The crux of cryptocurrencies

By R Gandhi

Cryptocurrencies, or virtual currencies, have caught the fancy of over one-and-a-half crore Indians as per claims of cryptocurrency exchanges. The trading volume in these exchanges has been growing smartly. This is despite the regulatory uncertainty, looming legislative ban and reluctance of banks to provide banking services surrounding cryptocurrencies in India.

Even during the recent heavy drop in the value of Bitcoins and other cryptocurrencies, the exchanges claim that the trading volumes have spurt. Clearly, there is immense interest in dealing in cryptocurrencies. The Reserve Bank of India’s guidelines to banks in April 2018 effectively prohibiting the use of the banking system for dealing in virtual currencies in India, the Supreme Court verdict in March 2020 overruling those guidelines and the Government’s declared intention to bring in a law prohibiting privately issued virtual or cryptocurrencies and the popularity of cryptocurrencies as enumerated above have all created the current crypto conundrum in India.

Recalling History

It will be good to recall the history of cryptocurrencies for a better understanding of the current situation in India. The radicals known as Cryptopunks, Timothy May of Intel & Eric Hughes in 1992, propounded an idea to bring a private currency based on crypto logic; this was based on a mistrust of the mainstream system and an anarchist philosophy. Later, in 1998, there was a proposition to build B-Money — a money that could not be taxed or tracked. There were attempts to create Bit-Gold, which is based on the concept that what is difficult to solve (mine) will have value, ie, solving a puzzle of the cryptographic equation can be valuable. These ideas and attempts finally came to fruition, by 2008, in the form of Bitcoin, when Satoshi Nakamoto is widely believed to have ushered it in.

Since then, the challenges and thrills of cryptocurrency mining have become a serious vocation for many cyber enthusiasts; given its anarchist philosophy. Cryptocurrency mining and also trading in cryptocurrencies have attracted persons and groups indulging in illegal activities like tax evaders, money launderers, ransom seekers and terrorists.

In their wake, there have been multiple ways in which cryptocurrencies are being used. They are used like currencies, used for making payments for goods and services; and they are popular as investible and speculative assets. They are widely, as per anecdotal instances, used for nefarious activities like money laundering, ransom demands and terrorist financing, besides for avoiding taxation.

Over these 13 years, the idea of cryptocurrencies has mushroomed and as of September 12, 2021, as per coinmarketcap.com, there are 11,821 cryptos, of which it lists as many as 6,541 as being traded. There are 406 Crypto Exchanges in the world; the market cap of the traded cryptos is $2,121,722,724,723. The top two cryptos, Bitcoin and Ethereum, account for 40.7% and 19.0% respectively. The value of all cryptocurrencies fluctuates widely. (See box). There is a genre of cryptocurrencies, called stablecoins, which have 1:1 relationship with a fiat currency like the US dollar.

Questions, Apprehensions

Along with their expanding popularity and increasing visibility, and commoners getting attracted, several questions, apprehensions and doubts have been raised all over the world about the legality and safety of using cryptocurrencies. Further, cryptocurrencies have raised a host of issues around consumer and investor protection, as well as their use to shield illicit activity and for money laundering and terrorist financing. Expectantly, there were choruses demanding diverse policy actions – ranging from freedom for financial innovation of cryptocurrencies to regulation of cryptocurrencies and even banning them altogether. This has compelled policy authorities in several jurisdictions to declare their stance vis-a-vis cryptocurrencies.

As a Report of Commonwealth Working Group on the subject (2019) puts it, there is no single, commonly emerging global model for regulation of virtual currencies. Several countries have publicly concluded that – so far – there is no current need to bring in new regulation to address the overarching issues relating to virtual currencies and that they can rely on existing regulation to address the issues. At the other end of the scale, some countries have taken steps to substantially prohibit all use of virtual currencies, including for reasons of financial stability. Many more countries are said to be considering some form of regulation of virtual currencies.

India’s Stand

India started with a cautious stance in the beginning. As far as back in December 2013, the Reserve Bank of India had cautioned the general public and the users on virtual currencies, in particular about the risks of using virtual currencies. It said that virtual currencies are not authorised by any central bank or monetary authority. There are potential financial, operational, legal, customer protection and security-related risks in using them.

Virtual currencies, being in digital form, are stored in digital/electronic media; are prone to losses arising out of hacking, loss of password, compromise of access credentials, malware attack, etc. Loss of the e-wallet could result in the permanent loss of the virtual currencies held in them. Payments by virtual currencies are on a peer-to-peer basis. No established framework for recourse to customer problems/disputes/chargebacks etc is available.

There is no underlying or backing of any asset for virtual currencies. Value seems to be a matter of speculation. Its legal status is unclear. And usage of virtual currencies for illicit and illegal activities has been reported. The Reserve Bank reiterated this caution in February 2017 and in December 2017 also. On April 6, 2018, the Reserve Bank issued guidelines to all entities regulated by it that they shall not deal with or provide services to any individual or business entities dealing with or settling virtual currencies.

Parallelly, the government of India has also been active in matters relating to cryptocurrencies. A high-level Inter-Ministerial Committee (IMC) was constituted on November 2, 2017, under the Chairmanship of Secretary, DEA, to study the issues related to virtual currencies and propose specific action to be taken in this matter. The Union Finance Minister, in the Budget speech in 2018, also announced that the government does not consider cryptocurrencies as legal tender or coin and would take all measures to eliminate the use of these crypto assets in financing illegitimate activities or as part of the payment system. It said that virtual currency in and of itself does not have any of the benefits associated with a fiat currency. Further, the Committee noted that non-official virtual currencies can be used to defraud consumers, particularly unsophisticated consumers or investors.

Another concern from the use of non-official digital currencies is to the economy and the financial system with implications for monetary supply, particularly given their volatility and crippling use of resources including energy. On account of the anonymity associated with virtual currencies/cryptocurrencies, they are vulnerable to money laundering and use in terrorist financing activities while also making law enforcement difficult.

Keeping all of the aforesaid in mind, the Committee recommended that all private cryptocurrencies, except any cryptocurrency which may be issued by the government, be banned in India. It also provided a draft Bill for such a statute. In February 2021, the government informed that it would bring a Bill on cryptocurrencies as the existing laws are inadequate to deal with the issues concerning cryptocurrencies. As the contours of the proposed Bill are not yet public, speculation, discussions and debate on the subject have increased.

Regulating Crypto

There is a case for treating and regulating crypto as a separate asset class with a view to enabling governments around the world to effectively deal with illegal activities associated with virtual currencies. After quite a lot of debate over the years, people have fully understood that crypto cannot be a currency because the fundamental element of a currency — that it should be a legal tender — is missing in this case, ie, one cannot compel a cryptocurrency to be accepted by another person as it is not a legal tender. The emerging general view is that it should be deemed as an asset, not as a currency, not as a payment instrument and not as a financial instrument as there is no clear identified issuer.

What are the properties of an asset? An asset can be physical, financial or virtual. Virtual like IPR or brand value. It will have value, which may be fluctuating in either direction. It can be bought, sold, traded, or dealt with through contracts. Such dealing can either be in full, or in parts; it can either be in divided fashion or in undivided fashion; it can be bartered for goods and services; it can be monetised in parts or in full. So, cryptocurrencies or virtual currencies will qualify as an asset.

Once we have an understanding and acceptance that it is an asset (not a currency), it becomes relatively a little easier to have regulation around it. However, there is every possibility of using this virtual asset for criminal activity in absence of regulation and there are numerous instances indicating that. Any jurisdiction should have a clear framework by which any part of the economic activity should not be seen as supportive of any criminal activity. Every society will have its own rules, and will expect compliance from all its members and will penalise non-compliance.

A practical way to resolve the current conundrum is, therefore, to first deem the crypto or virtual currencies as an asset. Given the associated risks of crypto or virtual currencies, it may be practical to restrict their dealing only by qualified investors and entities, who have established the capacity to understand and take such risks.

(The author is former Deputy Governor, Reserve Bank of India)

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