The history of cryptocurrencies can be traced back to (another) tumultuous time during the 2008 financial crisis when the trust in financial participants, such as banks and government institutions, was sharply waning. Bitcoin1 was introduced as a currency that had trust as its very foundation, because of how it functions. Bitcoin is underpinned by a decentralized and distributed ledger technology called "Blockchain". Aptly described by the authors of the book - The Truth Machine: The Blockchain and the Future of Everything, blockchain technology produces "an immutable" ledger that is not controlled by a single, centralized entity but by a "consensus protocol" thereby making the ledger a "shared record of the truth"2.
Bitcoin remained relatively unknown in its initial years and did not have a "price" - not to be confused with "value" - until 2010-11. Eventually, there was a surge in its popularity which led to an increase of its traded/exchanged price. In 2013, when the European Union bailed out Cyprus, Cypriot citizens bought Bitcoins fearing collapse of their financial systems, which led to a surge in Bitcoins' demand and price.
Anonymity, trustworthiness of the underlying Blockchain technology and the removal of financial system intermediaries from the transaction framework are the major factors that contributed to Bitcoin's popularity. With the growing popularity of Bitcoin, other cryptocurrencies also came to be introduced. By 2018, with the price of Bitcoin peaking at nearly USD 20,000, cryptocurrencies could no longer be ignored.
As cryptocurrencies gained popularity, they also began to garner interest, intrigue and suspicion from governments, central banks and regulators. Studies were conducted, papers were published, and a general consensus emerged that cryptocurrency cannot be given the status of legal tender. The range of regulation has varied significantly, with countries like Japan, Germany and The Netherlands taking a more lenient regulatory approach, and countries such as India and China effectively banning cryptocurrency dealing.
As the regulatory stance in various jurisdictions continues to evolve, we answer some conceptual questions surrounding cryptocurrencies and its regulation in India.
What are cryptocurrencies?
Cryptocurrencies are digital representations of value that can be stored and transferred digitally. As the name suggests, cryptocurrencies work through the use of cryptography i.e. mathematical principles and computational practices using which data is stored and transmitted.
Some of the popular cryptocurrencies are Bitcoin and XRP (Ripple).
How are cryptocurrencies different from fiat currency?
Fiat currency, or what we call "money", is legal tender backed by a country, state or government. Cryptocurrencies are not backed by a country, state or government.
Fiat currency has the following characteristics or functions:
(a) it serves as a medium of exchange;
(b) it acts as a unit of account;
(c) it acts as a store of value; and
(d) it constitutes a final discharge of debt.
Cryptocurrencies can have all or some of the characteristics of fiat currency. Much of this depends on how a jurisdiction regulates cryptocurrency. While some countries have gone to the extent of banning cryptocurrency, others have given it commodity, asset, deposit or security status.
Cryptocurrencies do not have 'legal tender' status in any country or state.
Are cryptocurrencies the same as digital currencies?
There is no standard definition on digital currency yet. If digital currency is defined to mean any currency that can be stored, traded or transferred digitally, then cryptocurrencies can be regarded as digital currencies. However, the converse would not be true as not all digital currencies would be cryptocurrencies. There may be digital currencies that are linked to fiat currency. For instance, People's Bank of China is looking to introduce a digital currency whose value would be pegged to Chinese Yuan3.
Though the exact characteristics and functions of cryptocurrencies are still largely unsettled, currencies that are digital, decentralized and implemented through cryptography can be considered as cryptocurrencies.
What is blockchain?
Blockchain is the technology that underpins Bitcoin. Often defined as "the distributed ledger technology", Blockchain is one way of implementing a distributed ledger.
For centuries now, transactions have been recorded in ledgers and this practice forms the foundation of financial systems. A distributed ledger is a shared record of transactions where the transactions are approved and stored with all participants of the network.
Blockchain is a distributed ledger technology where each participant system or "node" connected to the Bitcoin network operates on a cryptographic protocol to validate transactions and store an identical copy of the record of transactions.
Blockchain networks, or for that matter, distributed ledger networks can be public (can be accessed and inspected by anyone) or private (limited access).
While the jury is still out on the legality of Bitcoin and other cryptocurrencies, blockchain is considered to be the next ground-breaking innovation that could transform how businesses operate.
Are cryptocurrencies regulated in India?
Currently, cryptocurrencies are not regulated in India.
In 2018, the Reserve Bank of India (RBI), India's central bank and monetary regulator, had issued a circular (2018 Circular) prohibiting banks and financial institutions from dealing in and from providing services that facilitate dealing in virtual currencies.
In March 2020, the 2018 Circular was struck down by a three-judge bench of the Supreme Court of India (Supreme Court). The decision is discussed in detail below. With that, a vacuum was created and currently, there is no law regulating cryptocurrencies in India. There is a draft bill in the works which is discussed later in this article.
On what grounds did the Supreme Court strike down the 2018 Circular?
In 2017, the RBI had issued press releases (see here and here) clarifying that it has not given any licence or authorization to any entity to deal in cryptocurrencies in India and consumers must exercise caution while trading in or purchasing cryptocurrencies.
On 6 April 2018, the RBI issued the 2018 Circular which effectively cut-off access to banking channels by cryptocurrency traders and exchanges.
The 2018 Circular provided for an inclusive list of services that would be covered under prohibited conduct. The list included - "maintaining accounts, registering, trading, settling, clearing, giving loans against virtual tokens, accepting them as collateral, opening accounts of exchanges dealing with them and transfer / receipt of money in accounts relating to purchase/ sale of VCs." Entities that were providing services when the 2018 Circular was issued, were given three (3) months to cease all such activities. In effect, the 2018 Circular brought trading of and dealing in cryptocurrencies to a standstill.
The 2018 Circular was challenged before the Supreme Court in separate writ petitions filed by the Internet and Mobile Association of India and companies running cryptocurrency exchanges in India along with their shareholders and promoters.
On 04 March 2020, the Supreme Court in a seminal decision (Decision) struck down the 2018 Circular for being unconstitutional.
The writ petitions had challenged the 2018 Circular as unconstitutional on various grounds. Some of the grounds of challenge and corresponding observations of the Supreme Court are tabulated below:
Grounds of challenge
Observations/ conclusions of the Supreme Court
The RBI does not have the power to regulate or ban virtual currencies in India since virtual currencies fall outside the purview of the RBI Act, 1934, the Banking Regulation Act, 1949 and the Payment and Settlement Systems Act, 2007 (PSS Act).
The PSS Act was enacted to enable the RBI to regulate and supervise payment systems in India.
Under Section 18 of the PSS Act, the RBI has the power to issue directions to participants of Indian financial system including banks, to not deal with entities that trade in virtual currencies.
The RBI did not apply its mind and also failed to take into account relevant considerations in issuing the 2018 Circular.
Over a period of five (5) years, the RBI took several steps in apprising itself as well as the financial system participants of the risks associated with virtual currencies and did not take any extreme step until the 2018 Circular. Therefore, it cannot be said that the 2018 Circular was a result of non-application of mind or that the RBI did not factor in relevant considerations.
The 2018 Circular was a result of colorable exercise of power by the RBI.
An action can be considered as colorable exercise of power if it was willfully wrong and was done without reasonable or probable cause.
By issuing the 2018 Circular, the RBI acted in good faith and with an intent to safeguard the interests of the public.
The 2018 Circular is disproportionate and fails the reasonableness test under Article 19(1)(g) of the Constitution of India (Constitution) which guarantees to all Indian citizens the right to carry on any occupation, trade or business.
The 2018 Circular fails the proportionality test as (i) the RBI deprived virtual currency traders from accessing the financial system even though virtual currencies were not banned, (ii) the RBI did not find any wrongdoing by virtual currency exchanges, and (iii) no entity regulated by the RBI had suffered any actual harm on account of virtual currency exchanges.
The Supreme Court on application of the 'doctrine of proportionality'
The Decision notes that the 2018 Circular was challenged by (i) hobbyists who purchase and sell cryptocurrencies as a hobby, (ii) cryptocurrency traders, and (iii) persons who run cryptocurrency exchanges.
In the Decision, the Supreme Court observed that (i) while cryptocurrency hobbyists do not have the locus standi to challenge the 2018 Circular under Article 19(1)(g) of the Constitution, cryptocurrency traders and persons running cryptocurrency exchanges do have the locus standi; (ii) cryptocurrency users and traders can access avenues other than cryptocurrency exchanges, but persons running cryptocurrency exchanges do not have any other means of sustenance; and (iii) the RBI by denying access to banking and payments channels, has effectively shut down cryptocurrency exchanges, even though there is no evidence that cryptocurrency exchanges have had any adverse impact on entities regulated by the RBI.
The Supreme Court went on to conclude that since cryptocurrencies are not banned in India, depriving cryptocurrency exchanges from accessing banking and payments channels would be disproportionate. With that, the Supreme Court struck down the 2018 Circular issued by the RBI.
What are some concerns surrounding digital currencies / assets?
Digital currencies can be broadly categorised as central bank digital currencies (CBDCs) and non-CBDCs. CBDCs are pegged to fiat currencies, while non-CBDCs would include all forms of digital currencies other than CBDCs. While some governments are fairly enthused about CBDCs, non-CBDCs have mostly met with scepticism.
A major concern over non-CBDCs is that they could destabilise monetary systems that central banks and governments have worked so hard to establish. This concern assumes that non-CBDCs are volatile in nature and such volatility cannot be fixed or controlled. The assumption may not be entirely accurate.
Digital currencies, when they are treated as commodities, can act as vouchers or coupons that we often use, like Sodexo vouchers. In fact, local currencies recently introduced in small towns to deal with the COVID-19 pandemic have met with reasonable success4. Non-CBDCs could accomplish what these local fiat currencies were able to achieve.
Another major concern over non-CBDCs is its potential to fund unlawful activities. While the concern is a valid one, it ignores the fact that fiat currencies have been and continue to be used for the very same purpose. This risk can be mitigated by having an appropriate regulatory framework on anti-money laundering (AMT) and combating the financing of terrorism (CFT).
Aside from these, there are also concerns relating to fraud, security and consumer protection.
Fraud-related concerns have gained momentum in view of several crypto-related fraudulent incidents across the globe including fraudulent initial coin offerings5 and ponzi schemes6. These concerns can be allayed by having a legal framework on the supervision of entry and exit points along with strict KYC checks.
Security-related concerns including hacking and theft can be addressed by having guidelines on minimum security standards to be followed by operators and exchanges.
Consumer protection concerns can be addressed through record-keeping, grievance redressal and dispute resolution mechanisms. These mechanisms could either be market-driven or regulation-driven.
Thus, while several concerns have been raised with regard to digital currencies/ assets, these can be adequately addressed by a robust regulatory framework.
It also needs to be highlighted here that CBDCs, non-CBDCs and even digital assets could raise privacy concerns depending on factors such as the extent of anonymity offered. Balancing the need for anonymity with other concerns, is likely to be a tricky affair.
What lies ahead for digital currencies/ assets in India?
The Decision may have brought momentary relief to cryptocurrency users, traders and exchanges in India, but it remains to be seen how the legislative framework for regulating cryptocurrencies in India would play out. There have been news reports suggesting that the Government of India may be looking to ban cryptocurrencies.
A draft bill titled as the 'Banning of Cryptocurrency and Regulation of Official Digital Currency Bill, 2019' (Draft Bill) was prepared by the Inter-Ministerial Committee constituted on 2 November 2017 to propose specific action on cryptocurrencies. The Draft Bill has been under consideration and is yet to be introduced in the Parliament.
The Draft Bill gives a wide definition7 to "cryptocurrency" and effectively prohibits the use of and dealing in all forms of digital assets, not just digital currencies. This is in sharp contrast to several jurisdictions across the world that are structuring their regulatory map to let digital assets evolve.
In a recently published policy paper, Ripple makes several proposals for policy measures to develop digital assets, and its underlying technologies, in India. One proposal is to include digital assets under the regulatory sandbox framework of the Reserve Bank of India (RBI). If implemented, this would allow testing of innovative business models and products around digital assets. Outcome of this testing can go a long way in providing valuable inputs for framing necessary policies and regulations on digital assets.
As the Indian Government mulls over future policy measures regarding digital assets and digital currencies, it may consider adopting a phased approach on permissible activities. Banning digital assets/ currencies even as tradable assets or securities would be premature as we are yet to see the sector dynamics play out. A ban could also lead to offshore trading and a grey market in India, which may not be desirable.
1 The genesis of cryptocurrency is a white paper published by Satoshi Nakamoto proposing "a system for electronic transactions" based on a peer-to-peer network, where transactions would be verified and recorded by nodes, or computing systems, that are part of the network, thereby making such transactions decentralized. Soon after, in 2009, Satoshi Nakamoto implemented the first cryptocurrency - Bitcoin.
2 In blockchain we trust, https://www.technologyreview.com/2018/04/09/3066/in-blockchain-we-trust/.
3 Calls for a US 'digital dollar' rise as China powers ahead with a digital yuan, https://www.cnbc.com/2020/01/23/davos-calls-for-a-us-digital-dollar-as-china-works-on-digital-yuan.html.
4 Mexico, Italy towns produce local notes to help residents in crisis, https://www.coinworld.com/news/precious-metals/mexico-italy-towns-produce-local-notes-to-help-residents-in-crisis (Castellino del Biferno, a small town in Italy, printed its own local currency - Ducati, to deal with the impact of COVID-19 pandemic. Ducati has been made "exchangeable" with Euros. In Mexico, the small town of Santa Maria Jajalpa has issued a local currency - jajalpesos, that can be used to purchase food.)
5 New Study Says 80 Percent of ICOs Conducted in 2017 Were Scams, https://cointelegraph.com/news/new-study-says-80-percent-of-icos-conducted-in-2017-were-scams
6 Canadian cryptocurrency firm collapsed due to Ponzi scheme by late founder, regulator says, https://www.reuters.com/article/us-crypto-currencies-quadriga/canadian-cryptocurrency-firm-collapsed-due-to-ponzi-scheme-by-late-founder-regulator-says-idUSKBN23I3AF
7 Clause 2(1)(a) of the Draft Bill defines cryptocurrencies to mean "any information or code or number or token not being part of any Official Digital Currency, generated through cryptographic means or otherwise, providing a digital representation of value which is exchanged with or without consideration, with the promise or representation of having inherent value in any business activity which may involve risk of loss or an expectation of profits or income, or functions as a store of value or a unit of account and includes its use in any financial transaction or investment, but not limited to, investment schemes."
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