The Curious Case of Cryptocurrencies: Part II

[Pranav Tolani is associated with a corporate law firm in Mumbai and can be reached at [email protected]]

The first post in this series is available here]

The Indian Position

While India has active cryptocurrency traders as well as cryptocurrency exchanges, there has been no serious development on the regulatory front, except, of course, the repeated warnings by Reserve Bank of India and the Indian Finance Minister against investing in cryptocurrencies. Officially, at least three circulars have been issued in this regard – with one April 2018 circular specially arousing a controversy. The Circular effectively directed all banks to stop facilitating individuals and businesses dealing in virtual currencies by July 2018. Services include maintaining accounts, registering, trading, settling, clearing, giving loans against cryptocurrencies, accepting them as collateral, opening accounts of exchanges dealing with them and transfer/receipt of money in accounts relating to purchase/sale of virtual currencies. Certain stakeholders approached the Supreme Court for a stay on the order – but so far, it has refused to do so. Without bank support, cryptocurrency enthusiasts are now looking at creative ways to continue trading – for example, by depositing their cryptocurrencies in an escrow with a cryptocurrency exchange and settling the trade in cash. Cryptocurrency exchanges have been facilitating this P2P model strongly as well.

Digging deeper to parent statutes, the Reserve Bank of India Act 1934 – the primary law dealing with banking, monetary and fiscal regulations in India – does not define what comprises legal tender. It does, however, specify that only the Reserve Bank of India has the power to issue bank notes and only bank notes issued by the Reserve Bank of India shall be considered legal tender – over several years, various instruments have been prescribed as legal tender, including One Rupee coins.
Further, the Foreign Exchange Management Act 1999 – the law formalising external trade and exchange policies of India – defines the term currency’ as ‘all currency notes, postal notes, postal orders, money orders, cheques, drafts, travellers’ cheques, letters of credit, bills of exchange and promissory notes, credit cards or such other similar instruments, as may be notified by the Reserve Bank of India’. Furthermore, Indian currency’ has been defined as the currency which is expressed or drawn in Indian Rupees. Similarly, ‘currency notes’ are defined to mean and include cash in the form of coins and bank notes.

From a combined reading of the above, it is quite clear that cryptocurrencies are neither ‘currency’ nor legal tender in India. A connected question is if cryptocurrencies are tradeable ‘securities’ (defined to include shares, scrips, bonds, derivatives, government securities etc. – instruments ‘issued’ by an entity) under the Securities Contracts Regulation Act 1956? The answer is again a no – the definition itself and judicial precedents have set clear parameters for the same (a position reflected by global regulators as well).

On the same note, while cryptocurrencies may be called ‘commodities’, the term is not defined in any Indian statute. In any case, the formal commodities trading market is strictly regulated by the Securities and Exchange Board of India – which, so far, has not allowed cryptocurrency trading on the commodities exchanges in India.

Then there are issues around taxation. It is not clear how tax authorities will treat tokens – as currency (income?) itself or capital assets. Further, depending upon how the tokens are acquired (through mining, trading or exchange) and sold, the gains can be taxed as business income or capital gains. However, the position is not statutorily clear.

Hence, without any recognition from the financial regulator or a functioning framework from the securities markets regulator, cryptocurrency activities in India function in a legal grey area. While it can be argued that contractual and conveyancing laws (the Indian Contract Act 1872, Transfer of Property Act 1882 and Sale of Goods Act 1930) should still be suitable to govern cryptocurrency transactions – in the author’s view, the provisions therein are quite outdated to appropriately regulate the sophisticated activities in this modern-day concept.

Challenges and the Way Ahead

Cryptocurrencies, in their current form, present only one use-case – an investment opportunity. However, as already mentioned, most investment activity is likely a result of speculation and a fear-of-missing-out syndrome than educated analysis of the market dynamics. In fact, since the crash (or, correction) after December 2017, there has been no significant upward movement and the market is more-or-less at a plateau. It is unlikely (unless some very startling development changes the status quo) that the market recovers to reach the same high again given that cryptocurrencies do not present any serious real-life utility (at least, as of today). Even the market plateau can possibly be explained by the HODL (a misspelling of ‘hold’) strategy which advises cryptocurrency investors to avoid dumping their tokens when there is a market drop to avoid further depletion of capitalisation – or because of new optimistic investors joining the market every day.

On the other hand, if cryptocurrencies are used in the manner they were anticipated i.e. as decentralised substitutes of bank issued currencies used to buy goods and services – there are other issues. The first is a lack of statutory recognition. As long as they are not formally given the status of legal tender, cryptocurrencies will never be accepted as viable cash consideration. At least in India, any transactions involving cryptocurrencies with goods and services would be in the nature of what is legally known as ‘exchange’– a swap of one good/service for another or be consideration in kind. Again, this is an overarching presumption since neither the statutory framework, nor jurisprudence have provided explicit provisions for the same. Regardless of their legal recognizability, there indeed are players in the market who accept cryptocurrencies as ‘money’ – but given the extreme volatility, caution is advised.

Second, regardless of the above, cryptocurrencies seem grossly inadequate to substitute traditional bank issued currencies and payment systems due to various other reasons like staggered availability of internet access, no physical footprint, no proper valuation mechanism, no regulator to control volatility, huge dependence on computer systems, lack of informed investors, no fundamental metrics to analyse performance etc. Also, with so many cryptocurrencies, exchange rates and fungibility (of one cryptocurrency into another – for example, Bitcoin into Ethereum or Ripple) is a challenge.

Ancillary issues include high electricity consumption (annual cryptocurrency mining consumption has been claimed to be equal to the annual electricity consumption of Argentina) for mining cryptocurrencies, skewed market etc. Also, cryptocurrencies present themselves as vehicles of fraudulent activities given the lack of subject knowledge. Initial coin offerings invite subscription from public without any regulatory oversight (compared to the stringent provisions for equity IPOs in the SEBI Issue of Capital and Disclosure Requirements Regulations 2009). They either never return any investments or turn out to be shams. Privacy concerns on the Blockchain infrastructure being decentralised and public also exist. Intermediaries are unregulated – hence, neither do they maintain appropriate security standards (thus, being prone to hacks), nor do they have any KYC norms for participants.

The decentralised nature, if not the cause, makes it hard to control volatility. It also makes the system prone to manipulation and abuse. The use of Bitcoins on the narco-Silk Road is an example of how the pseudo-anonymity offered in the absence of a regulatory outline can leave scope for wrongful use.

Way Ahead

However, having said the above, it is important to note that, even with all the issues, banning cryptocurrencies is not the appropriate solution. It will only prompt the market to move underground. The ideal way would be to study the dynamics and legislate them accordingly. A governmental committee has already been set up to consider regulation as on date – hopefully, a forward-looking approach will tame the anarchical market. More recently, the government has indicated that it may allow crypt-tokens – however, at least as of now, these tokens seem more like pre-payment instruments which can be loaded with INR, than as ones representing decentralised cryptocurrencies.

While recognizing them as currencies seems far-fetched and impractical (given that they are not issued by the Reserve Bank of India) in the Indian context, Indian regulators can allow trading as an investment class asset on the commodities exchanges. (Interestingly, Japan and Switzerland recognize cryptocurrencies as non-currency legal tender.) Moreover, cryptocurrency exchanges can be separately legislated along the lines of stock exchange regulations. Initial coin offerings can be made to abide by strict disclosure and compliance norms. In a regulated market, not only will the stakeholders have a platform to safely trade cryptocurrencies – the market can also thrive (although the author doubts once the hype is over, there will be any serious incentive in cryptocurrency investing or trading).

On the other hand, cryptocurrencies can (and have already) inspire countries to host their national currencies on Blockchain-based bank-free (and hence, cheaper and arguably more secure) payment systems – Singapore, Russia, England and even India are considering doing the same. Another alternative is to create a central regulator, which – while it will not issue these cryptocurrencies – could artificially check volatility to make cryptocurrencies usable as ‘money’. Venezuela, troubled with dangerous hyperinflation, is considering implementing something on these lines to attract foreign investment.

Given the current trends – it is likely that the ‘mania’ will eventually subside, and the market will fade subsequently. Keeping the same in mind, it is ideal to regulate the situation instead of halting it – allowing things to take an organic course, either to a natural death; or to the moon, as cryptocurrency enthusiasts endearingly say.

[Concluded]

Pranav Tolani

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