November 9, 2023
DeFi and the Law – LIDO and Liquid Staking under Japanese Law
So Saito
Shinpei Asano
So & Sato Law Offices
This article describes the structure of and applicable Japanese law to liquid staking, which
has been expanding rapidly in recent years, and its most significant protocol, LIDO.
I. A Summary of Legal Analysis(1) To analyze liquid staking, it is generally necessary to consider (1) the sales, purchase,and exchange regulations of the Payment Services Act (We call crypto regulation in thePayment Services Act the "Crypto Assets Act" after this), (2) the custody regulationsof the Crypto Assets Act, and (3) the fund regulations of the Financial Instruments andExchange Act, which is a kind of Japanese Security Act (the “FIEA”).
(2) For staking, LIDO accepts staking of ETH and issues stETH in exchange for staked
ETH. We believe that this conduct is not considered as "sales, purchase, or exchange ofcrypto asset" in the terms of the Crypto Assets Act. We believe stETH is just issued as
proof of staking and not "exchange" under the Japanese Civil Code.
(3) If the staking of ETH is considered a custody of crypto assets, the custody regulation of
the Crypto Assets Act may apply. However, if the deposit is made against a smart
contract and the protocol or node operator is technically incapable of transferring theETH, etc., the custody regulation does not apply.
(4) The most controversial question should be whether the fund regulations of the FIEA
would apply to liquid staking. LIDO's mechanism might be considered as a fundbecause (i) ETH, etc., is contributed to the protocol by a user of LIDO, (ii) the nodeoperator manages it, (iii) a portion of the staking fee is distributed to the user, (iv) theuser seems to bear the penalty risk and thrashing risk of the staking, and (v) thismechanism seems to like a fund. However, we believe that we can argue that the fundregulation will not apply to LIDO because (i) staked ETH itself is not converted toanything, (ii) it is used for just a kind of collateral to compensation to penalty/slashing,and (iii)we can argue this mechanism is entirely different from usual funds.
(5) In addition to the above, we can argue that the Japanese financial regulation might not
apply to DeFi if there is no “operator” because Japanese law just regulates persons andlegal persons. However, this argument needs an actual fact analysis of the relevant
liquid staking. Further, this argument cannot apply to a person or legal entity, if any,
who intermediate Japanese residents to DeFi. Thus, the arguments from (1) to (4)1above are important.
II Basic Overview of Liquid Staking, ETH Staking, and LIDO
1 Liquid Staking
Liquid staking is a DeFi (decentralized finance) mechanism whereby a person receives astaking fee for a crypto asset while receiving an additional alternative asset (a staking-prooftoken) and can invest said alternative asset in another DeFi.
2 Proof of Stake and Staking
Proof of Stake (POS) is the authentication mechanism of the blockchain by a person who
has a certain level of involvement (stake) in the crypto asset.
Unlike the Proof of Work (POW) mechanism used in Bitcoin and other cryptocurrencies,
authentication can be performed without requiring a large amount of calculations, thus
reducing electricity consumption and making it more environmentally friendly.
3 ETH Staking
Ethereum has been structured using POS instead of POW from ETH 2.0. In Ethereum
staking, (1) you can become a validator by depositing 32 ETH, (2) the validator authenticateseach transaction on Ethereum and thereby receives a certain amount of ETH as a reward, and(3) if the validator intentionally provides false information, he/she will be penalized byforfeiting a part of the deposited ETH (thrashing), (4) a validator is always required to beonline, and if they are down, they will also be penalized to a certain extent.
4 How LIDO Works
LIDO is the world's largest protocol for Liquid Staking. At present, it is estimated that morethan 30% of the staking volume of Ethereum is done via LIDO.
LIDO is supposed to work as follows:1 .

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Although this article will focus on ETH staking, LIDO supports Polygon and Solana staking in addition toEthereum as of today.

2Prepared by So&Sato Law Offices from published materials① LIDO allows users to stake ETH without maintaining their staking infrastructure andwithout economically locking up their assets.
② When a user wants to stake ETH to LIDO, the user should send ETH to LIDO's smart
contract. In response, the user receives a 1:1 token called stETH.
③ stETH is a token that represents the deposit of ETH to LIDO for staking, and when a usersends stETH to LIDO to burn stETH, the user will receive ETH. stETH can be freelybought and sold, and if there is another DeFi that accepts stETH, the user can earn double
rewards by using stETH on another DeFi (however, DeFi protocols that accept stETH
still seem to be limited).
④ LIDO will use ETH received through the smart contract to perform staking. LIDO will
receive 10% of the reward obtained from staking, which will be distributed to the person
in charge of the staking (node operator) and the LIDO DAO. The remaining 90% will bedistributed to the users. The distribution to the users is made by adding the number ofstETH in the address of stETH, and the number of ETH managed by LIDO is always thesame as the number of stETH.
⑤ LIDO uses multiple node operators. Node operator candidates apply to LIDO, statingthat they wish to become node operators, their experience and technical capabilities, etc.,
and are then voted on by the DAO, which is composed of LIDO token holders, the LIDO's
governance tokens, to determine whether they are eligible to become node operators.
⑥ Note that ETH has thrashing risks and penalties. LIDO hedges against such risks by usinga large number of node operators. LIDO also manages some ETH separately and uses it
as insurance against thrashing risk.
⑦ LIDO is an open-source, peer-to-peer protocol and is not operated by a single operator,3etc., as the LIDO DAO makes the decision on its operation.
III Liquid Staking and Japanese Law
When offering liquid staking like LIDO, it is necessary to consider whether the trading andcustody regulations of the Crypto Assets Act apply and whether the fund regulations of theFIEA apply.
1 Regulation of the Issuance of Crypto Assets
When a user contributes ETH to LIDO, the user will receive stETH, and conversely, whena user sends stETH to LIDO, the user will receive ETH.
The question arises as to whether this action constitutes an exchange of ETH for stETH. If
it is considered an exchange of crypto assets, the regulations of the crypto asset exchange
services might apply.
StETH, however, is issued to prove the deposit of ETH, and we believe the issuance of such
stETH does not constitute a sale or exchange under civil law and thus does not constitute anexchange of crypto assets (and vice versa).
2 Custody Regulation of Crypto Assets
The contribution of ETH to LIDO might be considered a deposit of crypto assets to LIDO
and raises the issue of whether the custody regulations of the Crypto Assets Act apply to LIDO.
However, it appears that the contribution to LIDO is a contribution to a smart contract,and LIDO cannot use said ETH except for staking (i.e., it does not control the private key)
due to the structure of the smart contract.
Under the Japanese custody regulations, "If a business operator does not possess any of theprivate keys necessary to transfer the crypto assets of a user, the business operator is notconsidered to be in a position to proactively transfer the crypto assets of the user. In such case,the business operator is basically not considered to fall under the category of "managing crypto
assets for others" as defined in Article 2.7.4 of the Payment Services Act. (Result of Public
Comment No. 9 on the Draft Cabinet Order and Cabinet Office Ordinance Concerning
Amendment to the Payment Services Act, etc. of 2019). If the smart contracts can technically
prevent the free transfer of ETH by people related to LIDO, we believe LIDO is notconsidered to be subject to the custody regulations under the Crypto Assets Act.
3 FIEA Regulations
The question arises whether LIDO or liquid staking is considered a fund (collective4investment scheme), given the mechanism of receiving ETH contributions, the node operator
managing it, distributing a portion of staking fees to users, and users bearing the risk ofthrashing and other penalty risks.
The definition of a fund under Japanese law is generally as follows (Article 2, Paragraph 2,Items 5 and 6 of the FIEA). If a fund investor's right is tokenized, the tokens are consideredelectronically recorded transferable rights (Article 2, Paragraph 3, Pillar 1 of the same law).
If the issuer itself is offering or private offering the tokens, registration as a Type 2 Financial
Instruments Business is required (Article 2, Paragraph 8, Item 7, (g), Article 28, Paragraph 2,
Item 1, and Article 29 of the same law, Article 1-9-2, Item 2 of the Order for Enforcement ofthe FIEA), and if the third party is offering or private offering the tokens, registration as a
Type 1 Financial Instruments Business is required (Article 28, Paragraph 1, Item 1 and Article
29 of the FIEA).
Definition of the Funds under Japanese law(A) (i) partnership contracts, (ii) silent partnership agreements, (iii) limited partnershipagreements for investment, (iv) limited liability partnership agreements, (v) membershiprights in incorporated associations, and (vi) other rights (excluding those under foreignlaws and regulations).
(B) The Investor(s) receives the right to receive dividends of income or distribution ofproperties that arise from a business conducted by using money (including crypto assets)
invested or contributed by the investor(s).
(C) None of the following(a) the case where all of the investors are involved in the business subject to the investment(in the way specified by a Cabinet Order)(b) the case where the investor(s) shall not receive dividends or principal redemption
more than their investment
Funds under Foreign Law(D) Rights under foreign laws that are similar to the above rights.
The concept of "other rights" in (A) above is very broad, and it is said that (i) through (v)are merely an enumeration of examples, regardless of the legal form. It can be argued thattokens issued in fully decentralized finance are not "rights" because they are not considered"rights" in the usual legal interpretation, but there is currently a prevailing view that some5rights are recognized for Bitcoin, etc.2, and in relation to this article, we assume that somekind of right is recognized even for smart contracts.
Nor does it fall under any of the exceptions in (C) above.
The main issue is the interpretation of (B) above, which states "dividends of income or
distribution of properties that arise from a business conducted by using money" and "invested
or contributed." If we simply take the point that ETH is sent to the smart contract, it is usedin the business of the POS, and the award from staking ETH is distributed to users, it would
seem to satisfy both the "dividends of income or distribution of properties that arise from abusiness conducted by using money," and "invested or contributed” requirement.
However, liquid staking is very different from ordinary funds in the following respects, and,arguably, liquid staking is not a fund to which the FIEA applies.
(1) In the case of a regular fund, the money and other assets contributed are fully owned by
the fund operator, and the fund operator can technically use them in various ways,
although they are contractually bound. In the case of liquid staking, the ETH contribution
is made to the smart contract, and LIDO or node operators are not free to use it;ownership (ownership-like rights) over ETH is always considered to be held by the user,(2) In the case of a regular fund, the money received is used to purchase shares, fund abusiness, etc., and changes from money to shares, etc. In LIDO staking, the ETH sent tothe smart contract is not specifically changed into anything else but is maintained as it is.
(3) The only reason ETH is locked is to ensure that there is no thrashing in the event offraudulent reporting in the validation process or penalties if a node goes offline.
(4) Based on (1) through (3) above, if we compare the legal nature of staking to a traditional
economic act, it can be thought that the user is merely locking ETH into a smart contract
as a kind of collateral to secure default liability and is merely receiving compensation forproviding third party collateral. The provision of such collateral and the receipt ofcompensation do not satisfy the requirements of "dividends of income or distribution ofproperties that arise from a business conducted by using money" and "invested orcontributed," as referred to in the fund.
4 Argument that the Operator Does Not Exist and Therefore Is Not Subject to Regulation

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There is some argument as to whether Bitcoin, a crypto asset with no issuer, is a "right" or not as follows:(a) it is not a right; (b) it is a real right or something similar; (c) it is a property right; and (d) it is a rightbased on an agreement (consent) to the program code, or some other right similar to ownership (AkiraKamo, "The Legal Nature of Virtual Currency under Private Law: The Bitcoin Program Code and Its LegalEvaluation," p. 16). Note that perhaps to avoid such arguments, the definition of crypto assets under thePayment Services Act uses the term "property value" rather than the term "rights."

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In the case of DeFi, it could be argued that the operator does not exist in the first place andis not subject to regulation. Japanese law is a legal system that regulates persons and legal
entities, such as operators. A completely decentralized financing scheme would not be subject
to regulation. However, we need to carefully consider whether there really is no operator forDeFi. In general, DeFi aims for the operator to be non-existent, but even so, it is unclear
whether many DeFi are truly completely operatorless.
Further, if the scheme is subject to financial regulations under the law, assuming there is anoperator, the intermediary for the scheme could be subject to regulations even if there is nooperator for DeFi itself. It would prevent, for example, an unlicensed Japanese company fromsending customers to the DeFi.
Therefore, when examining the legal issues of DeFi, it is necessary to consider two issues:(i) if there is an operator, whether it is subject to legal regulation, and (ii) whether an operator
exists.
However, it is unclear from the published documents whether the LIDO DAO is truly
decentralized, so this article mainly discusses (i) above.
Disclaimer
The content of this article has not been confirmed by the relevant authorities or organizations
mentioned in the article but merely reflects a reasonable interpretation of their statements.
The interpretation of the laws and regulations reflects our current understanding and may,therefore, change in the future. This article does not recommend the investment in LIDO orliquid staking. This article provides merely a summary for discussion purposes. If you needlegal advice on a specific topic, please feel free to contact us.

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