KEY BUILDING BLOCKS OF DEFI
Decentralized finance – more commonly known as DeFi – has gained increasing traction over thelast few months. With new services and platforms being launched every week, the environmenthas become increasingly complex despite its short history.
This article provides an overview of the key building blocks of DeFi and the regulatory implications
under Japanese laws.
Key building blocks of DeFi
(1) decentralized exchanges(2) automated market makers(3) lending platforms(4) aggregators(5) vaults(6) derivatives

DEX
Decentralized exchanges (DEX) provide users with a marketplace where they can buy and sell crypto
assets. The basic concept of DEXes is similar to that of centralized exchanges. Stated differently,
DEXes typically maintain order books and matching engines.
In some cases, both the order book and matching engine are on-chain, in other cases they are offchain and only the settlement occurs on-chain.
ExamplesBinance DEX
dydx
switcheo
From a regulatory perspective it is necessary to distinguish between the order book/order matchingand the settlement.
Depending on the degree of decentralization, i.e. the degree a creator of a DEX can access the funds
or control the smart contract via admin rights, activities may either be regulated or unregulated.
(Potentially) Regulated Activities(1) order book/order matching >> crypto asset exchange service +/(2) safekeeping of deposited crypto assets in smart contract for settlement >> crypto asset exchange
service in form of custody service +/-custodial1
off-chain order booknon-custodial

regulated✓yes✓
on-chain order bookcontrolledyes✓✓
on-chain order booknot controlled

yes
✓

✓

yes

noyes

AMM
AMMs do not have order books. Instead they use liquidity pools that consist of at least one pair ofcrypto assets. The price of each crypto asset is measured against the other asset in the pool.
Uniswap for example uses the following formula to determine the price of each crypto asset in thepool:x*y=k
In this equation, x and y represent the number of each token in the pool. While x and y vary overtime, k remains constant and allows the AMM to determine the price of each asset at any point oftime.
If a user exchanges ETH for DAI in an ETH/DAI pool, for example, the price of DAI becomes more
expensive relative to ETH. This opens arbitrage opportunities if the ETH price in the pool deviatesfrom the actual market price. To make use of the arbitrage opportunity a trader must only supply
DAI to the pool and withdraw ETH. As a result, the price of ETH will be rebalanced and aligned withthe overall market price.
The liquidity in the pools is provided by liquidity providers (LP). In exchange for providing liquidityLPs participate in the fees charged for interacting with the pool and in some cases receive agovernance token as additional incentive.
ExamplesUniswap
Curve
1

Creator of smart contract controlling a user’s funds has far-reaching admin rights and may be able totransfer deposited funds (after amendment) of smart contract.

Balancer(Potentially) Regulated Activities(1) exchange of crypto asset with LP token  >> crypto asset exchange service -/(2) exchange of crypto assets  >> crypto asset exchange service -/(3) safekeeping of deposited crypto assets in smart contract controlling the AMM pool >> crypto
asset exchange service in form of custody service +/(4) issuance of LP token  >> issuance of security +/(5) issuance of incentives  >> crypto asset exchange service similar to ICO -/LENDINGTo borrow funds via one of the existing lending platforms, users must deposit crypto assets to theprotocol. When supplying funds to the lending protocol, lenders receive a token representing theirshare in the lending pool. This token may be used as collateral when borrowing funds from theprotocol.
Depending on the protocol, an additional token, typically in form of a governance token, may beissued to both the lender and borrower as an incentive to use the platform.
Borrowers pay interests to the protocol which either forwards them directly to the lender or releases
them once the lender decides to unlock his funds from the protocol.

Examples
CompoundAave(Potentially) Regulated Activities(1) exchange of crypto asset with token representing share in pool  >> crypto asset exchange
service +/(2) exchange of token representing share in pool with crypto asset  >> crypto asset exchange
service +/(3) safekeeping of deposited crypto assets in smart contract controlling the lending pool >> crypto
asset exchange service in form of custody service +/(4) issuance of token representing share in pool  >> issuance of security /(5) issuance of governance tokens as incentive  >> crypto asset exchange service /-AGGREGATORS
Aggregators connect users, wallets, and smart contracts with liquidity. By doing so, they allow themto swap tokens for the best price available across multiple platforms.
Other aggregators constantly look for the best yield and distribute the supplied funds accordingly.
Examples
1inch
Kyber

(Potentially) Regulated Activities(1) intermediary services for the exchange of crypto assets >> crypto asset exchange service +/(2) search of and execution at best price >> investment advice -/VAULTS
Vaults automatically optimize the returns on the funds supplied to them. To do so, they plug into
multiple AMMs and lending protocols and move the funds wherever they generate the highest
returns.
Where AMMs and lending protocols issue tokens as incentive, vaults automatically sell and reinvest
them into the vault. One of the most prominent examples is yearn.finance.
Examplesyearn(Potentially) Regulated Activities(1) deposit of y LP token to vault  >> crypto asset exchange service in form of custody service /(2) allocation of crypto assets to pools with highest yield >> investment advice /-DERIVATIVES
Derivatives platforms allow users to speculate and hedge their positions. For efficiency and costreasons exchanges such as dydx use a hybrid off-chain/on-chain solution. The order book and ordermatching is performed off-chain while the margins paid by users of the platform are maintained by
the protocol on-chain.
The infrastructure most derivatives exchanges operate on, is similar to that of DEXes.
Examplesdydx(Potentially) Regulated Activities(3) order book/order matching >> financial instrument business operator license +/(4) deposit of margin to smart contract managing deposited funds >> crypto asset exchange service+/-CONTACTSo Saito
Partners.saito@innovationlaw.jp
Joerg Schmidt
Foreign Associatej.schmidt@innovationlaw.jp

DISCLAIMER
THIS DOCUMENT IS FOR GENERAL INFORMATION purposes only. It does not constitute legal advice;
thus, it may not be relied upon regarding a specific legal issue or problem. The projects mentioned
in this document are used for illustrative purposes only. Given the format of the document not all
details of the token design and underlying business model have been considered, so that the resultsof the assessment may deviate from the results by the regulator or a legal opinion prepared for therespective project.