This article is written by Krithika Kataria, a 3rd year student of NMIMS School of Law, where she discusses the feasibility of allowing mutual funds to do cryptocurrency trading.

Introduction

A new out of the box idea more often than not becomes the burning issue of the day. And so is the case with virtual currency. With its ever-increasing value, digital cryptocurrency is catching a great deal of attention. In the light of this vast topic, the author will study a particular aspect of cryptocurrency concerning mutual funds. This paper will discuss whether or not mutual funds should be allowed to engage in cryptocurrency trading.

For this purpose, the author has split the paper into three main parts: First part explains cryptocurrency and the legal framework in place for it. The second part describes mutual funds regulations regarding the securities they can invest in and whether it would be permissible for mutual funds to do cryptocurrency trading. The third part looks at the merits and demerits of allowing mutual funds to do cryptocurrency trading and lays out certain precautions the country must take while allowing cryptocurrency trading by mutual funds.

Cryptocurrency – The Cryptic Currency

Cryptocurrency is a digital currency that has no centralized authority monitoring it. A cryptocurrency is a medium of exchange that uses cryptography to manage the creation of new units as well as to secure the transactions.[1] At present, it differs from every other currency type as it is not fiat currency, i.e., it is not issued or backed by the Government of the respective country. The rate of creation of such units is defined beforehand and is publicly known [2] in contrast with the control of supply by the Government in the case of fiat money.

Bitcoin is a cryptocurrency, and as it is one of the most widely used cryptocurrencies; the terms are often used interchangeably. Rather than relying on any regulatory authorities, Bitcoin uses a blockchain, a public ledger where all the transactions made using Bitcoins are recorded and so can be considered secure transactions.[3] This is a relatively new concept so different countries have a different perspective on this subject of virtual currency.

Canada is the first country to have a defined legal structure for Bitcoin. In Canada, businesses dealings in this digital currency are subject to the Proceeds of Crime (Money Laundering), and Terrorist Financing Act of 2000 (PCMLTF) and taxes need to be paid accordingly. On the other hand, the financial department of Denmark has declared that Bitcoin is not a currency and hence will not fall under any financial services categories, including electronic money, currency exchanges, or any other financial regulations.[4]

Countries like India and China have shown that they are skeptical about the concept of cryptocurrency. In India, the government agencies have been very vocal about their concern in cryptocurrency trading. There is even a team known as India’s Special Investigation Team (SIT) that is said to be in the process of drafting a report which will elaborate all the problematic issues with the decentralized cryptocurrency. In December 2013, the RBI issued a press release cautioning users, holders and traders of virtual currencies, including Bitcoins, about the potential financial, operational, legal, customer protection.[5] Despite this there do exist some very big players in the Indian market who buy and sell Bitcoins like Zebpay, Unocoin, Coin secure, Btcxindia among others.

In reality, there is no legal framework regulating cryptocurrencies and they haven’t been declared ‘currencies.’ As such, the law will be interpreted differently by different groups to understand if they are legal or not. One of the glaring obstacles for Indian investors who are interested in investing in cryptocurrency is the confusion about its legal status.

Mutual Funds

The mutual fund sector is a very complex field that needs tight regulation for all its players, which include sponsors, investors, fund managers, and other intermediaries, for consistent growth. Various authorities regulate the mutual funds in India like SEBI, AMFI, other SROs, RBI, and the Investor‘s Association of India.[6]  With the SEBI regulations, all mutual funds have been brought under a common regulatory framework to ensure a higher degree of transparency in their operations and adherence to a standard structure. The SEBI and RBI make regulations with the sole purpose of safeguarding the interests of investors.

Open-ended retail funds

Mutual funds can invest in, under the SEBI (Mutual Funds) Regulations 1996 (MF Regulations):

• Securities: shares, debentures and equity-linked instruments, Foreign securities
• Money market instruments.
• Privately-placed debentures.
• Securitised debt instruments (either asset-backed or mortgage-backed securities).
• Gold or gold-related instruments.
• Real estate assets.
• Infrastructure debt instrument and assets.

Restrictions on investments

A mutual fund must not,

• Invest more than 10% of its net asset value (NAV) in debt instruments issued by a single issuer.
• Invest more than 10% of its NAV in unrated debt instruments issued by a single issuer and the total investment must not exceed 25% of the NAV of the scheme.
• Own more than 10% of any company’s paid up capital carrying voting rights.
• Buy and sell securities only on the basis of deliveries.
• Make temporary investments in short-term deposits of commercial banks, subject to the applicable laws.
• Make any investment in:
  • any unlisted security of an associate or group company of the sponsor; or
  • any security issued by way of private placement by an associate or group company of the sponsor; or
  • the listed securities of group companies of the sponsor which is over 25% of the net assets.
• Invest more than 5% of its NAV in the unlisted equity shares or equity-related instruments in case of an open-ended scheme and 10% of its NAV in case of a close-ended scheme.[7]

It can be inferred from the above list that mutual funds cannot legally invest in real estate or property or any other assets, as the securities described in the regulations are only shares, debentures, and equity-linked instruments.

The question that may be raised here is where does cryptocurrency fit on the list? At the face of it, it is not explicitly mentioned. Express um facit cessare tacitum, which literally translates to ‘when there is express mention of certain things, then anything
 not mentioned is excluded’, applies in this situation and hence it is easy to conclude that Mutual funds cannot take part in cryptocurrency trading as no such provision is expressly laid out in the SEBI regulations. If this is to be allowed, the RBI and SEBI have to provide for it in the regulations.

Cryptocurrency and mutual funds

Upon looking deeper into the subject, one can argue that cryptocurrency may form a part of one of the investments that allow mutual funds. The most obvious one would be to see if cryptocurrency could be considered a currency. The definition of currency laid out in section 2(i) of FEMA, is comprehensive and does not cover Bitcoin. While cryptocurrency may be very similar to currency or legal tender, it does not fall under the definition of a currency or the purview of Government rules and regulations.

Another possible route is to characterize cryptocurrency as a commodity. The term commodity has not been defined
 anywhere under the law in India. In the case of Tata Consultancy Services V. State of Andhra Pradesh,[8] Hon’ble Justice Sinha, concurring with the court’s view, stated that a commodity is understood to mean goods of any kind, which could be something of use or
 an article of commerce.[9] Hence, a cryptocurrency may be characterized as a commodity. So one way of legalizing cryptocurrency trading is to legalize commodity derivatives trading by mutual funds. The market regulator is in advanced stages of talks on allowing mutual funds and portfolio management services (PMS) to trade in commodity derivatives.[10]

There are multiple benefits of trading in cryptocurrency. As mentioned earlier, all transactions are recorded in a public ledger. It is marked by the blockchain transaction which ensures secure digital transactions. It is also effortless to use and promotes instant settlement.

However, at present, the RBI has explicitly shown that it doesn’t favor cryptocurrencies. In fact, it regards it as a violation of the country’s existing foreign exchange norms because the conversion of Bitcoins [11] into foreign exchange does not fall yet under the purview of the central banking institution and hence it makes such transactions highly unsafe and vulnerable to cyber attacks. Adding on to this, there are other regulatory risks, scalability risks, risks of hacking, and extreme volatility associated with Bitcoins. One of the most significant concerns regarding trading in cryptocurrency, to the government and investors both, the sale of cryptocurrency is anonymously, and hence, there is a high possibility of illegal financial transactions and the forming of a black market.

One secure step that can be taken to prevent the mishaps that can occur due to trading in cryptocurrency is to allow only financial institutions such as mutual funds, which have experts in the field, to invest and trade in cryptocurrency. In a country like India where the majority of people still do not have internet access let alone knowledge about this technologically-advanced invention, it is a safer option to only legalize trading in cryptocurrency for institutions like mutual funds who have the means and expertise to make informed decisions and maximize on such investments. This can be done by amending the SEBI (Mutual funds) Regulations, 1996. To completely rule out the option of legalizing cryptocurrency would be taking away a golden opportunity that could help boost the country’s economy. This majorly lies on the basis that cryptocurrency may have a role in the future of payments and other forms of wealth transfer.

The RBI must set further strict KYC norms for this purpose. New KYC norms will be required to regulate this new system. There are even suggestions that India could come up with cryptocurrency within its own legal framework so that regulation will be more natural. Cryptocurrency transactions can be taxed when it is mined or transferred. Mutual funds can be mandated to issue a disclosure form to its customers disclosing the high risks associated with cryptocurrency trading. If these measures are considered and implemented, the author believes that it is safe to allow mutual funds to trade in cryptocurrency and hence they should be allowed.

Conclusion

To conclude, the Government of
 India needs to recognize cryptocurrency as an opportunity and harness this opportunity for the social and economic betterment of the Nation. As the Internet once represented an opportunity, Bitcoin also represents an opportunity which, as highlighted by various eminent commentators, can help in decentralization of economic power, greater financial access and ultimately, break down socioeconomic barriers.[12]

Although there are many barriers to allowing cryptocurrency trading, and the legal framework for cryptocurrency is in its infancy, in the future this new, easily-accessible technology will undoubtedly be adopted by many countries if it continues to grow at the rate it is currently increasing. One way of legalizing cryptocurrency is to understand it to be a commodity and thereby legalizing commodity derivatives trading by mutual funds as per SEBI rules.

The author’s research show that trading in cryptocurrency should no doubt be permitted till a foolproof legal framework is in place. For this purpose, India can create its own cryptocurrency which will then be easy to regulate. An ultimate safety option could be to peg cryptocurrency to the gold standard. But this may not be acceptable and would be hard to implement. Hence, for the time being, there is no better stepping stone than first only allowing mutual funds to invest in cryptocurrency until a completely foolproof legal framework is created and cryptocurrency trading is made either legal for the public.

The reasons are manifold. Firstly, mutual funds will have the means to evaluate the value of such trading and have experts in the field who know how to trade in it. Secondly, since it is a highly speculative investment, mutual funds can provide a disclosure report of the high risks involved, and then those voluntarily ready to invest can invest in cryptocurrency. It is vital that there are regulations in place that will mandate the disclosure report of the risks involved for investors’ money to be put into cryptocurrency. This will ensure that investors voluntarily decide once they have complete knowledge about the risks involved.

Despite the many obstacles present, India must find a way around them to reap the benefits of this technology of tomorrow.

Finally, “Every new technology comes with new legal and tax problems and technology is a double-edged sword. It is imperative that the new technology is understood on a timely basis and the appropriate regulatory regime is developed so that India does not miss out on a vast opportunity. We should not throttle this business.” [13] Nishit M.Desai.

References

1.Andy Greenberg, Crypto Currency (2011),Forbes.com ( Last visited Nov 5th 2017).

2 Nicholas A, Plassaras, Regulating Digital Currencies: Bringing Bitcoin within the Reach of the IMF , https://www.zebpay.com/wp-content/uploads/2016/04/Bitcoins.pdf ?( Last visited Nov 5th 2017).

3.Jerry Brito, Andrea Castillo, Bitcoin: A Primer for Policymakers [2013], http://mercatus.org/sites/default/files/Brito_Bitcoin ? ( Last visited on 4t h Nov,2017)

4.European Central Bank, Virtual Currency Scheme http://www.ecb.europa.eu/pub/pdf/other/virtualcurrencyschemes201210en.pdf ( Last visited Nov 5th 2017)

5.Hiralal Thanawala, 7 reasons why you should not invest in Bitcoins ( 2017), Economic times //economictimes.indiatimes.com/articleshow/60891341.cms?utm_source=contentofinterest&utm_medi um=text&utm_campaign=cppst ( Last visited on 5 th Nov,2017

6. Llewellyn, David T, Regulation of retail investment services( 1995), Economic affairs, London 13 (Spring)?? ( Last visited on 7t h Nov,2017)

7.Dina wadia,Sahil Shah, Investment Funds in India , (2016) Practical Law, https://uk.practicallaw.thomsonreuters.com/7-517 0357?transitionType=Default&contextData=(sc.Default)&firstPage=true&bhcp=1 (Last visited on 5t h Nov,2017)

8.Hon’ble Mr. Justice S.B. Sinha’s view in Tata Consultancy Services v. State of Andhra Pradesh, 271 ITR 401 (2004). ?

9. Section 2 of The Sale of Goods Act, 1930 ?
10. Jayashree Upadhyay, SEBI in talks on allowing mutual funds in Commodity derivatives trading (Sept 2017)http://www.livemint.com/Money/8B6EwkPgkO0ewo74pGpMTM/Sebi-likely-to-allow-mutual-funds-to-trade-in-commodity-deri.html( Last referred on 5 th November,2017)

11.5 reasons you should go for cryptocurrency ( Oct 2017) , //economictimes.indiatimes.com/articleshow/60891733.cms?utm_source=contentofinterest&utm_medi um=text&utm_campaign=cppst( Last reffered on 5t h Nov,2017)

12 Bitcoins-A Global Perspective (April 2015) , Nishit Desai, http://www.nishithdesai.com/fileadmin/user_upload/pdfs/Research%20Papers/Bitcoins_A_Glob al_Perspective.PDF ( Last visited on 7th November,2017)

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