Since the Supreme Court overturned India’s ban on cryptocurrencies, trading volumes have increased exponentially and home-grown crypto startups have blossomed. But the government has yet to establish a regulatory regime, and reports of another ban and the launch of an official government coin are spooking investors. In this special report, co-published with Cyril Amarchand Mangaldas and L&L Partners, legal experts assess the status of cryptos in India and the prospects for effective regulation.
Cryptocurrencies have seen growing recognition from some central banks, but Anu Tiwari and Anindita Bhowmik find that their reception at home remains mixed
In recent years, cryptocurrencies have gained popularity as an investment route notwithstanding the underlying regulatory uncertainty.
The Reserve Bank of India (RBI), during 2013-2017, issued press releases cautioning against the risks associated with cryptocurrencies, culminating in a controversial circular proscribing bank from dealing in them, or engaging with entities or persons dealing in them. However, in 2020 the Supreme Court, in Internet and Mobile Association of India v the RBI (the IMAI judgment), struck down this circular for being disproportionate.
Still, regulatory hostility to cryptocurrencies continued unabated, with the government having promulgated the Banning of Cryptocurrency and Regulation of Official Digital Currency Bill, 2019 (Crypto Bill 2019), to ban cryptocurrencies. This was followed by the Cryptocurrency and Regulation of Official Digital Currency Bill, 2021 (Crypto Bill 2021), which was included in the agenda of the lower house of parliament (Lok Sabha) in the budget session, but not tabled.
While the Crypto Bill 2021 is not in the public domain, its purport, as per the official bulletin, is to:
(1) create a facilitative framework for the creation of an official digital currency (ODC) to be issued by the RBI; and
(2) prohibit all private cryptocurrencies in India while, however, allowing for certain exceptions to promote the underlying technology of cryptocurrency and its uses.
Minister for Finance and Corporate Affairs Anurag Thakur recently indicated that the government may take a “calibrated approach” towards digital assets and protect the interests of crypto investors in the Crypto Bill 2021.
The Crypto Bill 2021, once enacted, would finally clear the longstanding regulatory uncertainty surrounding cryptocurrencies while streamlining the fintech, banking and payments sector in its adoption of the underlying technology.
The key issue surrounding regulation of cryptocurrencies is the inability to identify their legal status. Depending on the text of the statute involved, and the context, courts in different jurisdictions have identified cryptocurrencies as being property, commodities, non-traditional currency, payment instruments, or money. Money/currency. Neither the Reserve Bank of India Act, 1934, nor the Banking Regulation Act, 1949, nor the Payment and Settlement Systems Act, 2007 (PSSA), nor the Coinage Act, 2011, define the words “currency” or “money”.
Payment system. For the RBI to regulate cryptocurrencies under the PSSA – read with the Master Directions on Issuance and Operation of Prepaid Payment Instruments, dated 11 October 2017 (as amended) – it must hold monetary value. However, cryptocurrencies may not have any inherent value, and their value, if any, is contingent on market speculation (unlike a prepaid payment instrument) and, due to the decentralised nature of certain cryptocurrencies, there exists no payment system operator.
The IMAI judgment, however, recognised the RBI’s power to regulate cryptocurrencies under the PSSA, since cryptocurrency transactions include a “payment obligation” or “payment instruction”.
The Foreign exchange Management Act (FEMA) defines the terms “currency”, “currency notes”, “Indian currency” and “foreign currency”. The IMAI judgment recognised that the RBI could notify cryptocurrencies falling under the category of “other similar instruments” under the definition of the term “currency”, under the FEMA, and therefore users and traders of cryptocurrencies would be deemed to carry on an activity that falls squarely within the purview of the RBI.
Securities. Initial coin offerings may be regarded as a “security”, and therefore may fall under the regulatory purview of the Securities and Exchange Board of India (SEBI). The definition of the term “securities”, under the Securities Contract Regulation Act, 1956 (SCRA), does not include cryptocurrencies, but it may be considered a security due to the inclusive nature of the definition, which includes “other marketable security”. It may be argued that cryptocurrencies can be considered as a “security” if generated, distributed and sold in a centralised manner.
Commodities. The SEBI’s September2016 circular – read with the Ministry of Finance’s September 2016 and October 2019 circulars – does not explicitly include any cryptocurrencies in the list of notified goods for the purpose of the term “commodity derivative” under the SCRA. However, the central government may choose to notify cryptocurrencies as commodities under the above-mentioned notification. Indian crypto exchanges have recently made representations seeking regulation by SEBI rather than the RBI, stating that crypto assets are in the nature of commodities rather than currency.
Direct tax implication. The Income Tax Act, 1961, does not explicitly provide clarity on taxation of cryptocurrencies. However, the sale of cryptocurrencies may be taxed as “capital gains” if considered an investment or business income.
Indirect tax implication. In a case of cryptocurrencies being treated as goods, the same may be deemed a “taxable supply”, and therefore subject to goods and services tax (GST). A recent proposal to impose an 18% GST on cryptocurrency trading reflects this understanding.
Future of cryptocurrencies
Decentralised finance. The nascent decentralised finance (DeFi) industry has further expanded the scope of cryptocurrencies, in terms of crypto-backed lending and reducing the costs associated with cross-border remittances, against the background of India being the leading remittance recipient. While the DeFi industry has had its share of risks and failures, considering anti-money laundering and compliant DeFi solutions are already in the works, this should further bolster confidence in DeFi as a viable alternate financing option.
SALT blockchain-based digital lending. The secured automated lending technology (SALT) platform enables members to obtain loans by way of furnishing their blockchain as collateral. Recently, Cashaa, a London-based online cryptocurrency platform, tied up with the United Multistate Credit Co-operative Society to provide savings accounts and loans to its customers and crypto investors in India.
Blockchain in financial sector. Given that major economies of the world are already adopting varied approaches to dealing with cryptocurrencies and blockchain, we are witnessing increasing involvement of blockchain technology in the financial services space (including the interest of global banks in their wealth and private banking arms). Notably, Tata Steel and HSBC successfully executed a blockchain-enabled transaction as a global first for the steel industry. KYC/AML requirements. To date, thereare no KYC (know your customer)/AML (anti-money laundering) requirements for registration/licensing with the RBI for undertaking any cryptocurrency business in India. This is unlike Singapore, which requires:
(1) registration of cryptocurrency exchanges with the Monetary Authority of Singapore, involving detailed CFT (combating of financing of terrorism)/KYC/AML obligations; and
(2) due diligence on the cryptocurrency exchange and issuer.
Trading disclosures. In addition to the steps undertaken by the RBI, pursuant to a notification by the Ministry of Corporate Affairs, with effect from 1 April 2021, all companies are required to disclose details of their investment and trading in cryptocurrencies in a financial year in their financial statement.
Market uncertainty. In addition to the regulatory uncertainty as detailed above, there have also been recent instances of lack of support by Indian banks to crypto exchanges, and suspension of rupee deposits at crypto exchanges for new users, without there being any formal regulatory directive in this regard. This has further muddied the waters in relation to the future of this sector.
Cryptocurrencies are no longer relegated to the margins of global finance. Recognising that cryptocurrencies are here to stay, a majority of central banks have begun exploring, engaging, experimenting or developing central bank digital currencies (CBDC). In this backdrop, it may be time for the RBI to issue its CBDC, along the lines of the CBDCs by the People’s Bank of China and the Central Bank of Russia, or the already implemented sand dollar issued by the Central Bank of Bahamas.
This may bridge the downsides presently associated with cryptocurrencies (volatility, money laundering and tax evasion), while improving the efficiency and ease of financial transactions, and working towards reducing the present high cash-to-GDP ratio of the economy. A regulatory sandbox option may be explored, where a pilot project may be launched in a controlled environment, prior to a wider launch.
Notwithstanding the issue of a digital rupee, with cryptocurrencies’ growing recognition (including a recent listing of a cryptocurrency exchange on the Nasdaq), a calibrated regulatory response – like Singapore’s model involving licensing – would be advisable, rather than an outright ban on cryptocurrencies.
Senior associates Bharath Sridhar and Utkarsh Bhatnagar assisted the authors with this article.
The regulation of cryptocurrencies presents many advantages for the government, not least that it creates new streams of tax revenue, write Rajiv Luthra and Anirudh Gotety
The past few months have been an invigorating time for cryptocurrencies. All-time highs, institutional support and listed companies committing a part of their balance sheets to Bitcoin are some developments that have announced the arrival of cryptos to the mainstream. Since the Supreme Court of India overturned the Reserve Bank of India’s (RBI) banking ban imposed on crypto exchanges in March 2020, crypto trading in India has seen an uptick. This trend was further accelerated by the pandemic and people’s desire to diversify their portfolios with this emerging new asset class.
After initially proposing to completely ban private cryptos under the Banning of Cryptocurrency and Regulation of Official Digital Currency Bill, 2019, the government has indicated that it might reconsider the move. A ban would be ill-advised, especially without considering the second-order effects of such an action. An outright ban would lead to illicit trade, stoking the very classes of transactions that the government fears.
It will also lead to Indians falling behind in the accumulation of this new age “digital gold”, and the government losing out on tax revenue. Separately, a ban will hurt innovations like non-fungible tokens, which are based on the technology underlying cryptocurrencies.
On the other hand, not regulating them is leading to uncertainty and confusion, while the transactions the government fears are continuing unabated. Clearly, the only option left for the government is to regulate.
Cryptocurrencies are more akin to cash than any other payment method or asset known to us. They are stored in “wallets”. If you wish to transfer cryptos out of your wallet, you only need to know the public address of the receiver’s wallet. No amount of regulation can prevent the actual transfer of cryptos from one wallet to another, much like the physical exchange of cash cannot be prevented.
However, similar to what is done for cash transactions, crypto transactions can also be regulated to make them secure, or to filter the unwanted ones. The government needs to start thinking of Bitcoin and other cryptos as digital cash. The same amount of effort and energy expended to combat illicit cash dealings needs to be expended to combat the illicit crypto trade.
KYC and AML norms
Cryptos are based on the blockchain, a decentralised ledger. A record of all transactions ever made on the blockchain is visible to everyone. Some cryptos, like Bitcoin, are semi-anonymous, which is to say that a particular crypto wallet has a public key. Combine these two factors, and once you put a name behind a public key, the government could theoretically access information on all transactions ever made by that wallet, and by extension, that person. This can be the starting point for regulation.
Strong know your customer (KYC) and anti-money laundering (AML) norms for crypto wallets in the country should be the bulwark of the regulatory landscape for cryptos in the country. In line with other jurisdictions, regulations must incorporate strict KYCs and suspicious transaction reporting norms. AML laws around cryptos should be made certain.
The Financial Crimes Enforcement Network, a bureau of the US Department of the Treasury, is mulling a regulation that would require exchanges to allow wallet transfers only to other wallets that have completed the KYC. A regulation like this would go a long way in assuaging the government’s concerns on money laundering.
Regulation of exchanges
The Securities and Exchanges Board of India (SEBI) tightly regulates stock exchanges and the issue of securities to the public in India. However, crypto exchanges in India are running without regulatory oversight. To their credit, popular local crypto ex-changes have put in place KYC norms mirroring that of traditional brokerage firms. However, there is precious little in place in terms of consumer grievance redressal. Recently, a popular cryptocurrency exchange crashed during a surge in trading in India. Customers were left stranded until the exchange went back online.
The exchanges serve multiple functions. They operate: An exchange for various cryptos, like the National Stock Exchange for traditional securities; as brokerages connecting buyers and sellers; and even provide a crypto wallet (akin to a depository participant providing demat accounts). Needless to say, effective regulations for each of these functions need to be put in place. The regulations will need to address accountability, transparency, and a degree of uniformity around crypto exchanges. This could be done by setting up licensing to tackle fraudulent entities that engage in multi-level marketing and Ponzi schemes. Strong consumer protection and grievance redressal mechanisms will have to be put in place.
Initial coin offerings (ICOs) are another beast to tame. ICOs are akin to a startup fundraise and are of two types. The first type offers digital tokens to investors at fixed prices to be exchanged for the new cryptocurrency in the future. The second uses the capital to start the company. The digital tokens can be redeemed during future funding rounds, or an IPO. These tokens are traded on exchanges and are negotiable. ICOs have raised billions of dollars and worried regulators globally, given that the tokens raised are not backed by any asset. Many ICOs have turned out to be elaborate scams.
The SEBI was established to protect the interests of investors in securities, and to promote and regulate the securities market. It is perhaps time for the SEBI, or perhaps a new regulator, to do the same for the crypto market. A reading of the definition of “security” under the Securities Contracts (Regulation Act), 1956, and the Supreme Court’s jurisprudence on the same suggests tokens offered through ICOs already fall under the regulatory purview of the SEBI. The ghost of the Sahara Scam is still haunting India’s regulators and the government would not want a repeat of that.
Classifying as a capital asset
Separately, clarity will be required on whether cryptos would be considered as goods, or a distinct asset class. The classification would have both taxation and exchange control ramifications. The government would be well advised to classify cryptos as capital assets because they are not being used as a medium of exchange (i.e., as a currency), but are being accumulated and traded as securities.
There is a significant tax advantage to regulating cryptos. The government’s coffers would be in for a windfall. Reports indicate that some Indian crypto exchanges have recorded daily trading volumes upwards of US$200 million.
On the direct tax front, the income with the exchanges, users and others could be charged under the relevant chapters of the Income Tax Act. Capital gains would be applicable on the income made by individual investors. Cryptos could also be treated as stock-in-trade for crypto-related businesses and taxed as business income. Exchanges would of course be liable to pay income tax on the commission income they make as well. The government should formulate bespoke provisions for cryptos under the Income Tax Act.
On the indirect taxation (GST) front, a whole gambit of crypto services could be taxed – the commission crypto miners receive, the margins exchanges charge, service fees and a lot more.
On the exchange control front, cryptocurrencies such as Bitcoin should be deemed capital assets. Under Indian law, capital account transactions are prohibited unless expressly allowed.
The government should come up with specific regulations to address cross-border cryptocurrency transactions. Therefore, any cross-border crypto transactions would be prohibited unless specifically allowed by the regulations.
The government should actively encourage institutional support for cryptos, be it exchanges, banks or payments systems. It should try to imagine its reach over cryptos if banks, which are tightly regulated by it, are allowed to actively join the mix.
This model is certainly more desirable for the government because it already has the capacity to regulate these institutions. The government would be better equipped to regulate them and leave the grunt work to the banks and exchanges, similar to how the government regulates banks holding cash or physical assets like gold.
While cryptos have a host of risks that are well documented, they have immense benefits for most – merchants, the exchequer, regulators, etc. India would therefore be well served to not discount the potential of cryptocurrencies. At the very least, regulations must be put in place to prevent the stated reasons for which the government was contemplating a ban.
It is important to note that the term “cryptocurrency” is a catch-all term. There are about 2,000 different cryptocurrencies with different applications. Each crypto and each application would have distinct regulatory implications. The recommendations made in this article are for established cryptos like Bitcoin and Ethereum, and could of course change should the use of cryptos in India change over time.
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