This article is written by Vasu Manchanda and Kshitij Dahiya, students of Faculty of Law, Delhi University.

“There are three eras of currency: Commodity based, politically based, and now, math-based.”

– Chris Dixon

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Introduction

Virtual Currency (“VC”) is basically a type of unregulated digital currency, available only in electronic form. According to a report titled “Virtual Currencies-Key Definitions and Potential AML/CFT Risks” issued by the Financial Action Task Force (“FATF”) in 2014 [1], it is defined as a digital representation of the value that can be traded digitally and functioning as a unit of account, store of value, and/or a medium of exchange, but without having a legal tender status. [2] 

It fulfils the aforementioned functions only by an agreement with the users and is not issued by any jurisdiction. It is stored and transacted over secure and designated software through digital wallets on a computer or mobile phone application. Transactions occur over the internet through dedicated and secure networks. Further, it is considered to be a part of digital currency groups which also includes cryptocurrencies. 

According to the same report issued by FATF, cryptocurrency is defined as a math-based, decentralised convertible VC that is protected by cryptography, by relying on private and public keys, in order to transfer value from one user to another. It is signed cryptographically each time it is transferred. [3] The defining elements of cryptocurrency are as follows:

• Transaction anonymously takes place between public keys that are uniquely assigned to every participant. Thus, the identities of the participants remain cryptic;
• Participants have access to an unalterable record of transactions carried on the network;
• There is no centralised control and;
• The value is solely dependent on market sentiments. There is no underlying asset.

How does Cryptocurrency work?

Several cryptocurrency exchanges exist from where the users can buy and sell cryptocurrencies for Dollars, Euros, etc. It is then kept in the digital wallets on a computer or mobile phone. Through the digital wallets, their transaction can be done by the users for buying any commodity available on platforms that accept cryptocurrencies as a medium of exchange. 

The network is further secured by individuals known as ‘Miners’ who verify transactions and are rewarded newly generated cryptocurrencies in return. After being verified, they are recorded in a transparent public ledger that is easily accessible to participants.

An important judgment delivered by the Supreme Court of India (“Supreme Court”) in the case of Internet and Mobile Association of India v. Reserve Bank of India [4], that can shape the future of cryptocurrencies and have a revolutionary impact on the crypto industry in India, is analysed as follows. 

Case overview

The advent of bitcoin in India led to the setting up of various cryptocurrency exchanges which were majorly operating without any laws or regulations prohibiting or regulating their use. However, on April 6, 2018, Reserve Bank of India (“RBI”) issued a circular not prohibiting the use of cryptocurrencies itself but prohibiting banks and financial institutions regulated by RBI from dealing in or providing services for facilitating any artificial legal entity or individual dealing in cryptocurrencies such as bitcoin, libra, etc. 

Thereafter, on March 4, 2020, the Supreme Court quashed the said circular on the ground of proportionality and held it to be a disproportionate regulatory action. The three-judge bench held that the virtual currencies should be subject to regulation instead of blanket prohibition, under the Indian law.

Issues

Three broad and major issues about the regulation or prohibition of cryptocurrencies addressed by the Supreme Court, in this case, are as follows:

• Whether the RBI has the capacity to regulate matters pertaining to VCs?
• Whether VCs amounted to money?
• Whether the circular issued was within the purview of the power of RBI?

Contentions

The petitioners (Cryptocurrency exchanges Koinex, CoinDCX, Throughbit, and CoinDelta) raised the following major contentions challenging the RBI’s circular. They contended that:

• The RBI exceeded its power granted under the Banking Regulation Act, 1948, Payment and Settlement Systems Act, 2007, and the Reserve Bank of India Act, 1934, to issue the circular, as VCs were not subject to the above-mentioned acts and regulations.
• The legal character of VCs is not the same as money or other legal tenders as they neither have the same degree of acceptance to function as an acceptable medium of exchange nor can they be utilised to settle a debt. It is rather a good or tradable commodity. Thus, RBI had no role in regulating or prohibiting it.
• Even if it is to be assumed that the RBI had the powers to regulate virtual currencies; still they cannot prohibit banks and other financial institutions from dealing in them altogether.
• What RBI could not do directly, it did indirectly, i.e. “colourable exercise of power”. The indirect effect of the circular was shutting down of VC exchanges; something that RBI had already admitted was beyond the scope of its powers.
• The approach of RBI was not in synchronization with that of other regulators under whose purview, the subject matter rested. Money laundering came under the purview of the Department of Economic Affairs, and evasion of tax comes under the purview of the Central Board of Direct Taxes. None of these regulators asked for a complete ban on VCs initially.
• Other jurisdictions, especially the non-authoritarian ones, had adopted measures to regulate VCs instead of banning them outrightly.
• When proper safeguards such as anti-money laundering practices, Know Your Customer (KYC) measures, etc had already been adopted by the VC exchanges, there was no need to prohibit banks and other financial entities regulated by RBI from dealing in them.
• The fundamental right of the petitioners guaranteed under Article 19(1)(g) of the Constitution to carry on occupation, business or trade is violated.
• RBI exercised its power to issue a circular, guaranteed to it under a statute that cannot be equated with the same judicial acceptance as is given to executive or legislative action.

RBI contended that:

1. It derived its power from the Banking Regulation Act, 1948, Payment and Settlement Systems Act, 2007, and Reserve Bank of India Act, 1934, to issue the circular.
2. It was not a decision made in haste. Rather it was a proportionate response to the perils posed by VCs.
3. VCs were being used in a manner similar to the legal currency of the country in purchasing products available on Amazon.
4. There was a possibility to remit money abroad without the supervision of regulators.
5. It had the inherent duty to protect the payment system of the country from being compromised.
6. The fiscal and economic policies enunciated by RBI had the statutory force of law, and should not be interfered with by the courts.
7. It submitted extensive literature on VCs on which it relied on issuing the circular.

Observations and Decision

The Supreme Court refuted the first contention raised by the petitioners and held that the VCs are competent in performing almost all the functions of real currency and constitute a digital representation of value. They are competent to function as a unit of account, a store of value, and/or a medium of exchange. 

Thus, irrespective of the fact that VCs are not legal tender and do not form a part of the payment system, RBI still has the power to regulate them as they affect the financial system of the country. And, anything that has an impact or poses a threat to the financial system can be regulated or prohibited by RBI.

The Supreme Court observed that RBI through the circular did not impose a blanket ban on all trade in VCs but only directed banks and other legal entities that are regulated by RBI to not provide services to any artificial legal entity or individual dealing in or settling VCs. Thus, it can be inferred that the citizens who had taken up the trade of dealing in VCs were not prohibited from using cryptocurrencies stored in their digital wallets in making payments for purchasing commodities. 

Thus, though the circular had a crippling effect on the trade of VCs it could not be equated with a blanket ban. It was further observed that RBI had not made a decision overnight and had applied its mind after taking financial stability reports, and the Inter Regulatory Working group’s report on Fintech and Digital Banking, 2017 into consideration.

The contention of the petitioners alleging RBI of indulging in “colourable exercise of power” that resulted in collateral damages suffered by VC exchanges was also refuted. It was held that the decision of RBI was motivated by the need to protect the public interest and it had exercised its power over the legal entities it had jurisdiction over.

Furthermore, concerning other regulators, it was observed by the Supreme Court that every regulator, agency or department has a different function to perform. Thus, it was observed that RBI cannot be held wrong for adopting a different approach from other regulators. 

Similarly, with respect to comparative analysis with other jurisdictions, the Supreme Court held that the approach adopted by other jurisdictions, especially more developed ones, only had persuasive efficacy and could not direct what the RBI could or could not do.

However, having answered the first two issues in affirmative, it was whilst addressing the third issue that the test of proportionality was applied by the Supreme Court. Regarding the contention of the petitioners of their right to trade under Article 19(1)(g) of the Constitution, the Supreme Court held that VC exchanges that provide services such as buying, selling and storing of VCs in digital wallets were dearly affected as they would not be able to survive without having to access the banking channels. 

Thus, petitioners’ right to trade guaranteed under Article 19(1)(g) of the Constitution was infringed. However, as it is well-established that any restriction on trade needs to pass the test of reasonableness; similarly, RBI had to pass the test of proportionality to justify its action. The doctrine of proportionality relies on the following factors:

• There are no less invasive measures;
• Measures adopted are connected to the fulfilment of the intended purpose;
• There is a relation between the need for achieving the required objective and restricting the right, and;
• The measure adopted is designated for the intended purpose.

The Supreme Court held that there were less invasive means of achieving the same objective that was not considered by RBI at the time of issuing the circular, and it failed to provide data showing any resemblance of damage suffered by the financial entities regulated by it. Further, as per the proposals made by the European Parliament, and Crypto-Regulation Bill 2018, blanket ban on VCs was not advocated. 

Rather, the functioning of VCs was suggested to be brought within the purview of regulation. Thus, it was held that the circular could not be termed as a proper measure as it was adjudged to have failed the test of proportionality. Hence, it was quashed.

Impact of the judgment on the crypto industry

The Supreme Court’s decision might just be an interim respite to the crypto industry in India rather than a full-fledged relief. As of today, the banks and financial entities cannot deny providing services to VC exchanges. VC exchanges have regulatory approval to access banking and other allied banking services. Hence helping them facilitate the demand for VCs and attract foreign investments. However, it is pertinent to note that nothing has been said by the Supreme Court regarding the regulation of trade in cryptocurrencies. The lack of regulation remains a major constraint to the proliferation of VC ventures in India.

There is a possibility that the government because of the judgment might reconsider its latest draft bill on cryptocurrencies entitled “Banning of Cryptocurrency and Regulation of Official Digital Currency Bill, 2019” which seeks a ban on VCs. If such a law is enacted, it would disseminate the budding crypto industry in India which would also have an adverse impact on the fintech sector. RBI is even capable of issuing a new circular which does not violate the Supreme Court’s decision, on the premise that a new position of harm has been found while dealing with VCs.

However, the judgment would give impetus not only to the VCs rather related to blockchain technology and the entire crypto ecosystem as well. For instance, the Global decentralized cryptocurrency exchange Finance Group has formed a $50 million blockchain technology fund for the Indian market, within days after the judgment was pronounced. [5] On the administration front, ongoing state government initiatives like the Blockchain District by Telangana State Government and the 100 Smart Cities Mission of India will also get a stimulus. [6]

Further, despite the Supreme Court’s decision, an increase in investment by the investors and users is unlikely as the price of bitcoin has fallen drastically from its December 2017 peak and the global cryptocurrency market lost more than $50 billion over fears of recession due to the Coronavirus outbreak, owing to its inherently speculative and volatile nature. [7]

Suggestions and way forward

There needs to be a retrospective analysis by the government on the findings of two of its committees with one (Crypto Regulation bill, 2018) seeking to regulate VCs and the other (Banning of Cryptocurrency and Regulation of Official Digital Currency Bill, 2019) seeking to ban it. The government rather than banning it to curb the mischief of money laundering, KYC process, and other related issues should instead calibrate growth, innovation and risk involved to avoid the creation of underground channels and provide regulatory mechanisms for the same. In this regard, the following suggestions are made:

• The government should place VCs under the exclusive umbrella of RBI to ensure that there is clarity in provisions for the regulation of VCs.
• The government should set up an advisory council consisting of lawmakers, regulators, service providers, national and international crypto operators who would formulate policies and advise on intricate issues pertaining to cryptocurrencies. [8]
• The Income-tax department must issue guidelines on how to tax VCs differently based on the function exercised by the user. It can be held as stock-in-trade being transferred. It can act as consideration on the sale of goods and services and as an investment being transferred in exchange for real currency. For instance, if it is a self-generated capital asset in the form of mining then it would fall under Section 55 of the Income-tax Act, 1961, which is completely silent on the issue since the cost of acquisition of a VC cannot be determined yet. [9]
• The government should set up a government-backed VC exchange. This would give rise to a Public-Private Partnership model striking the chord of compliance and privity of transactions between users. This would also ensure the necessary KYC process compliance by the regulator to its required standard and give the users the concurrence of privacy of their transactions. This move could also give confidence to domestic and foreign investors who are still wary of the government’s decision. 
• The Deposit Insurance and Credit Guarantee Corporation (DICGC) is a wholly-owned subsidiary of RBI which insures bank deposits up to Rs. Five Lakhs in case a bank fails, similarly, mandatory provision can be imposed upon VCs, once it manifests into a widely accepted form of investment and exchange. A materiality threshold for the same should be configured by the government, to ensure stability. The materiality threshold must be commensurate to the value of the market and updated from time to time.
• Like China is planning to launch a sovereign cryptocurrency- the Digital Currency Electronic Payment (DCEP) as an alternative to the US dollar as a reserve currency. [10] Probably India could have its sovereign cryptocurrency too. This would solve many problems such as control over the supply of cash by the Central bank, tracking the currency, and would also avoid the creation of a parallel economy.
• VCs should be included in RBI’s sandbox to facilitate ideas for Research and Development.
• Capital gain and loss on liquidation of VCs need to be assessed by the authorities.
• Either adequate amendment needs to be made to the Indian Contract Act, 1872, Sale of Goods Act, 1930, the Indian Evidence Act, 1872, Securities Contracts (Regulation) Act, 1956, Payment and Settlement Systems Act, 2007 and all others that regulate contractual obligations of the parties, or new act on VCs should be legislated.
• The jurisdiction in case of cross country disputes needs to be ascertained because presently all the VCs are being developed by companies like Facebook, JP Morgan, etc that are global in nature.
• Provisions need to be made to assess the impact of the valuation of VCs globally on the domestic crypto industry.
• The legislature should delve into the possibility of VCs being transacted as shares.
• There should be mandatory registration of miners with RBI and periodical declaration of VC obtained through mining to Income Tax authority or the authority concerned.
• The Personal Data Protection Bill, 2019 needs to take into its ambit the data of the users stored by VC exchanges or on the public ledger. Laws to be legislated for data processors and social media intermediaries should also apply to VC exchanges registered in India.
• The applicability of the existing inheritance laws in India on the VC stock held by individuals also needs to be taken into consideration by the policymakers. 

Conclusion

The Supreme Court’s decision has only provided a temporary respite to the nascent cryptocurrency industry in India. It has not deliberated on the issue of its legality as it was never in question. It was clear in the judgement that since the legislature had not yet passed the draft bill and no actual damage had been suffered by the financial entities regulated by RBI, thus, the ban was unreasonable. However, there is no denying the fact that the risks identified by RBI of anonymity, money laundering, the complexity of the KYC process, and the need for protection of users and investors persist. 

Thus, a sound regulatory framework incorporating all stakeholders, and striking the equilibrium of protection of user’s interests as well as market sentiments must be introduced. The government instead of eliminating the future of the fintech industry must capitalise on the opportunity while ensuring the safety of the financial and payments system of the country.

References

[1] Writ Petition (Civil) No. 528 of 2018

[2] Financial Action Task Force, “Virtual Currencies- Key Definitions and Potential AML/CFT Risks” (June 2014)

[3] Ibid

[4] Writ Petition (Civil) No. 528 of 2018

[5] Aditi Shrivastava, “Cryptocurrency exchange Binance sets up $50 million Indian blockchain fund”, ET Rise, March 17, 2020, available at https://economictimes.indiatimes.com/small-biz/startups/newsbuzz/cryptocurrency-exchange-binance-sets-up-50-million-indian-blockchain-fund/articleshow/74665232.cms (last visited on April 1, 2020)

[6] inc42, available at https://inc42.com/buzz/telangana-aims-to-be-indias-blockchain-capital-with-new-incubators/ (last visited on April 1, 2020)

[7] Supra note 4

[8] Yahoo! Finance, available at https://finance.yahoo.com/news/cryptocurrencies-got-life-india-policymakers-052147742.html (last visited on April 1, 2020)

[9] Clear tax, available at https://cleartax.in/s/bitcoins-taxes-india (last visited on April 1, 2020)

[10] Barclay Bam, “Inside China’s Mission to create an all-powerful cryptocurrency”, Wired, February 4, 2020, available at https://www.wired.co.uk/article/china-digital-currency-crypto (last visited on April 1, 2020)

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