations differently.

Liquidity Constraints
Most PoS consensus mechanisms require the user to lock funds into asmart contract. Even if the funds are unlocked, the holder of the private
key may not receive the funds directly. An exchange staking its users'
funds may, therefore, not be able to respond to a withdrawal request
immediately.
An exchange may either counter the delay by using its own funds orprovide in its terms and conditions that there may be delays if a user also
wants to use the exchange’s staking services. The terms may further lay
out different periods for different protocols or simply use the longestperiod as a standard.

Economic Risks (Slashing)Some PoS consensus mechanisms provide for slashing in case of
misbehavior, excessive downtimes, or other violations of the protocol'srules. In other words, the person violating the rules loses a certain
amount of staked funds.
Where the economic risks and benefits are borne by the user, staking ismore akin to investments than to deposits. Investment activities are,however, regulated under the Financial Instruments and Exchange Act(FIEA) and require a different license. A crypto asset exchange license isnot sufficient.
Crypto asset exchanges that do not have the necessary licenses must,
therefore, implement measures to prevent users from bearing theeconomic risk of staking. One way to do so is by reconciling losses with
Page 6 of 8the exchange’s own funds.

Legal Considerations – Yield Farming
The legal considerations are generally the same for PoS and yield farming.
In short, an exchange may not carry out activities where the users run
the risk of making a loss.
Compared to staking, there is one fundamental difference, however. An
exchange will lose control over the lent amount. The control over theasset is transferred to the lending protocol, which in turn lends the funds
to other users.
In exchange for supplying the funds to the protocol, an exchange does,
however, receive another token which represents an increasing share in
the protocol’s funds. By transferring these tokens to the protocol, anexchange can generally redeem the locked funds from a lending protocol
at any time. This applies at least if there is sufficient liquidity. In the caseof illiquidity, an exchange may have to wait for a certain amount of time
until the redemption may be completed. An exchange may bridge thistime either by using its own funds or putting a contract in place thatallows it to wait with the refund until there is sufficient liquidity on therespective market.
The private keys controlling the tokens issued by the protocol can be
stored in a cold or hot wallet like any other key in possession of theexchange. Insofar, nothing different applies.

Conclusion
The PSA does not generally prohibit yield farming or staking services. Thisapplies at least if the economic risks of staking or yield farming are nottransferred to the user. It is also necessary to take a closer look at therespective PoS mechanism and adjust, where appropriate, thecontractual documentation.
We expect that PoS and yield farming will gain more traction on theJapanese market in the next few months. If you want to discuss thetechnical and legal implementation of PoS and staking services with us,
please feel free to contact us at any time.

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CONTACTSo Saito3
Partners.saito@innovationlaw.jp
Joerg Schmidt4
Foreign Associatej.schmidt@innovationlaw.jp

DISCLAIMER
The DeFi protocols and blockchain projects mentioned in this article are used for illustrative purposes
only. Given the format of the article, not all details of the protocol or consensus mechanism 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 and PoS consensus mechanisms
mentioned in this article.

3 Admitted in Japan and New York.
4 Admitted in Germany (not registered in Japan).

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