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This article is written by Ms. Veeral Mehta.

Introduction

Cryptocurrencies and the underlying concept of Blockchain are universally seen as revolutionary and disruptive. However, not just the government of different countries, but also the people of different sections and communities have reacted differently to this unprecedented phenomena and each one of them have viewed Cryptocurrencies through their respective prism. To add to this, several myths touted as facts and several facts touted as myths too have contributed to forming range of opinion. 

Advocate Ms. Veeral Mehta specializes in Financial Regulations. Through a series of articles authored by her, based on primary as well as secondary research, an attempt has been made to decode and demystify this phenomena. Series of these articles will provide insight to the readers with regards to the stand taken by different countries. What sort of regulatory mechanism they have evolved or are evolving either in favor or against Cryptocurrencies. In contrast, it is important to analyse the contrasting stance of the investor community, crypto products and service providers, and on the other-side the stance of GoI & the RBI. In the larger interest, which side would need to amend their approach and would need to take inevitable steps for course correction? In this context, it is also important to understand the Supreme Courts’ judgment and its essence?   

This article aims to highlight not just the advantages and the drawbacks of fiat currency vis-à-vis crypto currencies but also provides insight into the role & mind-set of fiat currency regulators with respect to consumer protection, systemic and financial risks involved with both and the process of  mitigating these risks. Also the articles extrapolate if the cryptocurrencies should be treated as payment systems, or security or commodity. Whether the government should issue a state-backed sovereign Cryptocurrency?

Most importantly, the prime objective of this series of articles is to layout broad contours of a regulatory framework for governing the issuance and usage of Cryptocurrencies and Crypto-linked assets in India based on the learning experience of several progressive and information technology savvy (especially Blockchain savvy) nations. It is also important to clarify that the objective of these articles is not to promote or demote Cryptocurrencies or Crypto based assets. As such the research & analysis done by the author is not limited and exhaustive to the extent of the content in this series of articles.                 

“Banking is essential, banks are not” was an argument presented by Bill Gates in 1994. He envisaged that though banking services would be needed, physical brick & mortar format of banks would become obsolete. Partially this has been proven true as more and more banking and plethora of financial services are virtually driven through the internet.

Also great steps have been taken in this direction. More & more alternatives to traditional financial systems, which are less reliant on traditional banks, are being created. We see this phenomena happening in several countries. The 2008 financial crisis created a trust deficit on government authorities, central banks and private banking institutions at global level. The crises at global scale could be contained only by bailout of insolvent banks. This was looked upon as a ‘breach of trust’.

It was during this era of distrust, that a disruptive cryptography driven blockchain technology proposed Peer-to-Peer financial system in the form of ‘virtual currency’. This application of a new technology made the role of a central banking entity somewhat redundant for currency transaction, which since then has gained immense popularity. Bitcoin was born during this chaotic time and provided stakeholders such as consumers or businesses to execute transactions without the reliance on one bank, allowing them to operate outside of the regular existing financial institutions.

Over a period of time, several jurisdictions realized the futility of prohibiting this innovative evolution of the currency in the history of mankind. The trend is evident that more and more countries are now fully comprehending this situation and as the adage goes “if you can’t fight them, join them’ is proving true. From a hostile stand, more and more countries have started to correct their stand and are making corrections to their perceptions and viewpoints. With this they are moving towards meaningful regulations so as to protect consumers and national interest at the same time not stifling the innovations.

The approach towards Cryptocurrencies in India have been largely negative to prohibitive. Despite a reasonably sized and growing market for cryptocurrencies in India, the RBI (Reserve Bank of India) systematically sought to prohibit the usage of cryptocurrencies by prohibiting banks from associating with persons dealing in such currencies through its circular, “Prohibition on Dealing in Virtual Currencies (VCs)” dated April 6, 2018. As such the RBI, IMC (Inter Ministerial Committee) and GoI (Government of India) adopted a hostile approach.

The RBI tried to justify the prohibition by highlighting the problems due to the dissymmetry in information pertaining to market and law enforcement risks, threat to traditional finance systems and to the economy in general. As a matter of fact, these concerns cannot be adequately addressed through a ban, as they not only confront India, but several other countries as well. The aforementioned RBI’s impugned circular has been set aside by the Hon’ble Supreme Court vide its order dated March 4, 2020 on the grounds of “proportionality”.

Authorities of various countries have interpreted blockchain technology and the phenomena of cryptocurrencies through their own prism and have been going through a learning curve. As such, the stance and approach to regulate crypto assets and crypto service providers can vary greatly or be on the similar lines between the countries. An example of the two extremes of the same spectrum are Venezuela and Estonia which have different prisms to look at cryptocurrencies.

Venezuela is suffering from hyperinflation, high crime rate and high corruption. The regime of President Nicolas Maduro faces numerous international sanctions. Venezuela has seen its currency ‘Bolivar’ rendered practically valueless. For Venezuelans, storing their money in a digital wallet in the form of Bitcoins, Litecoin, Dash or in any of the others, is still a better option than holding on the national currency. With a view to circumvent sanctions, the country in February 2018, tried to raise $ 4.9 bn through its own “Petro ” cryptocurrency. However, this was thwarted when President Trump banned Americans from trading in the “Petro”.

On the other hand, Estonia provides the most reliable and safe business environment for cryptocurrency related activities. This country is way ahead of any other country even in Europe as far as applications of blockchain are concerned. All crypto assets related businesses are registered and the law complies with the two main requirements of FATF (Financial Action Task Force) – namely the “KYC” (Know Your Customer) and the “Travel Rule”. They have AML (Anti Money Laundering) and Terrorism Finance Laws (EFSA 2017a) that actually means that Estonian Law System provides a clear verification of Cryptocurrency related activities and eliminates the possibility of commitment to criminal activities such as money laundering and contraband transactions. The companies that aim to provide this type of activities are lawfully required to proceed with authorization procedures done by the Financial Intelligence Unit.

The lack of regulation is often considered a weakness because consumers are not assured of standards and credibility and there is a possibility of more stringent/ prohibitive regulation being enacted later. Absence of regulation also leads to a perception of cryptocurrencies being used as a device or tool to facilitate criminal activities thereby making genuine businesses fearful and they often refrain from dealing in cryptocurrencies.

India has a potential to take lead on the global landscape by taking up initiative for a call to form a global body for standardizing technical and legal aspects of cryptocurrencies. It all depends on how hereafter the government of India and the related agencies respond to the potential opportunities.

Stand taken by India so far                        

This article highlights the systematic approach taken up by the RBI (Reserve Bank of India) and the GoI (Government of India) to have a blanket ban on all sorts of cryptocurrencies except creating a right for themselves to launch sovereign official Digital Currency regulated by RBI. 

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Background

Around 2013, cryptocurrencies started to gain popularity in India. Between 2012 and 2017 several cryptocurrency exchanges started operating. These included popular exchanges such as Zebpay, Coinsecure, Unocoin, Koinex, Pocket Bits and Bitxoxo. As the price of the cryptocurrency started to shoot up and was adopted by a considerate number of users making it more popular, the technology got attention by the worldwide regulators.

In India the first regulatory response was on 24th December 2013, when RBI issued a Press Release cautioning the public against dealing in virtual currencies including Bitcoin. Further, post demonetization in November 2016, volumes of buying & selling activities increased. It is also prognosticated that since the government emphasized on digital payment methods, people eager to make investments felt encouraged to invest in cryptocurrencies.

In Indian cryptocurrencies exchanges, there was a surge in buying and selling activities. This perhaps prompted RBI to issue yet another Press Release Note on 1st February 2017 reiterating its concerns regarding cryptocurrencies raised in its earlier Press Release of 2013.

Setting-up of IMC (Inter Ministerial Committee)

In November, 2017 the GoI constituted a high level IMC under the chairmanship of Shri Subhash Chandra Garg, Secretary, Department of EA (Economic Affairs) , Ministry of Finance and comprising of Shri Ajay Prakash Sawhney (Secretary, Ministry of Electronics and Information Technology), Shri Ajay Tyagi (Chairman, SEBI) and Shri B.P. Kanungo (Deputy Governor, RBI). The mandate of the Committee was to study various issues pertaining to Virtual Currencies and to propose specific actions that may be taken in relation thereto. This Committee submitted its report on 28th February, 2019 recommending a ban on private cryptocurrencies in India.

Arbitrary actions by RBI & GoI in parallel to the working of IMC

After constituting the IMC on 2nd November, 2017, immediately on 5th December 2017 both the RBI as well as the Ministry of Finance issued Press releases once again cautioning the general public about the dangers and risks associated with cryptocurrencies, with the Ministry of Finance Press Release baselessly echoing something that was stated in the US years ago and proven otherwise, that cryptocurrencies are like ponzi schemes.

Till the end of March 2018, while the IMC was still working on their study to form recommendations, in the meantime, the RBI and the Finance Ministry had issued various Press Releases on cryptocurrencies cautioning people against their risks. However, none of the circulars/ notifications ever took any legal action or gave any enforceable directions against cryptocurrencies.

It can be said that the arbitrary manner of functioning leaped to a next level with the RBI circular dated April 6, 2018 whereby the RBI prevented “Commercial and Co-operative Banks, Payments Banks, Small Finance Banks, NBFCs, and Payment System Providers not only from dealing in virtual currencies themselves but also directing them to stop providing services to all entities which deal with virtual currencies.” Given the extent to which the market for cryptocurrencies had already developed in India, the RBI circular was a fairly drastic intervention by any measure. However, it was not supported with any information on the cost– benefit analysis of prohibiting cryptocurrencies nor was it preceded by a public consultation. There were no tangible efforts on part of the RBI &/or GoI to understand the risks involved in letting unregulated underground cryptocurrency trade continue in absence of regulations.

Due to this circular, cryptocurrency exchanges, which depended on normal banking channels, could not access any banking services within India. This crippled their business operations since converting cash to cryptocurrencies and vice versa which was an essential part of their operations. Pure cryptocurrency exchanges which did not deal in fiat currency, were unable to carry out their regular operations such as paying for office space, staff salaries, server space, vendor payments, etc. could not be possible without access to banking services.

As the operations of cryptocurrency exchanges took a severe hit and the number of transactions on these exchanges reduced substantially, people who had bought cryptocurrencies on these exchanges as an investment were forced to sell their crypto assets and cash out before they lost access to banking facilities. The cryptocurrency exchanges themselves found it hard to sustain operations in the face of the dual hit of reduced transaction volumes and loss of access banking services.

Recommendations of IMC and counter analysis

The Committee notes with serious concern mushrooming of cryptocurrencies almost invariably issued abroad and numerous people in India investing in these cryptocurrencies. All these cryptocurrencies have been created by non- sovereigns and are in this sense entirely private enterprises.

Counter Analysis – The very reason why Bitcoin was conceived, was due the drawback of the central bank controlled fiat currency. The main drawback is that fiat currencies are “Trust” based. The inventors of cryptocurrencies highlight that the history of fiat currency is full of the breach of that trust due to the predators of influential politicians, business people and corrupt people.

There is no underlying intrinsic value of these private cryptocurrencies. These private cryptocurrencies lack all the attributes of a currency. There is no fixed nominal value of these private cryptocurrencies i.e. it neither acts as any store of value nor are they a medium of exchange. Since their inceptions, cryptocurrencies have demonstrated extreme fluctuations in their prices. Therefore, the Committee is of clear view that the private cryptocurrencies should not be allowed. These cryptocurrencies cannot serve the purpose of a currency. The private cryptocurrencies are inconsistent with the essential functions of money/currency, hence private cryptocurrencies cannot replace fiat currencies.

Counter Analysis – Should the government necessarily prohibit assets whose prices are highly volatile? For example, some equity scrips in the securities market face more volatility than others. Should such scrips be suspended from trading? Real estate’s prices also often see a lot of fluctuations. Seeking to ban an asset only on the ground that its prices fluctuate a lot is a slippery slope. The intrinsic value of a cryptocurrency is based on the demand and supply of it. However, it is not entirely accurate to suggest that cryptocurrency is not capable of being used as a store of value. For example, several retail outlets in some countries have started accepting payment through cryptocurrencies. Similarly, firms are raising capital through ICOs. A review of global best practices also shows that private cryptocurrencies have not been recognized as a LEGAL tender in any jurisdiction.

Counter Analysis – The private cryptocurrencies though we’re not meant to replace the fiat currency, its value proposition as a viable tool of investment cannot be undermined. The state may not recognise something as legal tender. That’s one thing. Banning people from holding and trading it is quite another. Something need not be recognised as a legal tender, but yet may be used by people to satisfy contracts. For example, people are allowed to accept property in exchange for property, although ‘property is not legal tender’.

The Committee recommends that all private cryptocurrencies, except any cryptocurrency issued by the State, be banned in India.

Counter Analysis – Sovereign cryptocurrencies have been looked upon as a tool used by the rogue nations to circumvent  sanctions.  In the case of Petro, Venezuelan Government tried to circumvent sanctions. However, this was not successful as President Trump had immediately banned the Americans from dealing in Petro. Even though a lot of countries have announced plans to come out with sovereign cryptocurrency in the past five to six years, apart from Venezuela no other country has come out with their own sovereign cryptocurrency. Thus, apart from Venezuela, Russia with CryptoRuble and the US with Fedcoin, several other countries like China, Japan, France, Canada, UK, Brazil, Australia, South Africa, Singapore, Hong Kong, Sweden, Philippines, Indonesia, Lebanon, Eastern Caribbean, South Korea, Israel and the Netherlands all have thought of some type of programs exploring the blockchain technology as a currency or have announced plans to release their own State owned cryptocurrency. They all have evolved regulations for VCs in general, which India hasn’t till date. Also, the success of any state owned currency in any of the country is yet to be seen.

The Committee endorses the stand taken by the RBI to eliminate the interface of institutions regulated by the RBI from cryptocurrencies. The Committee also recommends that all exchanges, people, traders and other financial system participants should be prohibited from dealing with cryptocurrencies.

Counter Analysis – While referring to the minutes of the first and second meeting of IMC, it should be noted that in the first meeting it was concluded that banning cryptocurrencies in India would be very difficult and was actually ‘NOT AN OPTION’. The representatives from EA, SEBI and MeitY are in favour of regulating the cryptocurrencies whereas the RBI and CBDT have used their weight to take a stand in favour of banning cryptocurrencies. After the first meeting the Deputy Governor through a video conference call had urged for banning the cryptocurrencies. As such no plausible reasons have been furnished either by RBI or by CBDT as to why the phenomena of VCs should be banned. The Committee has recommended a law banning the cryptocurrencies in India and criminalizing carrying on of any activities connected with cryptocurrencies in India.

Counter Analysis – The RBI and the CBDT have failed to explain their adamant stand. They have failed to recognize that several countries have not banned or criminalised the cryptocurrency trade. On the contrary they have in place crypto regulations which are compliant to the requirements of FATF for both, the ‘Crypto asset holders’ and the ‘Crypto Service Providers.’

The Committee also recommends that the Government may consider establishing a Standing Committee to take into account the technological developments globally and within the country and also the views of global standard setting bodies to revisit the issues addressed in the Report as and when required.

Counter Analysis – This has not been the attitude of either the GoI nor that of RBI. As such till date there is no movement from either in this regard. On the contrary, the title of the draft bill itself is heavily prejudiced which is “Banning of Cryptocurrency & Regulation of Official Digital Currency Bill, 2019”. This Draft Act has a very vague definition of “Official Digital Currency” as in the definition section, the onus and the power to define this is left to the RBI who can keep on changing it from time-to-time as it may wish.

The Committee is of the view that it would be advisable to have an open mind regarding the introduction of an official digital currency in India.

Counter Analysis – This is not something new or different from what several countries have been thinking over. The introduction of an official / sovereign digital currency does not preclude the possibility of having a regulatory framework governing the issuance and trading of cryptocurrencies.

It may be possible to visualize some models of future official digital currencies but as of date it is unclear whether there is a clear advantage in the context of India to come up with an official digital currency. Hence, the Committee recommends that, if required, a Group may be constituted by the Department of Economic Affairs, with participation of the representatives of the RBI, MeitY and Department of Financial Services for examination and development of an appropriate model of digital currency in India.

Counter Analysis – If it is unclear whether there is a clear advantage or not to have an official digital currency then why the insistence for India to have its official digital currency controlled by RBI and recommendation no.8 of this committee to have “OPEN MIND” in this regards? Needless to mention, the committee is aware that as such there isn’t a convincing value proposition to have an “Official Digital Currency”. Despite this it is surprising that the matter was steered in the direction of banning the private cryptocurrency and at the same time a draft law promulgating regulation of official digital currency seems to be in a predetermined manner.

If, in due course of time, it is decided to issue a digital currency in India having the status of a legal tender, the RBI should be the appropriate regulator of such digital currency by virtue of its powers under Section 22 of the RBI Act.

Counter Analysis – Legal tender is governed by the RBI Act. As discussed above, it is possible for a jurisdiction to permit people to hold and issue cryptocurrency and trade in crypto assets, without conferring the status of legal tender on it. However, if and when a legal tender status is conferred upon crypto assets, it will need further deliberations on the possible impact of this on the monetary policy and money circulation in the country. It can be safely said that conferring jurisdiction in respect of possible future events, was outside the scope of IMC’s mandate.

Draft bill: “Banning of cryptocurrency & regulation of Official Digital Currency Bill, 2019”

The draft bill was drafted when the matter of banning the cryptocurrencies was sub judice and SC had not yet pronounced its verdict on the petition challenging the ban. Further, a systematic approach is highlighted to stifle the cryptocurrencies starting with the RBI issuing ‘warnings’ and further banning the cryptocurrency by restricting all banking entities in India so as not to facilitate any transactions pertaining to any cryptocurrencies. Even before SC came out with a verdict that such a circular is liable to be set aside, the government drafted the captioned bill.

While the RBI and the present government are zealous to ban existing private cryptocurrencies and have decided to have a state promoted sovereign cryptocurrency controlled by RBI as a form of a legal tender, it should be noted that often such currencies are viewed as tool adopted to create a means to bypass sanctions. Currently there are no known states that have adopted successfully the state owned cryptocurrency.

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Road map for India                             

Cryptocurrencies for larger interest

Cryptocurrencies are unique financial assets as they can be used as a mode of payment as well as a security. However, the value of cryptocurrencies are not inherently linked to any underlying assets in the real economy. Their value intrinsically depends on the demand and supply.

Different jurisdictions have taken different approaches. Each of the countries have viewed this phenomena through the prism of their perceived interest. Interestingly, there are two contrasting aspects emerging. First aspect is that a regulator has an impulse to protect consumers from the dangers of a new technology as well as protect the national interest by assessing various potential risks. And the second aspect is that flexibility and deeper understanding is necessary to nurture new concepts and support newer technology to develop and provide an envisaged ecosystem for it to thrive and grow successfully for larger benefits. It is observed that some countries have adopted a hostile approach which has a stifling effect, whereas some countries have demonstrated how sensitive and meaningful regulations reap benefits.

Objectives of Regulating Cryptocurrencies

In general, regulation of the traditional Financial Sector is motivated by three objectives:

  1. Consumer Protection
  2. Prudential Regulation
  3. Financial stability and systemic risks

However, when it comes to Cryptocurrencies below are some pertinent points in this context.

(a) Re: Consumer Protection: It should be noted that a decentralized ledger based Cryptocurrency is “self-governing” in nature. This is a built-in aspect of such a blockchain type. Any external intervention cannot effectively or directly be implemented on a specific decentralized cryptocurrency, excepting laying down rules, regulations and audits for checks & balances of exchanges, miners, wallet providers and these may remain same irrespective if the cryptocurrency was of decentralized blockchain type or otherwise. For example, the Japan Blockchain Association (JBA) has established self-regulation standards, which includes the use of ‘cold wallets’ instead of online ‘hot wallets’ amongst its 15 crypto exchange members.

(b) Re: Prudential Regulations: It should be noted that ideally a crypto-asset and a ‘traditional’ asset that are otherwise equivalent in their economic functions and the risks they pose should not be treated differently for prudential purposes. It may happen that banks may start accepting Bitcoin or other cryptocurrencies as deposits and as deposit taking institutions, they may pay interest on the cryptocurrency deposits, or eventually, develop a fractional reserve banking model on Bitcoin. Until now, the banking sector doesn’t engage in borrowing and lending cryptocurrencies. This could change in time to come, despite all the risks involved in such a transaction. Also the banking sector, as well as non-banking financial sector or for that matter any central bank till the writing of this article, has not prescribed standards for accepting cryptocurrencies as collateral. Secondly, there is also the absence of LOLR (Lender of Last Resort).

An open question is if it is prudentially acceptable for the banks to take upon themselves based on directives of the central bank to issue their own retail oriented cryptocurrencies.

c) Re: Financial Stability and Systemic Risks: Experts opine that collapse of the overall cryptocurrency market is unlikely to give rise to any financial stability concerns. The reason is the total market capitalization of the overall cryptocurrencies at its peak was smaller than the market capitalization of the largest NASDAQ listed company which is Apple Inc; with a market capitalization of $ 1.08 tr as of September 11, 2018. At the same time, the market capitalization of Bitcoin, the largest and the most popular cryptocurrency was around $ 110 bn and the total market capitalization of all cryptocurrencies stood at around $ 189 bn. Despite this insignificant size, it may constraint central banks like RBI in its role for financial stability even in presence of systemic risk in cryptocurrency market. As far as financial and systemic risks are concerned, the role that any central bank can play is that of a ‘contributory & supporting’ role which is different from the shared competence and has the narrowest scope.

Need for a global organization for standardization of cryptocurrencies regulations

Cryptocurrencies cannot be contained within the confines of a jurisdiction. They are ubiquitous beyond borders and boundaries – globally transactional in nature, unlike most of the traditional financial schemes or assets. Also most of the cryptocurrencies can be purchased in fractions. This is somewhat different from ‘standard denominations’ in case of any fiat currency or different from standard quantity which would form a ‘lot’ (for example ‘lot of 50 equity shares or multiple thereof’). This aspect of cryptocurrencies provides the benefit of trading to even a smallest investor in the most remote corner of the world. 

There are thousands of cryptocurrencies in the market, and they can broadly differ from one another in terms of the type and configuration of the blockchain they have devised. For example, cryptocurrencies based on open decentralized blockchain may need a different regulatory approach from those built on closed centralized blockchain. Therefore, largely centralized Ripple may need a little different set of rules from Bitcoin which is decentralized. Therefore, to address the regulatory challenges posed by cryptocurrencies, a uniform and direct regulation approach could make the regulation task difficult.

Overtime, global standards have evolved for regulation of the financial sector. For example the Basel norms are a global standard for the regulation of banks. Jurisdictions are free to not follow them, but those who do not follow these norms risk keeping their financial system less integrated with the global financial system. Similarly, IOSCO (International Organization of Securities Commissions) have evolved norms for the regulation of exchanges and the securities market infrastructure. Several jurisdictions allow recognition to the intermediaries of another jurisdiction only if the regulator is a member of IOSCO. On similar lines, there is a case for developing global standards for the regulation of cryptocurrencies as well.

Regulations in general may solve some issues, from the perspective of investors, reduce scams, however fighting against the underworld and criminals laundering money need police and security services to join financial authorities to work together in making regulations related to cryptocurrency exchanges, trading and transactions. Quite contrary to popular opinion, tracing the person transacting in bitcoin or similar cryptocurrencies, is not impossible.

Often people mistakenly believe that bitcoin transactions are performed anonymously. This is not true, it is actually pseudonymous. All transactions to and from addresses are open and can enable authorities to link transactions to locate addresses of the person behind the transaction, with the help of regulated information such as proof of identity, address and bank details.

Regulated cryptocurrency exchanges can give information regarding who withdrew the money. Countries in European Union have strong policies governing disclosure of the name, proof of address and bank details to the exchanges.    

Broad contours of regulatory framework for crypto assets in India      

Presently in India, there is no comprehensive definition of crypto assets or cryptocurrencies. There is no express law that would categorize a cryptocurrency as commodity, security, or currency. The categorization of virtual currencies is essential so that the relevant regulatory bodies and many of the existing laws can be mapped based on categorization. While dealing with the definition we observe two different approaches for defining cryptocurrencies. It is important to understand the rationale behind the two approaches.

First approach – U.S.A

Approach adopted by the U.S through its draft ‘Cryptocurrency Act of 2020 defines cryptocurrencies into categories namely, crypto-commodities, crypto-securities and crypto- currencies. This is done in order to assign the appropriate federal crypto regulator and is defined as a soul government agency with authority to regulate which means:

  • CTFC – Crypto-commodities
  • SEC – Crypto-securities
  • FinCEN – Crypto-currencies

Each of the above federal crypto regulators is required to make available to the public and keep a current list of all federal licenses, certifications, or registrations required to create or trade in all digital assets. The Act also requires the Secretary of the Treasury through FinCEN to establish rules similar to financial institutions on the ability to trace cryptocurrency transactions.

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Second approach – Singapore

The Singapore Government has not defined virtual currency. Several terms such as “cryptocurrency” or “token” or “coin” are used interchangeably. All the activities surrounding virtual currency are regulated under securities law or any other applicable legislation. This leaves the door wide open for interpretation.

In this regard a new piece of legislation the “Payment Service Act” has been enacted and yet to be enforced till the writing of this article. The PSA when enforced will regulate the purchase and sales of virtual currencies. However, this Act has not defined either cryptocurrency or virtual currency. It has never the less defined ‘digital payment token’.

Usage of cryptocurrencies as

Security

Commodity

Valid Payment System

Under the Indian law security is defined under “The Securities Contracts (Regulations) Act, 1956” and presently the Act does not provide any regulatory guidance in the context of virtual currency. 

As such SCRA would need suitable amendments to have a desired control on crypto securities including the ICOs. A point to note is the regulations should not call for all the requirements which are specified in case of IPOs, where the issuers are known and also the issuer entities are subject to the regulations under the Companies Act 2013 in respect of the issuance and transfer of securities. Nevertheless, upto what extent such dilution may be allowed should be based on meeting the travel rule requirement of the FATF.

In case virtual currencies are categorized as commodities, the activity of the virtual currency exchange may be regulated as a commodities exchange, which can have implications under inward foreign FDI, that is, the Consolidated FDI Policy Circular of 2017 and the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations 2017. 

Based on the present laws, VCs are not considered commodities. According to SEBI Circular136 as well as notification under SCRA, VCs are not included as commodities.

Under Section 2(1)(i) of the PSS Act, a payment system is defined as ‘a system that enables payment  to  be  effected  between  a  payer  and  a  beneficiary. If  virtual  currency-based systems do form payment systems, any person commencing or operating them will require the authorization of the RBI under Section 4(1) of the PSS Act.

There is nothing in the PSS Act to exclude virtual currency, since only the term payment is referred to, as opposed to currency, legal tender or money. Therefore, it needs to be judged whether a particular cryptocurrency-based system enables payment to be effected between a payer and a beneficiary, or a person to commence or operate such system.

Prevention of money laundering and financing of criminal activity

Pseudonymous character of Cryptocurrencies poses a challenge to track transactions. What can be tracked in the blockchain are the wallet identities and not the individual identities. It is for this reason as well as from the perspective of consumer protection, as mentioned above in (a), JBA has self-imposed regulation to make use of only ‘cold wallet’ which makes it possible for transaction tracking up to the individual identities. Cold Wallets are offline needing KYC norms to make it operable. Hot wallets are alias based online wallets which do not require KYC and tokens/ coins from one hot wallet to another hot wallet could be done directly with/ without an Exchange being an intermediary. Cold Wallets unlike ‘hot wallets’ are not susceptible to hacking, phishing, theft and general cybercrimes. Also as such, ‘Hot wallets’ are anonymous, making cryptocurrency trading a convenient tool for fraud, tax-evasion, and evasion of international sanction, sale of illicit goods and services and money laundering.

Presently, KYC & AML norms are enforced under different legislations and RBI directions. Nevertheless, KYC & AML norms are not directly applicable to virtual currency based businesses. These norms under various laws, for example PMLA, 2002 and RBI Master Direction – KYC Direction 2016 only apply to businesses regulated by the RBI and the other regulators such as SEBI. Therefore, businesses dealing with security related virtual currencies, or operating payment systems may be subject to KYC / AML requirements.

Regulating miners & exchanges

There is no specific law in India which would help keep in check exchanges and mining of Virtual currencies. Both, the miners as well as the exchanges should be registered and audited for being compliant to most importantly AML & CFT requirements in line with FATF guidelines.

While there is no judicial precedent on this issue, FEMA and its regulations may be relevant where the block reward is sent to a virtual wallet address in India and subsequently transferred abroad to a foreign wallet. However, an arrangement where an Indian entity only provides the physical mining infrastructure and the newly generated virtual currency is availed directly by a wallet address that is held by a non-resident entity abroad should not attract the export and import-related legal obligations under FEMA. In such a situation, as the virtual currency was never held in India, there is no transfer of a virtual currency from India to a foreign country.

Taxation

Taxation of VCs related business can attract income tax as well as goods and services tax (GST).

Direct Tax

Indirect Tax

In principle any income generated in India should be taxed for Income. However the ITA may need additional suitable amendments to get the activities related to VCs under its gambit. 

When the efforts to address removal of limitations of the present ITA is done, care should be taken to provide clarity for distinguishing income tax arising from activities of cryptocurrencies, whether it is by a corporate or by an individual. Also, clear lines should be drawn to distinguish / define crypto transactions as securities or crypto transactions as commodities and accordingly the tax rate be decided.

The Tariff Schedule for Goods does not contain any specific category for virtual currencies. Therefore assuming that VCs would be classified as residuary goods, they should be charged accordingly for GST.

Double taxation issues may arise where consumers might be subject to GST while purchasing virtual currencies, and again on their use in exchange for other goods and services. Such issues may need resolution in time to come.

FATF guidelines on AML/CFT

All the Crypto Service Providers in India must comply with the FATF guidelines. The FATF on June 21, 2019 issued the guidance for Risk Based Approach to Virtual Assets and Virtual Asset Service Providers. The key requirements of these guidelines include: Initial Risk Assessment; Abiding by the Travel Rule; Registration and Licensing of VASPs; Regulation, Supervision and Monitoring of VASPs; International Cooperation and National Coordination.

Plan of work to evolve a regulatory framework

  1. For the purpose of a regulatory framework it is essential to have a legal definition of cryptocurrencies and based on its technical configuration classify them as securities/ commodities or payment instruments along with the respective regulatory body that would be in charge.
  2. Certain eligibility criteria should be set for issuing licenses to the cryptocurrency service providers. A proper inspection should be carried before issuing the license for instance carrying out a check pertaining to risk management, operational policies, and financial resources. The Crypto Exchanges must abide by the strict KYC norms and carry out a detailed verification check of the investors before providing any crypto services. This is important for the traceability of the transactions.
  3. Although the FATF Recommendations are not binding, India like many other countries must look forward to implementing them. Some examples of countries implementing FATF guidelines are  – The USA – FinCEN has issued its interpretive guidance which in many aspects is similar to the FATF approach. Similarly, German Government also indicates in its proposed draft law implementing the 5th AML Directive (EU).
  4. These new FATF rules for the virtual assets industry gives more certainty about the AML/CFT obligations on a global level. These requirements may facilitate the mainstream adoption of the VAs and increase their acceptance by traditional financial institutions.
  5. A complete ban on cryptocurrencies is difficult to implement and also likely to lead to underground cryptocurrency trading. Regulating will enable the government to oversee their activities, thereby preventing their usage in illegitimate activities.
  6. Recommendation of an outright ban, along with criminal penalties, is excessive, as the risks involved with virtual currencies can be addressed with less invasive measures. G20, FATF, and leading jurisdictions such as the European Union, Singapore, the United Kingdom and the United States, have all proposed regulatory approaches to address the risks, so that the benefits are not lost out on.
  7. The two major benefits of Virtual currencies are a reduction in intermediary layers and cost effectiveness. In practicality, it is not difficult to circumvent prohibition on dealing with cryptocurrencies.
  8. As such, in order to mitigate with the risk and promote benefits, a balanced regulation approach may be necessary. It is hoped by the industry and the investor community that any impending government decision should recognize this aspect to design a fine framework.
  9. Though the regulatory models of several countries are refined over a period of time, India should pick-up from the learning curve that other countries have gone through so that progress towards balanced regulations can be made in a short period of time.

Conclusion

Right from the start the way RBI, various ministries and agencies of GoI, and the judiciary has handled the cryptocurrencies exhibit glaring knowledge gap coupled with a narrow view of what the cryptocurrencies are and how successfully several countries have evolved the regulations, categorized cryptocurrencies, have conform to the guidelines of FATF and have made available this ingenious tool for generation of wealth. RBI and the government’s view in general have been so narrow that they have not been able to provide any plausible reason as to why they should ban all cryptocurrencies. While on one hand RBI indirectly imposed the ban on cryptocurrencies by restricting all banking entities, it pondered for over five years without any application of mind as to how this can be regulated and neither have bothered to take a holistic view of how other countries have benefited by evolving suitable regulations especially from the view point of AML and the requirements of FATF.

The SC has, in the decision in IMAI v/s. RBI, effectively laid down an important test for determining the constitutionality of a regulatory intervention. This test essentially requires regulators to demonstrate the specific harm that a financial product or financial service is likely to cause to the investors, the public or the financial stability of India, before prohibiting it. This does not preclude a future prohibition on cryptocurrencies in India, the uncertainty and the adverse view taken by the RBI with respect to cryptocurrency have effectively negated the possibility of such businesses being established in India. Unless the RBI and the Central Government use this opportunity to draw up a reasonable regulatory framework for persons desiring to issue, mine or trade in Cryptocurrency, India will again be behind the curve in reaping the benefits of this market.

References

  1. Risk management, regulation and the cryptocurrency markets: https://blockchaintechnology- news.com/2018/02/risk-management-regulation-cryptocurrency-markets/
  2. Central Banks and Regulation of Cryptocurrencies: https://www.researchgate.net/publication/334510219_Central_Banks_and_Regulation_of_Cryptocurrencies      
  3. Discussion Draft: https://thetokenist.io/wp-content/uploads/2019/12/Cryptocurrency-Act-of-2020.pdfhttps://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11566
  4. http://www.nishithdesai.com/fileadmin/user_upload/pdfs/NDA%20In%20The%20Media/News%20Articles/18 1207_A_The-Virtual-Currency-Regulation-Review-India.pdf
  5. Risk management, regulation and the cryptocurrency markets: https://blockchaintechnology- news.com/2018/02/risk-management-regulation-cryptocurrency-markets/
  6. Central Banks and Regulation of Cryptocurrencies: https://www.researchgate.net/publication/334510219_Central_Banks_and_Regulation_of_Cryptocurrencies  
  7. RBI cautions users of Virtual Currencies against risks: https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=30247 
  8. Cryptocurrency Regulation in India – A brief history: https://cis-india.org/internet-governance/blog/cryptocurrency-regulation-in-india-2013-a-brief-history
  9. RBI cautions of Virtual Currencies: https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=39435 
  10. Reserve Bank cautions regarding risk of Virtual Currencies including Bitcoins: https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=42462 
  11. Press Information Bureau Government of India – Ministry of Finance: Virtual Currencies: https://pib.gov.in/newsite/mberel.aspx?relid=160

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