South Korea can be considered one of the most active countries in the world in the field of cryptocurrency and blockchain. It has a large and vibrant crypto community with millions of users, investors, traders, and hundreds of startups, exchanges, and service providers. In terms of cryptocurrency adoption and trading, South Korea is also at the forefront.
However, like other regions, South Korea also faces many challenges and risks in the cryptocurrency field, such as hacking, fraud, money laundering, tax evasion, and market manipulation. These issues have prompted the South Korean government and regulatory agencies to take more proactive and stringent measures to regulate cryptocurrencies to protect users, the industry, and society from potential harm.
In March 2023, the National Assembly passed the "Virtual Asset User Protection Act," marking an important step towards establishing a legal framework for cryptocurrencies. The act defines virtual assets as digital assets that can be traded or transferred electronically and specifies the basic rights and obligations of users and service providers. It also empowers the Financial Services Commission (FSC), South Korea's primary financial regulatory authority, to oversee and regulate the cryptocurrency industry and issue detailed implementation rules and guidelines. The FSC has been dedicated to drafting and proposing various rules and regulations to complement the act and address specific and emerging issues in the cryptocurrency field.
However, due to the significant differences between cryptocurrencies and traditional assets in terms of issuance and market structure, existing regulations such as the Electronic Financial Transactions Act and the Capital Market Act have shown limitations in comprehensive cryptocurrency regulation. In particular, the decoupling of UST and the bankruptcy of FTX in 2022 have caused significant damage to the global cryptocurrency industry and increased calls for regulatory efforts to establish a secure and reliable system beyond specific countries. Therefore, countries such as the United States, the European Union, and Japan have recently accelerated the formulation of cryptocurrency-related regulations to strengthen investor protection.
In South Korea, the virtual asset regulatory framework began to take shape in 2021 and became more apparent in the following years. Currently, there are three key regulations related to virtual assets in South Korea: Security Token Guidelines, Mandatory Declaration of Virtual Assets by Senior Officials, and the Virtual Asset User Protection Act (Virtual Asset Act).
This article aims to explore the trend of WEB3 regulation in South Korea by introducing the legislative background, legislative content, and the current status of the three aforementioned regulations.
I. Security Token Guidelines
On February 5, 2023, the Financial Services Commission (FSC) issued guidelines for the issuance and circulation of security tokens, aiming to implement them by the second half of 2024.
1. Background
With the advancement of information and communication technology, there is an increasing emphasis in South Korea on the need to prevent existing regulations from hindering the development of emerging financial industries such as financial technology and blockchain. In response, the Financial Services Commission of South Korea implemented a financial regulatory sandbox system starting from April 2019 under the "Financial Innovation Support Special Act."
2. Content
(1) Definition
Security tokens are defined as "digitized securities using distributed ledger technology under the Capital Market Act." This analogy compares securities to food and their issuance form to containers, emphasizing that despite new "containers" or token forms, the nature of securities remains unchanged. Therefore, in addition to physical securities recorded on certificates and electronic securities registered in centralized accounts, securities tokens recorded on distributed ledgers will also be regulated under the Capital Market Act.
(2) Primary Market
An important aspect of the security token primary market is the introduction of an "issuer account manager," which can handle the issuance and registration of securities simultaneously. Under current law, when an issuer issues securities, the registration is done by account managers such as securities companies and banks at depository institutions. However, for tokenized securities, the issuer account manager can simultaneously execute issuance and registration, eliminating intermediate steps and aiming to simplify the securities issuance process.
To become an issuer account manager, one must meet the standards set by the FSC. Issuers who do not meet these standards will follow the traditional securities issuance structure, being solely responsible for issuance and completing registration through account managers.
(3) Secondary Market
The secondary market can be divided into the exchange market and over-the-counter (OTC) market.
Exchange Market: The Korea Exchange (KRX) introduced a digital securities market for trading non-conventional securities.
OTC: Establishing OTC brokers to allow retail investors to engage in bilateral over-the-counter trading.
Of particular note is the FSC's plan to differentiate authorized requirements for OTC intermediaries based on the type of securities in the over-the-counter market. This includes exemptions from sales disclosure and market supervision, effectively encouraging new entrants to engage in small-scale investments. This demonstrates an active approach to revitalizing non-conventional securities trading, which was previously outside the scope of existing distribution systems and market management.
3. Current Status
At the "Public Hearing on Electronic Securities and Capital Market Act Legislation" held on July 13, Representative Chang-Hyun Yoon of the People Power Party revealed amendments to regulations for security tokens. The amendment was proposed on July 28 and is planned to be reviewed by government and legal committees before being voted on in a plenary session of the National Assembly for final approval. However, as it has not been formally promulgated, details may change after further discussion. The current amendment was submitted to the Political Affairs Committee on November 15 and has passed the bill committee.
To formally legalize the security token guidelines, substantial amendments to the Electronic Securities Act and the Capital Market Act are required. The industry is widely discussing these two laws to promote the rapid and secure growth of the security token industry in South Korea.
Key aspects of the amendment to the Electronic Securities Act include recognizing blockchain electronic registration as an official ledger input method, granting it the same ownership transfer presumption as centralized electronic registration. Therefore, defining the scope of securities that can be registered using distributed ledger registration, specific requirements for distributed ledger as an input method, and management of personal information recorded on distributed ledgers are considered urgent tasks.
The amendment to the Capital Market Act aims to expand investor choices by allowing the circulation of non-conventional securities, which was previously unattainable due to investor protection issues. Therefore, discussions are actively underway regarding the authorization requirements for over-the-counter brokers, operational methods, and investment limits for general investors.
With the guidelines released in February and the amendments proposed in July, expectations for the South Korean security token market are growing. The South Korean securities industry is forming various security token alliances to gain a first-mover advantage. These alliances are voluntary organizations composed of securities companies, banks, and innovative financial services (sandbox) aimed at creating a security token ecosystem through specialized areas such as customer fund management and trading platform support.
KRX has also applied to designate the digital securities market for security token trading as a sandbox under the FSC. Il-Chan Ahn, the head of digital business at the Korea Exchange, expects that securities tokens worth over 30 billion Korean won will be freely traded by investors through securities companies without the need for separate dedicated accounts, similar to existing stocks. However, even after the establishment of the exchange market, it will take about six months from the start of trading to actual trading, as it needs to go through the same process as the current listed securities market, including preliminary review, submission of securities reports, public listing, and issuance procedures.
II. Mandatory Declaration of Virtual Assets by Senior Officials
The law named the "Senior Officials Virtual Asset Mandatory Declaration Act" (informally known as the "Kim Nam-guk Kim Prevention Act") was passed by the National Assembly on May 25, 2023, and came into effect on December 14 of the same year. Therefore, senior officials are now obligated to report any virtual assets held by themselves, spouses, and direct family members.
1. Background
On May 4, 2023, there were reports that Representative Kim Nam-guk (former Democratic Party member) held WEMIX worth 6 billion Korean won in his personal virtual asset wallet, which led to increased attention to this legislation. Subsequent scrutiny of unclear fund sources and transaction processes led to Kim being referred to the National Assembly Ethics Committee under the "Conflict of Interest Prevention Act." It was revealed that Kim had more assets than he had previously declared. This event sparked public demands for transparent reporting of virtual assets by senior officials, ultimately leading to the passage of this law.
2. Content
According to the revised Public Service Ethics Act, all members of the 21st National Assembly must voluntarily report the status of their acquisition and holding of virtual assets during their term from the start of their term (May 30, 2020) to May 31, 2023, including details of the services and transactions used under their names. This includes transaction dates, purchase prices, sale prices, transaction costs, and counterparties. The Anti-Corruption and Civil Rights Commission (ACRC) will collaborate with relevant departments such as the FSC and KRX, as well as virtual asset exchanges, to supervise this process and ensure the integrity of officials' asset declarations.
3. Current Status
The registration period for the status and changes of virtual assets held by senior officials began on June 15, 2023, and ended on June 30, 2023. According to the meeting of the National Assembly Ethics Consultation Committee on July 21, among the 299 members who submitted detailed information, 11, including Nam-Kuk Kim, have a history of holding virtual assets. However, these reports initially only covered assets held personally, and from 2024 onwards, virtual assets held by immediate family members and spouses will be mandatorily disclosed.
The Kim Nam-guk incident raised awareness and accelerated the legislation of the Public Service Ethics Act. As a result, the number of suspicious transaction reports submitted by virtual asset exchanges has increased. Under the current Reporting and Use of Specific Financial Transaction Information Act, exchanges are required to report suspicious transactions to the FSC Financial Intelligence Unit (FIU). As of September 2023, the number of such reports for the year has exceeded the total for 2022, indicating an increase after the implementation of the amended act.
Three, Virtual Asset User Protection Act
On June 30, 2023, the Virtual Asset User Protection Act was passed in the National Assembly and is expected to be implemented in July 2024. The enactment of this law aims to address the limitations of managing virtual assets solely based on existing laws, the Electronic Financial Transactions Act, and the Capital Market Act. In response to these limitations, especially after the Terra incident in 2022 highlighted the challenges in preventing unfair trading practices, the government listed the establishment of digital asset infrastructure and regulatory framework as one of the 120 national tasks in July 2022.
1. Background
Due to the inadequacy of the existing Electronic Financial Transactions Act and Capital Market Act in comprehensively managing virtual assets, the South Korean government introduced a reporting system for virtual asset service providers and various anti-money laundering and investor protection regulatory measures. In March 2021, an amendment to the Reporting and Use of Specific Financial Transaction Information Act was passed. However, this amendment primarily focused on anti-money laundering and faced difficulties in preventing unfair trading practices, as evidenced by the Terra incident in 2022.
Therefore, in July 2022, the government listed "35. Establishing digital asset infrastructure and regulatory framework (Financial Services Commission)" as one of the 120 national tasks and announced the formulation of the "Digital Asset Basic Act" (now the Virtual Asset Act) specifically for virtual assets.
Both the ruling and opposition parties in South Korea agreed to actively establish a minimum necessary regulatory framework for virtual assets and then gradually refine the details. The enactment of the Virtual Asset Act is the first phase of this regulatory policy, focusing on the most urgent aspects: investor protection and regulation of unfair trading practices across various sectors of the virtual asset industry.
2. Content
The Virtual Asset Act defines virtual assets and virtual asset service providers similar to the Reporting and Use of Specific Financial Transaction Information Act but excludes central bank digital currencies (CBDC) issued by the Bank of Korea from the category of virtual assets.
Virtual Assets: Electronic certificates with transferability and economic value, excluding game coins, electronic currencies, electronic registered stocks, etc.
Virtual Asset Service Providers: Operators of virtual asset trading, custody, wallet services, etc.
The first phase of the law focuses on protecting the assets of virtual asset users, regulating unfair trading, and strengthening the regulatory authority of financial regulatory agencies.
(1) Protection of User Assets
The law introduces specific provisions not found in the Reporting and Use of Specific Financial Transaction Information Act, such as detailed methods and measures to ensure the security of held virtual assets. Virtual asset service providers must keep user deposits separate from their own funds and maintain them with reputable institutions such as banks or trusts. Additionally, they must hold virtual assets of the same type and quantity as the deposited funds. Service providers are also required to store a certain proportion of deposits in cold wallets, which are disconnected from the internet to protect users' assets from hacking risks. They must also purchase insurance or reserves to address events such as hacking attacks or system failures and retain transaction records for 15 years after the transaction is completed.
(2) Regulation of Unfair Trading Practices
The first phase of the Virtual Asset Act includes and regulates the following five unfair trading practices:
- Use of undisclosed information: Prohibits trading activities using information that has a significant impact on investment decisions before disclosure to the public.
- Market manipulation: Prohibits all forms of trade-based market manipulation, including order matching, manipulation of trades, and actual trades.
- Fraud and deceptive trading: Prohibits transactions involving false input of important details, false pricing, or the use of dishonest means.
- Trading of virtual assets issued by oneself or affiliates: Learning from the FTX incident, prohibits trading of virtual assets issued by oneself or affiliates, with specific exceptions.
- Arbitrary blocking of deposits and withdrawals: Prohibits unfairly blocking deposits and withdrawals and requires timely notification to users for any unavoidable reasons, as well as reporting to the Financial Services Commission.
*Specific exception: Virtual assets issued as a means of payment for specific goods or services, where virtual asset service providers provide specific goods or services to users and receive virtual assets in return (Article 10, Paragraph 5, Item 1).
In addition, virtual asset exchanges and other market operators must monitor and report any abnormal transactions indicating significant changes in asset prices or trading volumes to protect users. Therefore, by July 2024, exchanges must develop systems to monitor these transactions and have the resources to carry out related tasks.
(3) Increase in Regulatory Authority
The law also clarifies and strengthens the regulatory authority of financial regulatory agencies to prevent unfair practices and lay the foundation for smooth enforcement. The FSC has the existing authority to request various documents, statements, and witness appearances from virtual asset service providers when necessary. The new provisions also allow for recommendations of dismissal, suspension, or service suspension for employees of service providers who violate these regulations.
Furthermore, sanctions for engaging in prohibited activities have been significantly increased. Criminal penalties include a minimum of one year of imprisonment or a fine of three to five times the illegal profit. In addition, administrative fines equivalent to twice the amount of avoided losses have been introduced, and collective lawsuits for damages have been stipulated.
3. Current Status
On December 11, the FSC issued legislative notices on the implementation order and regulatory provisions of the first phase of the Virtual Asset Act, detailing the content of the first phase of the Virtual Asset Act, which will be implemented on July 19, 2024. This implementation order is significant as it specifies the detailed content of the first phase of the Virtual Asset Act. The current Virtual Asset Act lacks regulatory guidelines.
The implementation order of the Virtual Asset Act includes additional exclusions for virtual assets, specifies the proportion of storage in cold wallets, and defines undisclosed information, directly affecting virtual asset service providers and investors.
In particular, the "User Deposit Management Institution Management Regulations" stipulate that only banks can manage user deposits. It further requires virtual asset service providers to substantially hold virtual assets of the same type and quantity as the deposits, making it nearly impossible for third parties to manage or operate custody and operation businesses in South Korea.
The Financial Supervisory Service (FSS) announced the establishment of a dedicated virtual asset agency, indicating strengthened reporting and inspection processes for virtual asset service providers. The Digital Asset Research Group, responsible for legislative support and market monitoring, will be divided into the "Virtual Asset Regulatory Bureau" and the "Virtual Asset Investigation Bureau." The Regulatory Bureau is a comprehensive department for managing and supervising service providers, while the Investigation Bureau is responsible for investigating unfair trading practices. The aim is to prevent money laundering through virtual assets, strengthen user protection, and rigorously restructure the existing review process for virtual asset service providers.
Four, Travel Rule
1. Background and Content
The Travel Rule originally referred to the requirement for financial institutions to record remitter information in the format required by the Society for Worldwide Interbank Financial Telecommunication (SWIFT) when conducting international transfers. However, as virtual assets increasingly become a global money laundering issue, the Financial Action Task Force (FATF) proposed in 2019 to expand the application of the Travel Rule to virtual assets, urging countries worldwide to apply it to their virtual asset service providers.
According to the Reporting and Use of Specific Financial Transaction Information Act, South Korea became the first country to implement the Travel Rule in virtual asset transactions on March 25, 2022. The regulation stipulates that when a virtual asset service provider transfers virtual assets worth more than 1 million Korean won, the sending service provider must provide and store relevant information for the recipient.
However, the current transfer rule only applies to transfers between domestic virtual asset service providers. The four major exchanges in South Korea (Upbit, Bithumb, Coinone, Korbit) are using solutions such as VerifyVASP (Upbit) and Code (Bithumb, Coinone, Korbit) to comply with this rule. However, transfers between domestic exchanges and foreign exchanges or individual wallets are not covered by this regulation. As a result, exchanges are following the FSC's guidelines and adopting a whitelist approach on their own.
2. Travel Rule in 2024
On June 27, the FATF issued a report titled "Virtual Assets: Targeted Update on the Implementation of FATF Virtual Asset and Virtual Asset Service Provider Standards," announcing ongoing monitoring of criminal activity routes related to DeFi and private wallets as part of the FATF. Additionally, the EU has been regulating individual wallets under the Markets in Crypto-Assets (MiCA) since June 2022, regardless of whether the transfers are domestic or international.
As South Korea was the first country to implement the Travel Rule globally, the current Reporting and Use of Specific Financial Transaction Information Act does not reflect the FATF's revised recommendations for the Travel Rule. This has led to some identified issues, such as the limited applicability of the rule to domestic exchanges and a lack of consistency with international regulations, thereby restricting transaction transparency. There are calls for continuous revisions to the Travel Rule in line with international trends, especially as the virtual asset industry is not bound by national borders, making the "sunrise issue" (regulatory differences between countries) more apparent. By 2024, there is an increasing need to expand the scope of regulation to include not only transfers between exchanges but also individual wallets, and the industry is intensifying efforts to address this demand.
For example, on November 29, the multi-chain infrastructure provider PiLab (operator of Bifrost), the Korea Information Certificate Authority (KICA), and the Travel Rule solution provider CODE signed a memorandum of understanding to develop and deploy Web3 KYC services. Since October 2022, Bifrost has been collaborating with KICA to develop a KYC solution for individual wallets and plans to expand the current Travel Rule KYC application scope conducted by virtual asset service providers to individual wallets.
Five, Conclusion
In 2023, the virtual asset industry in South Korea laid the foundation for capital market flexibility through the implementation of security token guidelines, built market trust and integrity through the mandatory reporting of virtual assets by senior officials, and prepared a solid foundation. The enactment of the Virtual Asset Act laid the groundwork for the industry to become a legitimate sector, with a focus on strengthening investor protection. Additionally, plans to introduce virtual asset-related accounting standards aim to address accounting uncertainties faced by companies holding virtual assets.
Since 2022, there has been an increasing recognition of the necessity for comprehensive regulation of virtual assets by the government, and 2023 was a year that laid the foundation for such regulation. It is expected that these fundamental measures will be fully implemented in 2024. In South Korea, the planned execution of key legislation, especially the first phase of the Virtual Asset Act and the revision of security tokens, has garnered significant attention in the regulatory landscape. The significance of the latter is particularly noteworthy, as it is expected to provide a channel for traditional financial institutions such as securities firms and banks to enter the virtual asset industry, marking a significant convergence between traditional finance and the emerging virtual asset sector.
The new rules proposed by the Financial Services Commission are a positive and necessary step for the cryptocurrency industry and society in South Korea, as they aim to provide a more robust and comprehensive regulatory framework to balance the interests and needs of users, service providers, and regulatory authorities. The new rules can also enhance the credibility and legitimacy of the cryptocurrency industry and promote its development and innovation by aligning with global standards and trends.
However, the public remains largely cautious, and many industry insiders also believe that the new rules are still not comprehensive enough, as they leave some gaps and uncertainties in the cryptocurrency field, especially in emerging formats such as NFTs, DeFi, and the metaverse. These areas require more attention and research, as they have the potential to change and disrupt various fields such as culture, entertainment, education, healthcare, and governance.
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