India's Crypto Quandary

Decrypting the developments in the regulatory space

In 2017, a high level Inter-ministerial Committee ("IMC") was constituted to study the issues related to virtual currencies ("VC") and make recommendations for the same. The IMC recommended a ban on all private cryptocurrencies in India since they were considered inconsistent with the essential functions of money/currency. The IMC noted that there was no country that had provided the status of legal tender to cryptocurrencies. It was also recommended that an official digital currency be introduced by the RBI to reap the benefits of VCs while avoiding its detriments. To this end, the IMC proposed a draft bill, which was not tabled in the Indian Parliament^[1].

On April 6, 2018, the Reserve Bank of India ("RBI") issued a circular^[2] that prohibited entities regulated by the RBI from dealing in VCs. This was set aside by the Supreme Court of India in March 2020^[3]. Subsequently, the RBI issued a notification clarifying the invalidity of the circular, as certain banks/regulated entities were warning their customers against purchase of VCs despite the Supreme Court's judgement^[4].

The RBI has followed a cautious approach towards the growing market of cryptocurrencies in India. In the aforementioned judgement, the Supreme Court observed that the RBI's measure of banning cryptocurrencies in India failed to pass the test of proportionality. In light of this, it was anticipated that a complete ban on private cryptocurrencies in India would not be imposed by the government. However, a new bill titled 'The Cryptocurrency and Regulation of Official Digital Currency Bill, 2021' ("Bill") that reaffirms the ban, is ready to be tabled in the monsoon session of the Parliament. The Bill seeks to prohibit all private cryptocurrencies in India with certain exceptions to promote the underlying technology and its usage. It will also create a framework for issuance of official digital currency by the RBI^[5].

A rundown of crypto related concerns

Considering that India is at a crossroads regarding the regulation of private cryptocurrencies, it is important to understand the risks posed by the adoption of these.

1. Decentralisation: A unique feature of private cryptocurrencies is their decentralised nature as there is no central authority that governs these networks. Cryptocurrencies, unlike fiat currencies, do not have a sovereign backing since they are not issued by any authority. They also do not have the backing of bullion (for example, gold) and have no intrinsic value of their own. Thus, they are considered at odds with the historical concept of money^[6]. As per the IMC's report, there is an apprehension that central banks cannot regulate the money supply in the economy if non-official VCs are widely used because they are decentralised. This could also have bearing on their ability to stabilise the economy. Additionally, cross-border transactions may also violate foreign exchange laws.

2. Risks to consumers: The performance of cryptocurrencies in the market is subject to factors such as technological changes, behavioural changes, and the financial investments in them. The IMC noted that the highly volatile and speculative nature of the crypto market puts the consumers at risk^[7]. In May this year, major Indian cryptocurrency exchanges, WazirX and CoinDCX suffered outages as the cryptocurrency market crashed after Elon Musk's tweet on Bitcoin. Investors were unable to sell their crypto assets due to the technological issues faced by the exchanges^[8]. The value of cryptocurrencies is thus susceptible to extreme shocks, fluctuations, market manipulation and can lead to significant losses of investors. The transactions carried out through cryptocurrencies are also irreversible which is another risk faced by consumers. It is to be noted that, currently there is no legislation that governs private cryptocurrencies in India. Therefore, if regulations are introduced that protect consumers, it may be possible to manage these risks.

3. Environmental impact: Elon Musk's decision to suspend purchases of vehicles in Bitcoin (the tweet mentioned above) was based on the environmental toll caused by mining of the cryptocurrency. In this regard, the IMC noted in its report that, mining of private cryptocurrencies is resource intensive and requires high levels of storage and processing power. A study by Cambridge University suggests that bitcoin mining consumes more electricity than countries like Malaysia and Argentina consume in a year^[9]. However, it is pertinent to note that the usage of resources varies depending upon the mechanism of mining the cryptocurrency. Taking cue of the criticism, eco-friendly cryptocurrencies such as Chia, IOTA and Bitgreen have also emerged^[10].

4. Criminal activity: Due to the pseudo-anonymity or anonymity that cryptocurrency transactions provide, governments fear that cryptocurrencies can be used for illicit activities such as money laundering, funding terrorism, tax evasion and etc. In one such case, the Enforcement Directorate has issued a show cause notice to WazirX, owned by Binance, for contravention of Section 3(a) the Foreign Exchange Management Act, 1999("FEMA") for transactions involving cryptocurrency^[11]. The IMC noted in its report that, the degree of anonymity provided makes tracking down offenders by law enforcement agencies difficult. The ambiguity in the legal status of VCs also raises issues in framing charges^[12]. However, these concerns may be mitigated by creating regulatory oversight. For instance, imposing mandatory requirements on cryptocurrency exchanges of carrying out customer due diligences processes such as know-your customer (KYC) and following anti-money laundering (AML) and combating of financing of terrorism (CFT) policies.

What is Central Bank Digital Currency?

RBI's Deputy Governor, Shri T Rabi Shankar, stated in July 2021, that the central bank is planning on introducing a VC, the Central Bank Digital Currency ("CBDC"), in a phased manner. Akin to fiat currency, the CBDC is a legal tender and is exchangeable one-to-one. It is a sovereign liability and distinguishable from cash because of its digital form^[13]. China has been a pioneer in experimenting with CBDCs since 2014 and has recently begun testing for digital yuan or eCNY in cities^[14].

The Deputy Governor in his speech explains that, CBDCs provide certain benefits to the payments system. Payments are final and minimise settlement risk, for instance, eliminating the role of an intermediary when an Indian importer has to pay an American exporter. A transaction by CBDCs would be similar to one with cash dollars and would be on a real-time basis. Further, cash usage to a large extent can be reduced by the use of CBDCs. Thereby, decreasing the transaction costs associated with printing, transporting and storing currency. He also notes that, cash is preferred for its anonymity and this preference can be redirected to CBDC by the assurance of anonymity^[15]. Similarly, one of the reasons for the growing popularity of cryptocurrencies is anonymity. The degree of anonymity(if any) associated with CBDCs is a key consideration that is being debated by central banks globally.

RBI noted in its latest report on currency and finance that CBDCs may be designed inter alia to promote non-anonymity at the individual level and monitor transactions. Concerns have also been expressed in the report over anonymity of CBDCs and its legal implications on cross-border payments^[16]. Therefore, it is unlikely that CBDCs will be able to provide the extent of anonymity that comes with cash or cryptocurrencies.

The introduction of CBDCs may be perceived as a reaction of the RBI to the widespread adoption of private cryptocurrencies in the country. Considering the volatility of cryptocurrencies, the Deputy Governor believes that CBDCs are necessary to protect the general public from the risks of private cryptocurrencies. However, can CBDCs act as an alternative to cryptocurrency? Apart from the anonymity conundrum, CBDCs are against the very ethos of cryptocurrency which is decentralisation. Thus, the demand for cryptocurrencies cannot be replaced with CBDCs and they cannot be marketed as an alternative to the same.

Although CBDCs are not comparable with cryptocurrencies, adoption of CBDCs or digital rupees, will help the country progress towards its goal of a cashless economy and financial inclusion. An important consideration that should be evaluated by the RBI is whether the use of CBDCs will compromise privacy of Indian citizens. Since CBDC transactions can be easily tracked and monitored, it can increase government surveillance and scrutiny of transactions. Accordingly, it is probable that citizens would still prefer cash over CBDCs. Owing to these privacy concerns, RBI should also ensure that principles governing CBDCs are in line with the Personal Data Protection Bill, 2019. Furthermore, changes to the legal framework such as amendments in the RBI Act, 1934, FEMA, 1999, and Information Technology Act, 2000 will have to be made to incorporate the digital currency.

Looking at international perspectives

Since the IMC's report in 2019, the global view has significantly changed with respect to cryptocurrencies. El Salvador became the first country to adopt a cryptocurrency, Bitcoin, as legal tender in June this year^[17]. It remains to be seen if other countries will follow suit. As of today, countries such as China, Bolivia, Columbia and Russia have banned cryptocurrencies and outlawed their use. Whereas, some countries like the United States, Canada, Australia and the European Union have taken a positive approach towards cryptocurrencies. Their governments have been issuing guidances and have also developed initiatives to facilitate trading. For instance, the European Union is developing a law that seeks to ensure full traceability of cryptocurrency transfers and for prevention of money laundering and terrorism financing. However, the proposal has been designed to address these threats without imposing excessive regulation upon the industry^[18]. Many states in the United States have introduced legislation accepting the use of Bitcoin and its underlying technology^[19]. None of the countries have, like El Salvador, made a definitive move to elevate a cryptocurrency at par with national currency. It is relevant to note that the International Monetary Fund has issued a warning that such an action can negatively affect the financial and economic stability of a country^[20].

A balanced approach in dealing with cryptocurrency is necessary since VCs and their technology is constantly evolving. Regulatory clarity is the need of the hour for the cryptocurrency industry in India. Therefore, the inadequacy of existing laws should be addressed at the earliest.

Ashima Obhan is a Partner and Seerat Bhutani is an Associate at Obhan and Associates. Views are personal.