[Job Michael Mathew is a 4th year BA.LL.B (Hons) student at NALSAR University of Law.
The first part is available here.]
Commodity Mutual Funds and Exchange Traded Funds?
In light of the above discussion, an investment vehicle like a mutual fund that invests in cryptocurrency and issues units of the fund in return for investing in the fund can be termed a commodity mutual fund since the underlying asset is a commodity. Under the SEBI (Mutual Funds) Regulations, 1996 (the MF Regulations), a mutual fund is defined as ‘a fund established in the form of a trust to raise money through the sale of units to the public or a section of the public under one or more schemes for investing in securities including money market instruments or gold or gold related instruments’. Thus, a mutual fund and, by extension, an ETF can invest in (a) securities including money market instruments or (b) gold or gold related instruments.
The Securities Contracts Regulation Act, 1957 (SCRA) contains a definition of ‘securities’ as well as definition of ‘goods’, which was added to the Act in 2015 when the Forward Contract Regulation Act, 1952 (FCRA) was abolished. ‘Goods’ are defined to include every kind of movable property, other than actionable claim, money and securities. ‘Commodities derivatives’ are defined to mean derivative contracts in those goods which have been notified by the Government through official Gazette. Thus, even though commodities are not defined in the SCRA, they are those goods which have been notified by the Government as such in the Gazette. The conclusion therefore is that since crypto currency is a commodity and MFs are only allowed to invest in securities which do not include commodities, MFs and ETFs investing in cryptocurrency will not be able to operate under the present state of law.
However, the definition of securities includes derivatives and the definition of derivatives interestingly includes commodity derivatives. Thus, even though commodities and securities are separate, securities are defined to include commodity derivatives. This lack of consistency is a result of the repeal of the FCRA in 2015. When the FCRA was repealed in 2015, the meaning of ‘derivatives’ was amended to include ‘commodity derivatives’. However, such addition was not met with the exclusion of commodity derivatives from the meaning of ‘securities’ which has always included ‘derivatives’. As a result, at one level the Act maintained a separation between securities and commodities but at the same time included commodity derivatives within the meaning of ‘securities’. A plain reading of the SCRA with the MF Regulations will indicate that MF and ETFs which invest in crypto futures are allowed even as crypto MFs and ETFs are prohibited. Such a conclusion was not one that the legislature nor the regulator may have had in mind and the same is indicated by the fact that in the MF Regulations gold and gold related products have been mentioned separately from securities in laying out the instruments in which a MF can invest. Therefore, if one is to see cryptocurrency as ‘commodity’, then it would not be possible for a bitcoin MF or ETF to be set up without amendments to the MF Regulations.
In this part, the author wishes to argue that even though on comparing securities and commodities and viewing cryptocurrency in light of such comparison it looks like cryptocurrency is more like commodity, that does not mean it is in fact a commodity. Commodities markets are much more strictly regulated than the securities market. For example, institutional investors until recently were not allowed access to the commodities market and secondly derivative contracts can be launched by exchanges in only those commodities that the Government has notified from time to time. Therefore, before any manager or sponsor wants to set up a MF that trades in crypto futures, the Government will have to notify cryptocurrency as one of the commodities in which derivative contracts maybe entered into. The regulatory intent behind the tighter control over the commodities market is the fear over the impacts of speculative behavior in such markets by institutional investors and others. The argument of the author is that the impact of speculative behavior over commodities such as rice, wheat or oil is extremely different from the impact on cryptocurrency. The interest that the regulator is trying to serve by controlling commodities market is not present in regulating cryptocurrency and therefore it should not be seen as commodity.
In light of the above, the author wishes to make the following proposal on the treatment of cryptocurrency. One way the regulator can deal with cryptocurrency in light of its distinction from other commodities is to amend the MF Regulations to specifically include cryptocurrency as one of the avenues where MFs can invest, just like gold. Gold is also a commodity and yet MFs are specifically allowed to invest in gold and there are a few gold ETFs also in the market presently. The rationale for allowing gold to be an avenue of investment in spite of being a commodity is the difference between gold and other commodities, much like the difference between cryptocurrency and other commodities. Thus, one can argue that the same reasons for allowing MFs to invest in gold should be used to allow them to invest in cryptocurrency as well.
Investment Vehicles in the US and lessons they offer
The first bitcoin-ETF application in the US was filed as early as in 2013. The SEC rejected the application on account of the fact that most of the bitcoin exchanges in the world are unregulated and therefore prone to manipulation. The implication is that since bitcoin exchanges are unregulated and prone to manipulation, the same will have an impact on the net asset value (NAV), which was proposed to be calculated on the basis of the price of bitcoin at a certain bitcoin exchange. The SEC feared that since the exchanges are unregulated one could potentially foresee a LIBOR scam sort of situation when exchanges work in collision to set prices which are favorable to the positions taken by them or their affiliates on the ETF. If one were to keep aside the question of whether or not a MF or ETF can invest in bitcoin, there is always the question of how the NAV will be calculated and how the same will be prone to manipulation on account of unregulated exchanges. The real question therefore on whether such vehicles are possible or not depends upon the regulator’s views on how prone to manipulation are bitcoin exchanges: even if one were to bring all the bitcoin exchanges under a certain jurisdiction under the ambit of the regulator there could still be a problem if there are substantial bitcoin exchanges in other jurisdictions where it is unregulated.
However, even as the SEC said that the fact that bitcoin exchanges are unregulated is a red flag, another regulator in the US was willing to overlook that in setting up bitcoin futures in the US. The CFTC allowed bitcoin futures to start trading in December last year. So, how exactly did CFTC allow this when SEC did not? Corresponding to NAV in futures is settlement price. In launching the futures, the concerned exchange stated that the settlement price would be decided on the basis Bitcoin Reference Rate. The sponsor partnered with an entity which prepared the index on the basis of a fixed methodology. The biggest difference is that as opposed to one exchange in ETF here it was based on prices across a number of exchanges. Adding to that the administrator had criteria of the exchanges that could join in the reference rate determining process.
Therefore, the real roadblock for an investment vehicle in cryptocurrency is the unregulated markets which make them prone to a number of frauds. Thus, before we see any sort of movement with respect to cryptocurrency investment vehicles in India, we will first see either an attempt by SEBI to regulate all bitcoin exchanges in the country or an attempt by bitcoin exchanges to get themselves registered with SEBI. Additionally, SEBI might prescribe conditions and eligibility norms of exchanges which may be taken into account for calculating NAV or settlement prices as the case maybe. It goes without saying that all of this can only happen if and when the Government stops considering cryptocurrencies as a Ponzi scheme. It wouldn’t be an understatement to say that there are a considerable number of hurdles before a cryptocurrency investment vehicle would be a possibility in India.
– Job Michael Mathew