India: Cryptocurency's Close Shave: An Analysis Of The Supreme Court Judgement Legalizing Trading In Virtual Currencies

The Supreme Court ("SC") of India in the case of Internet and Mobile Association of India v. Reserve Bank of India (decided as per order dated March 04, 2020) has held that the Reserve Bank of India ("RBI") Circular dated 06 April 2018 virtually banning cryptocurrencies (also referred to as "Virtual Currencies/ VCs") and their trade in India, is violative of Article 19(1)(g) of the Constitution of India, 1950 ("Constitution of India")

CONTEXT

Cryptocurrencies and Blockchain technologies are one of the most profound and intelligible innovations of the 21^st century, which in the long term have a potential to allow economies to detach themselves from governments, and herald an era of "trust-less" money. Cryptocurrencies although often seen from the myopic standpoint of Bitcoin as a currency or an alternative to money, is in reality, a dyson sphere of possibilities. Take for example, Ethereum, another cryptocurrency with the highest market capital after Bitcoin, is a decentralized software platform that enables Smart Contracts and Decentralized Applications (DApps) to be built and run without any downtime, fraud, control, or interference from a third party. The applications on Ethereum are run on its platform-specific cryptographic token, ether. Essentially, the cryptocurrency Ethereum may one day allow a trader sitting in China to automatically purchase a certain amount of goods at price X when the given price hits the limit price. What separates cryptocurrency from any other market allowing for such trade is that there is no central governing authority whatsoever, thereby eliminating the middleman.

Technology and innovation are major changes that often face opposition and ostracization from the incumbents, which in this case came in the form of RBI circulars dated 05 and 06 April 2018 in the exercise of powers conferred by Section 35A read with Section 36(1)(a) and Section 56 of the Banking Regulation Act, 1949 and Section 45JA and 45L of the Reserve Bank of India Act, 1934 ("RBI Act/Act") and Section 10(2) read with Section 18 of the Payment and Settlement Systems Act, 2007, directing the entities regulated by RBI (i) not to deal in virtual currencies nor to provide services for facilitating any person or entity in dealing with or settling virtual currencies and (ii) to exit the relationship with such persons or entities, if they were already providing such services to them.

The RBI took its first anti-cryptocurrency stance in the year 2013 when they issued a Press Release cautioning the public about the potential threats of cryptocurrency because of it lacking any authorisation from a central bank or monetary authority. Over the years, RBI and its research divisions had held via various reports that although in its nascent stage, cryptocurrency poses a major threat in terms of risk, volatility, and difficulty in tracking transactions thereby paving the way for money laundering and illegal activities. On 01 February 2017, RBI again issued a Press Release cautioning users, holders and traders of virtual currencies. This was followed by a carte blanche ban on cryptocurrency trade via the impugned circulars.

ISSUES

i) Whether the RBI Circulars dated 05 and 06 April 2018 are within the statutory mandate of the RBI.

ii) Whether the exercise of the powers by the RBI amounts to malice and non-application of mind.

iii) Whether the exercise of powers by the RBI amounts to colorable legislation.

iv) Whether the RBI Circulars dated 05 and 06 April 2018 violate Article 19(1)(g) of the Constitution of India on the grounds of proportionality.

ARGUMENTS OF THE PETITIONER

The arguments of the Petitioner can be summarized as follows:

i) Virtual currencies are not legal tender but tradable commodities/digital goods, not falling within the regulatory framework of the RBI Act, 1934 or the Banking Regulation Act, 1949.

ii) The powers of the RBI cannot be exercised in "public interest" to such an extent as to ban access to cryptocurrencies and exchanges.

iii) The RBI cannot extend their powers to include goods that do not fall within the purview of financial system or credit system of the country.

iv) Powers of RBI under the Payments and Settlement Systems Act 2007 does not apply to cryptocurrency exchanges as their services do not fall within the definition of "payment system" under the said Act.

v) Assuming cryptocurrencies were amenable to regulation by the RBI, the circular nonetheless disproportionately impinged on the Petitioners' rights.

vi) Many of the developed and developing economies of the world, multinational and international bodies and the courts of various countries have scanned crypto currencies, but found nothing pernicious about them.

vii) Not all cryptocurrencies are anonymous, and if the problem sought to be addressed is anonymity of transactions, the same could have been achieved by resorting to the least invasive option of prohibiting only anonymous cryptocurrencies.

viii) No study was undertaken by RBI before the impugned measure was taken and hence, the impugned decisions are not even based upon knowledge or expertise.

ix) A total prohibition, especially through a subordinate legislation such as a directive from RBI, of an activity not declared by law to be unlawful, is violative of Article 19(1)(g) of the Constitution of India.

x) Cryptocurrencies do not qualify as money, as they do not fulfill the four characteristics of money namely medium of exchange, unit of account, store of value and constituting a final discharge of debt and since RBI has accepted this position, they have no power to regulate it.

xi) The impugned Circular is manifestly arbitrary, based on non-reasonable classification and it imposes disproportionate restrictions.

xii) A decision to prohibit an article as res extra commercium is a matter of legislative policy and must arise out of an Act of legislature and not by a notification issued by an executive authority.

xiii) RBI should have taken into account the fact that the members of Petitioner association have taken necessary precautions including avoiding cash transactions, ensuring compliance with KYC norms, of their own accord and allowing peer-to-peer transactions only within the country.

ARGUMENTS OF THE RESPONDENT

i) Virtual currencies do not satisfy the criteria such as store of value, medium of payment and unit of account, required for being acknowledged as currency.

ii) Virtual currency exchanges do not have any formal or structured mechanism for handling consumer disputes/ grievances.

iii) Virtual currencies are capable of being used for illegal activities due to their anonymity/pseudo-anonymity.

iv) Increased use of virtual currencies would eventually erode the monetary stability of the Indian currency and the credit system.

v) The impugned decision is within the range of wide powers conferred upon RBI under the Banking Regulation Act, 1949, the Reserve Bank of India Act, 1934 and the Payment and Settlement Systems Act, 2007.

vi) The impugned decisions are not excessive, confiscatory or disproportionate in as much as RBI has given three months' time to the affected parties to sever their relationships with the banks. This is apart from the repeated cautions issued to the stakeholders by RBI through Press Releases from the year 2013.

vii) RBI considered various reports and research over a period of 5 years thereby evidencing the application of mind.

viii) The impugned decisions were necessitated because in the opinion of RBI, VC transactions cannot be termed as a payment system, but only peer-to-peer transactions which do not involve a system provider under the Payments and Settlement Systems Act.

ix) KYC norms are ineffective, as the inherent characteristic of anonymity of VCs does not get remedied.

OBSERVATIONS OF THE COURT

The SC's inquiry into the validity of the circular revolved around 2 major questions:

(i) first to see the role historically assigned to a central bank such as RBI, the powers and functions conferred upon and entrusted to RBI and the statutory scheme of all the above three enactments, and;

(ii) then to investigate what these virtual currencies really are.

THE ROLE OF RBI

The SC observed that as the Preamble of the RBI Act suggests, the object of constitution of RBI was threefold namely (i) regulating the issue of bank notes (ii) keeping of reserves with a view to securing monetary stability in the country and (iii) operating the currency and credit system of the country to its advantage.

The object of establishment of RBI is also spelt out in Section 3(1). It says that "a bank to be called the Reserve Bank of India shall be constituted for the purpose of taking over the management of the currency from the Central Government and of carrying on the business of banking in accordance with the provisions of this Act". The 2016 amendment to the Preamble was duly noted by the court, it was observed that the newly inserted paragraphs gave RBI the power to operate the monetary policy framework in India, and the primary objective in doing so is to maintain price stability. Though the expression "monetary policy" is not defined in the Act, an entire chapter under the title "Monetary Policy" containing Sections 45Z to 45ZO was inserted as Chapter IIIF. The provisions of this chapter are given overriding effect upon the other provisions of the Act, under Section 45Z. Under Section 22(1), RBI has the sole right to issue bank notes in India. Section 26(1) makes every bank note a legal tender at any place in India in payment, which is guaranteed by the central government.

While examining the ambit of Section 45JA (1) of the RBI Act, the SC observed that the concerns sought to be addressed by Section 45JA (1) are (i) public interest (ii) financial system of the country (iii) interests of the depositors and (iv) interests of NBFCs.

It was observed that the RBI has powers to call for information from financial institutions and give directions in order to enable it to regulate the credit system of the country to its advantage. The RBI is also obliged under sub-section (3) of Section 45L to have due regard to certain things, one of them being "the effect the business of such financial institution is likely to have on trends in the money and capital markets". A careful scan of the RBI Act, 1934 in its entirety would show that the operation/regulation of the credit/financial system of the country to its advantage, is a thread that connects all the provisions which confer powers upon RBI, both to determine policy and to issue directions.

Section 35A of Banking Regulation Act, 1949 empowers RBI to issue directions to banking companies. Such directions are binding on the banking companies. The directions under Section 35A may be issued (i) in public interest (ii) in the interest of banking policy (iii) to prevent the affairs of the banking company from being conducted in a manner prejudicial to the interests of the depositors or of the banking company itself and (iv) to secure the proper management of the banking company.

On the issues of payment systems under the Payments and Settlement Systems Act, the SC observed that Section 17 empowers RBI to issue directions to a payment system or a system participant, which, in RBI's opinion is engaging in any act that is likely to result in systemic risk being inadequately controlled or is likely to affect the payment system, the monetary policy or the credit policy of the country. An important provision for cryptocurrencies in the future is Chapter III of the Act which deals with "authorization of payment systems". Section 4(1) of the Payment and Settlement Systems Act, provides that any person other than RBI seeking to commence or operate a payment system shall take authorization from the RBI. Under Section 10, RBI is empowered to prescribe certain standards and guidelines for the proper and efficient management of the payment systems. These provisions are a major impediment to cryptocurrencies usage as legal tender, for when the day comes for merging with mainstream fiat currency, it will require RBI's support and approval.

FINDING THE IDENTITY OF CRYPTOCURRENCIES/VIRTUAL CURRENCIES ("VCS")

The SC generously delved into the history of cryptocurrencies, ranging from the Cypherpunk movement¹ to the whitepaper of Bitcoin written by Satoshi Nakamoto. The SC took note of Satoshi's intention behind Bitcoin, which is the fundamental of every blockchain application- "The root problem with conventional currency is all the trust that's required to make it work. The Central Bank must be trusted not to debase the currency but the history of fiat currencies is full of breaches of that trust."²

It was observed that the difficulty in regulating and defining VCs was that they neither completely fit in the definition of a commodity, nor widely accepted enough to be considered a currency. The SC dwelled in depth on the origins of cryptocurrency and its purpose. According to an International Monetary Fund Report, it was observed that there are four factors which lie behind the rise of crypto currencies, they are:

(i) the development of blockchain technology;

(ii) concerns about conventional money and banking, that arose out of the sub-prime mortgage crisis in 2008 and the unconventional monetary policies/quantitative easing;

(iii) privacy concerns and;

(iv) political views about the role of the Government.

The Petitioner and RBI both agreed on one point, which is VCs do not hold the status of legal tender, but RBI justified its decision of banning them on the grounds that VCs are capable of being used as a medium of exchange.

After examining the definitions given by various committees and countries all over the globe, the SC observed that there is unanimity of opinion among all the regulators and the governments of various countries that though virtual currencies have not acquired the status of a legal tender, they nevertheless constitute digital representations of value and that they are capable of functioning as (i) a medium of exchange and/or (ii) a unit of account and/or (iii) a store of value.

An important observation made by the SC on this comparative analysis was that "It is clear from the above that the governments and money market regulators throughout the world have come to terms with the reality that virtual currencies are capable of being used as real money, but all of them have gone into the denial mode (like the proverbial cat closing its eyes and thinking that there is complete darkness) by claiming that VCs do not have the status of a legal tender, as they are not backed by a central authority. But what an article of merchandise is capable of functioning as, is different from how it is recognized in law to be. It is as much true that VCs are not recognized as legal tender, as it is true that they are capable of performing some or most of the functions of real currency."

The court opined that it is incorrect to state that RBI's role and power can come into play only if something has actually acquired the status of a legal tender, and that for RBI to invoke its power, something should have all the four characteristics or functions of money.

In a landmark decision of the United States District Court of New York in the case of United States v. Ulbricht³ it was held that "Bitcoins carry value-that is their purpose and function-and act as a medium of exchange. Bitcoins may be exchanged for legal tender, be it US dollars, euros or some other currency". In another decision of the same court, it was held that "bitcoin clearly qualifies as money or funds under the plain meaning definitions. Bitcoin can be easily purchased in exchange for ordinary currency, acts as a denominator of value and is used to conduct financial transactions."⁴ Interestingly, several matters before the Commodity Futures Trading Commission held VCs to be "commodities", in relation to public administrative hearings to determine whether the defendant was engaged in violation of the provisions of Commodity Exchange Act. In another important decision State of Florida v. Michell Abner Espinoza⁵, the Court of Appeal pointed out that the definition of a "payment instrument" included "a cheque, draft, warrant, money order, travelers' cheque, electronic instrument or other instrument, payment of money or monetary value, whether or not negotiable". The phrase "money services business" was defined in the statute to include any person who acts as a payment instrument seller. Since the expression monetary value means a medium of exchange, whether or not redeemable in currency, the court concluded that VCs are payment instruments and hence a person dealing with the same is in money services business.

In a completely different context, the Singapore International Commercial Court ruled in B2C2 Ltd. v. Quoine Pte Ltd.⁶ that virtual currency can be considered as property which is capable of being held on trust.

Thus, the SC held that various courts in different jurisdictions have identified virtual currencies to belong to different categories ranging from property to commodity to non-traditional currency to payment instrument to money to funds, establishing a clear divide in perspectives, and no consensus on regulation. The SC has drawn an interesting analogy of the definition conundrum to the 4 blind men in the Anekantavada philosophy of Jainism (theory of non-absolutism that encourages acceptance of relativism and pluralism) who attempt to describe an elephant, but end up describing only one physical feature of the elephant, which is in essence the true state of regulators and adjudicators around the world.

RBI's STATUTORY MANDATE & CONSTITUTIONAL CHALLENGES

The SC further observed that it is well within the ambit of the RBI to caution banks to deal with a particular class of transactions, although the indirect effect of the same is to disable the exchanges that allow trading in VCs, rejecting the contention that cryptocurrencies are just goods/commodities and cannot be regarded as real money. If an intangible property can act under certain circumstances as money (even without faking a currency) then RBI can definitely take note of it and deal with it, and thereby rejecting the contention that RBI has no statutory power to issue the impugned Circulars and is ultra vires. The SC went on to the extent of making it clear that the RBI is vested with the power to regulate the market of cryptocurrencies and VCs.

In the case of Star India Pvt. ltd. v. DIPP and Ors.⁷ the ambit of the word "regulate" was deliberated upon by the court, and it as held that "the power to regulate implies the power to check and may imply the power to prohibit under certain circumstances, as where the best or only efficacious regulation consists of suppression".

Relying upon Khoday Distilleries Ltd. v. State of Karnataka⁸ the SC rejected the contention of the Petitioners that the legislature is the only body that can declare an article as res extra commercium. The SC went on to hold that there was in essence no ban on cryptocurrency trading and usage, and the RBI exercised its legal mandate to caution or prohibit banking companies against entering into certain types or class of transactions. This does not tantamount to total prohibition.

For the tests of colorability and malice, the domain of "public interest" was examined by the SC in the case of Meerut Development Authority v. Assn. Management Studies & Anr.⁹, Bihar Public Service Commission v. Saiyed Hussain Abbas Rizwi & Anr.¹⁰, and Utkal Contractors & Joinery (P) Ltd. & Ors v. State of Orissa & Ors.¹¹ wherein it was held that the term "public interest" must be understood and interpreted in the light of the entire scheme purpose and object of the enactment and it does not have a rigid meaning, taking its colour from the statute in which it occurs.

With regards to the test of Article 19(1)(g) of the Constitution of India, the SC observed that in Modern Dental College and Research Centre v. State of Madhya Pradesh¹² four tests were laid down, i.e. (i) that the measure is designated for a proper purpose (ii) that the measures are rationally connected to the fulfillment of the purpose (iii) that there are no alternative less invasive measures and (iv) that there is a proper relation between the importance of achieving the aim and the importance of limiting the right.

While considering the test of Article 19(1)(g), the SC held that individual traders are not affected from trading in VCs by virtue of the impugned circulars, just as VCs have not been per se banned by the RBI. The affected parties in this case are the VC exchanges that are unable to trade due to ban on banking services. The court heavily relied upon the European Union Parliament's view that it is not necessary to impose a total ban on cryptocurrencies/VC related business and the formal finance sector, and regulatory methods can be relied on.

The court heavily relied on Bank Mellat v. HM Treasury (No. 2).¹³ pronounced by the UK Supreme Court, in which the grounds for proportionality have been expounded. The SC observed that it was unanimously decided that that any assessment of rationality and proportionality must recognize that the nature of the issue required the Treasury (executive) to be allowed a large margin of judgment. The Court in the Mellat case held that banning only one particular bank would not prevent the inherent risk of banking sector and its outreach that may allow Iran to further its nuclear arms program, which was the reason and allegations in these proceedings against Mellat. Singling out Bank Mellat, according to the court, was arbitrary and irrational, and disproportionate to any contribution which it could rationally be expected to make to the direction's objective.

Addressing the final ground, the SC observed the following points on the grounds of proportionality:

(i) that RBI has not so far found, in the past 5 years or more, the activities of VC exchanges to have actually impacted adversely, the way the entities regulated by RBI function;

(ii) that the consistent stand taken by RBI up to and including in their reply dated 04-09-2019 is that RBI has not prohibited VCs in the country and;

(iii) that even the Inter-Ministerial Committee constituted on 02-11-2017, which initially recommended a specific legal framework including the introduction of a new law namely, Crypto-token Regulation Bill 2018, was of the opinion that a ban might be an extreme tool and that the same objectives can be achieved through regulatory measures.

DIFFERENT VC DIFFERENT REGULATION

An important point to note here is that the SC categorically rejected one of the submissions of the Petitioners that different VCs will require different levels of regulations. In this broad context VCs were divided into three types:

i) closed virtual currency schemes basically used in an online game;

ii) virtual currency schemes having a unidirectional flow (usually an inflow), with a conversion rate for purchasing the virtual currency which can subsequently be used to buy virtual goods and services, but exceptionally also to buy real goods and services and

iii) virtual currency schemes having a bidirectional flow, where they act like any other convertible currency with two exchange rates (buy and sell) which can subsequently be used to buy virtual goods and services as well as real goods and services.

Surprisingly to decide this issue, the SC has given the example of credits used in video games, comparing that issued by Nintendo and currency used in the game Second Life. The currency used in the former is non-convertible to fiat, although the latter allows the conversion. On the basis of these examples, the court held that the currencies can be both unidirectional or bidirectional depending on the entities that formulate it. Although this is partly true, some VCs are in reality truly anonymous (till date) and some are pseudonymous. The ones that are anonymous will require a higher level of regulation and scrutiny, as these are the VCs actually capable of being misused. These are not the only defining features, some have various applications such as smart contracts, distributed ledger-based media, banking payment settlements, and some are just intended to be digital gold.

The argument for different regulations further strengthens when we see the offshoots of Bitcoin in the market, i.e. Bitcoin Cash and Bitcoin SV, that were hard forks of Bitcoin Cash, which in itself was a hard fork from Bitcoin. Hard forks in the case of VCs are radical changes to a network's protocol that makes previously invalid blocks and transactions valid, or vice-versa. Each VC is extremely unique, and sometime in the near future, the SC and the RBI will have to change its stance on a uniform regulation of VCs, if at all they wish to regulate and not impose a total ban.

DECISION OF THE SUPREME COURT

On the basis of analyzing the nature of powers conferred upon the RBI and the treatment of cryptocurrencies in various jurisdictions around the world, the SC held that If an intangible property can act under certain circumstances as money (even without faking a currency) then RBI can definitely take note of it and deal with it. Hence it is not possible to accept the contention of the petitioners that they are carrying on an activity over which RBI has no power statutorily.

The SC further went on to hold that the RBI has been correct in exercising its powers under the Payments and Settlement Systems Act, and did not find the RBI guilty of non-application of mind, as it had arrived at a "satisfaction" under Section 35A(1) of the Banking Regulation Act after years of consideration. This consideration encompassed the advisories and warnings issued since 2013 and the various committees spearheaded to understand the regulatory aspects of VCs.

The Circular being addressed to "system participants" handling payment systems, in the overall scheme of the Payment and Settlement Systems Act, 2007, it is impossible to say that RBI does not have the power to frame policies and issue directions to banks who are system participants, with respect to transactions that will fall under the category of payment obligation or payment instruction, if not a payment system.

The expression "banking policy" is defined in Section 5(ca) to mean any policy specified by RBI (i) in the interest of the banking system (ii) in the interest of monetary stability and (iii) sound economic growth. Public interest permeates all these three areas. Thus, the contention that the impugned decision is a colorable exercise of power and it is vitiated by malice in law was rejected by the SC. To constitute colourable exercise of power, the act must have been done in bad faith and the power must have been exercised not with the object of protecting the regulated entities or the public in general, but with the object of hitting those who form the target. To constitute malice in law, the act must have been done wrongfully and willfully without reasonable or probable cause. The SC did not find substance in either of the grounds, and thereby rejected the contentions.

The court also rejected the contention that different VC's require different levels of regulation, as they fall under separate categories and have different levels of anonymity. The argument of light-touch approach of other countries and wait and watch approach of other agencies was swiftly rejected by the court on the grounds that the comparative approach cannot be straightjacketed into questioning RBI's stance, and that the other agencies perform separate functions from that of the RBI.

On the test of proportionality, the SC observed that although VCs are not banned till date, the functioning of VC exchanges has been crippled by the impugned Circulars, especially when RBI did not find anything wrong with their functioning. Till date, no entity regulated by the RBI has faced any loss or adverse effect directly or indirectly on account of VC exchanges. Despite the situation and no actual ban on VCs, the exchanges were facing significant difficulty in continuing their trade due to the ban on banking services. The argument of right to trade in VCs not being a fundamental right was also rejected by the SC, noting that there is no law till date explicitly banning their trade.

The impugned circular dated 06 April 2018 being the statutory direction was accordingly set aside on the grounds of proportionality.

CONCLUSION

This judgement ushers a new era in the economic and financial domains of India. Cryptocurrencies are not a result of a science experiment gone wrong, or like the internet, was not setup for military purposes. The need for cryptocurrencies arose due to various central institutions and middlemen violating the trust of the masses since time immemorial. The 2008 mortgage crisis is a stellar example of the misuse of trust reposed in the banking systems, the burden of which was borne by individuals all over the world. This crisis was also the tipping point, and fortunately the technology of our times allowed for the innovation of something so radical, without the limitations its predecessors had in the past. Any sufficiently advanced technology is indistinguishable from magic. That is truly the case with cryptocurrencies, as the technology and its potential was not completely understood by the RBI, and like most cases in our country, banning was the easier option.

The SC although rejected most of the contentions of the Petitioners, they were able to see through the double standards of the RBI in banning exchanges but not the trade, without proof of any damage caused to institutions under the domain of the RBI. The SC considered an exhaustive list of opinions made by committees of other jurisdictions, and held that there are various regulatory alternatives to banning, which could have been considered by the RBI.

Citizens from a number of failing economies such a Venezuela, Iran, Greece and Sudan have relied on cryptocurrencies, when traditional institutions have gravely failed in their responsibilities. Many countries such as Germany and Japan have welcomed cryptocurrencies and the markets are thriving. It is pertinent to note the ironic stance taken by the SC by stating that blockchain can be severed from cryptocurrency, and the former can be legal if the latter is banned. This statement is surprising as the biggest proof of value of blockchain technology today is Bitcoin and Ethereum, the two biggest cryptocurrencies, the latter having a much wider scope than just a medium of exchange. The volatility argument is another one that often fails to see how our traditional markets are just as susceptible, say for example the crash of Facebook stock prices after the Cambridge Analytica scandal surfaced and the current market scenario due to Covid-19. Surprisingly cryptocurrencies are running strong in the times of the pandemic, and are proving the antiquated notions wrong.

For the time being the SC has taken a progressive approach and protected the market. It is pertinent to note however that a majority of the arguments in favour of VCs relies on two major factors- the fact that till date no law banning cryptocurrencies has been passed, and that the RBI did not consider less intrusive measures of regulating the market instead of imposing a blanket ban. Once these two issues are redressed by the executive and the legislature, it will be a new test for cryptocurrencies/VCs in the Indian market.

Footnotes