A. Introduction
Blockchain technology stands as one of the most transformative innovation of this era, redefining traditional financial systems and ushering in new economic paradigms. With the advent of blockchain technology, user ecosystem faced numerous challenges, as they rightly say, "everything has its pros and cons". The rapid adoption of blockchain technology have had profound effects on various industries, business models, governments, and jurisdictions across the globe. 1
Blockchain technology has offered multitude of advantages like decentralization, inflation protection, diversity, speedy and cost-effective transactions, safe and secure environment, accessibility, and transparency. 2 However, money laundering, ransomware scams, illicit trade using darknet, thefts, hacking, terror funding etc. are some of the challenges associated with blockchain technology. 3
Rise in criminal activities:
While blockchain technology has introduced a wave of disruptive innovation, it has also raised significant concerns regarding illicit activities. The pseudonymized nature of the transactions makes it difficult for the authorities to trace and investigate. This makes them susceptible to money laundering activities, which presents a significant threat to market integrity. 4
While answering the questions in Parliament, the Government of India informed that the Directorate of Enforcement is investigating several cases related to Crypto frauds wherein a few crypto exchanges have also been found involved in money laundering. Necessary action as per provisions of Prevention of Money Laundering Act, 2002 (PMLA) has been taken by the Directorate of Enforcement. As on 14.12.2022, proceeds of crime amounting to Rs. 907.48 crores have been attached/seized, 03 persons have been arrested and 04 Prosecution Complaints have been filed before the Special Court, PMLA, in these cases. Further, under Foreign Exchange management Act, 1999 (FEMA), assets amounting to Rs. 289.68 crores have been seized under section 37A of FEMA and 01 Show Cause Notice to crypto exchange Zanmai Labs Pvt Ltd, known as WazirX, and its Director under FEMA for transactions involving crypto assets worth Rs. 2,790.74 crore has also been issued. 5
Recently, a probe by Economic Offences Wing (EOW), Odisha has disclosed about a Rs 1,000 crore pan-India cryptocurrency Ponzi scam. It has been reported that crime syndicate had received deposits from Non-Resident Indians in Hungary, Dubai, Canada, and Nepal. Due to these type of growing incidents analysts is debating if the Cryptocurrency transactions is the new form of "Hawala"6 . The concerns with respect to the security and national interest of India are also arising.
B. Status quo
Currently, there is no uniform or specific law that governs the aspects related to Blockchain or cryptocurrency industry. Despite being in its nascent stages of reforms, The Indian government, and the Reserve Bank of India (RBI) have taken steps to regulate and monitor cryptocurrency transactions to curb money laundering, tax evasion and other illegal activities e.g., Government of India vide Finance Act, 2022 has defined the cryptocurrencies as "Virtual Digital Assets" (VDAs)7 for the purpose of taxation.
However, to have a better understanding about the current legal framework, it is important to understand the events that took place between the period of 2013 - 2023 that has shaped the backbone of today's regulations.
Evolving Legal Framework
'Days of initial caution': 2013-2017 - RBI issued notification dated, Dec 24, 2013, cautioning users, holders, and traders of virtual currencies to be aware of the potential risks associated with cryptocurrencies 8 but it did not impose an outright ban. This cautionary note from the RBI indicates that while cryptocurrencies, such as Bitcoin, were gaining popularity in India during this time, there were concerns about their legality and potential risks.
Similarly, vide its notification dated Feb 01, 2017, RBI advised that it had not given any licence or authorisation to any entity or company to operate schemes or deal with bitcoin or any virtual currency. As such, any user, holder, investor, trader, etc. dealing with Virtual Currencies will be doing so at their own risk. 9
These notifications denotes the initial cautionary approach taken by RBI which were directed not to deter legitimate players but to provide a word of caution to people who could get effected by gullible crypto scams.
'Arising Legal Challenges': 2018- 2020 - In 2018, RBI banned regulated entities from dealing in virtual currencies. This was essentially done to cut off banking support for cryptocurrency exchanges in India. RBI's April 06, 2018 10 circular directed the regulated entities to:
(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.
However, RBI's April 06, 2018 circular was challenged before the Supreme Court of India in Internet and Mobile Association of India v Reserve Bank of India 11 (IMAI vs RBI) and was struck down failing the test of proportionality. The Supreme Court also noted that Government of India is unable to take a call despite several committees coming up with several proposals including two draft bills, both of which advocated exactly opposite positions. The Supreme Court, however, upheld the RBI's power and authority to regulate virtual currencies.
'Moving towards regulation': 2021 - Amidst the regulatory uncertainties the Indian government considered various measures to regulate cryptocurrencies which led to the introduction of "Cryptocurrency and Regulation of Official Digital Currency Bill, 2021". The purpose of which was to promote the underlying technology of cryptocurrency and provide a legal framework. However, no further action was taken by the legislature to move it for discussions and most likely will need a re-introduction in the parliament if it must take its future course.
An RBI notification dated 31 March 2021 clarified that its earlier notification dated 6 April 2018 prohibiting regulated entities from dealing with virtual currencies was struck down by the Supreme Court of India on 4 March 2020 in IMAI vs RBI, and can no longer be quoted when cautioning clients. The notification further provided that regulated entities may carry out customer due diligence processes in line with the regulations governing standards for KYC, AML, counter-terrorist financing (CTF) and obligations of regulated entities under the PMLA, in addition to ensuring compliance with the relevant provisions of the FEMA for overseas remittances.
'Income Tax' on VDA transactions: 2022-2023 - The Finance Act 2022 12 introduced amendments to the Income Tax Act 1961 by defining 'virtual digital assets' (VDAs). The amendments also imposed a flat 30% tax on income generated from the transfer of VDAs and a 1% tax deductible at source (TDS) on the transfer of VDAs from one person to another. Through its Circular 13/2022 13 , the Central Board of Direct Taxes has issued guidelines to address difficulties in implementing the revisions to the Income Tax Act, 1961 in relation to cryptocurrencies/VDA exchanges and peer-to-peer transactions. Apart from the taxation on VDAs, Indian Computer Emergency Response Team (CERT-in) on April 28, 2022 issued directions under Section 70B(6) of the Information Technology Act, 2000 relating to information security practices, procedures, prevention, response and reporting of cyber incidents. 14
C. Tackling 'Money laundering' menace
Enacted in 2002, PMLA forms the backbone of AML regulations in India. Although, it was not originally designed to address cryptocurrencies, authorities have made attempts to extend its provisions to govern any suspicious crypto-related activities. The objective of PMLA is to prevent and control money-laundering activities. It also allows authorities to confiscate and seize any property obtained from the proceeds derived from laundered money. 15
Section 3 of the PMLA defines 'money laundering' as follows:
"whosoever directly or indirectly attempts to indulge or knowingly assists or knowingly is a party or is actually involved in any process or activity connected with the proceeds of crime including its concealment, possession, acquisition or use and projecting or claiming it as untainted property shall be guilty of the offence of money-laundering."
Further, through an amendment dated August 1, 2019, an explanation was added to the above clause to clarify that a person involved in one or more of the following processes or activities connected with the 'proceeds of crime' is also guilty of money laundering:
- concealment;
- possession;
- acquisition;
- use;
- projection as untainted property; or
- claiming as untainted property.
The 'proceeds of crime' are defined in Section 2(u) as:
"any property derived or obtained, directly or indirectly, by any person as a result of criminal activity relating to a scheduled offence or the value of any such property or where such property is taken or held outside the country, then the property equivalent in value held within the country or abroad."
The amendment dated August 1, 2019 also added an explanation to the abovementioned clause, clarifying that the 'proceeds of crime' include not only property derived or obtained from the scheduled offence, but also any property which may directly or indirectly be derived or obtained as a result of any criminal activity relatable to the scheduled offence. The schedule includes offences under various statutes, such as Indian Penal Code, 1860, Information Technology Act, 2000, Trademarks Act, 1999, Copyright Act, 1957 and Securities and Exchange Board of India Act, 1992 apart from others.
Ministry of Finance notification dated 07.03.2023
While the Directorate of Enforcement was already investigating various crypto exchanges for possible money laundering and foreign exchange violations, Ministry of Finance vide its notification dated 07.03.2023 included various activities that will classify a business as a person carrying on designated business or profession which would, in turn, categorise such entity into a "reporting entity" under Section 2(1)(wa) of the PMLA.
One of the most significant developments in India's legal framework for cryptocurrency is the inclusion of VDAs within the scope of the PMLA. 16 Service providers involved in any of the notified activities have now become 'Reporting Entities' for the purpose of PMLA and have to adhere to same norms as prescribed by the PMLA.
The amendment requires activities by a person carrying on designated business or profession, when carried out for or on behalf of another natural or legal person in the course of business as an activity for the purposes of sub-clause (vi) of clause (sa) of sub-section (1) of section 2 of the PMLA and such activities shall include:
a. exchange between virtual digital assets and fiat currencies.
b. exchange between one or more forms of virtual digital assets.
c. transfer of virtual digital assets.
d. safekeeping or administration of virtual digital assets or instruments enabling control over virtual digital assets; and
e. participation in and provision of financial services related to an issuer's offer and sale of a virtual digital asset. 17
However, it is to be understood that while this notification specifically affects the virtual asset service providers (VASPs) in the industry, it does not exclude individuals who are using decentralized crypto wallets for such transactions as well. Any act or omission punishable under the scheduled offences of PMLA or used for any money laundering purposes will continue to fall under the scope and ambit of PMLA even if it is undertaken by an individual unaffected by the notification.
Compliances under PMLA
Under the new amendment, cryptocurrency exchanges or entities dealing with VDAs in India are now required to follow strict KYC norms, which include verifying the identity of users through documents such as Aadhaar cards, PAN cards, Passports and address proof. This helps in tracking and identifying users, making it more challenging for money launderers to operate anonymously. Further, Rule 9(1) of the Prevention of Money Laundering (Maintenance of Records) Rules, 2005 (PML Rules) requires reporting entities to do Client Due Diligence to determine if a client is acting on behalf of a beneficial owner, if so, identify the beneficial owner.
In furtherance to the notification to include VDA transactions under PMLA, the Financial Intelligence Unit – India (FIU-IND) under Ministry of Finance also issued guidelines under Rule 7 (3) of PML Rules on 10.03.2023 to various virtual digital asset service providers titled "AML & CFT Guidelines For Reporting Entities Providing Services Related To Virtual Digital Assets" (FIU Guidelines). 18
Registration - FIU Guidelines in terms of Rule 2 (wa) read with Rule 2 (sa) of PMLA requires all VASPs to register as Reporting Entities with FIU-IND. 19 As part of reporting entity registration, VASPs must disclose their account details with Banks/FIs where they hold accounts for transactions as well as for holding of client money. 20 FIU-IND vide its letter dated July 4, 2023 to all virtual digital asset service providers has also clarified and provided registration process for the VASPs. 21
Enhanced Monitoring - Sanctions screening' is a critical step in the KYC process that helps reduce financial crime. The FIU Guidelines requires VASPs to conduct sanctions screening both at the time of on boarding as well as when any VDA transfer is initiated. Since VDA transfers can currently be completed even without verification of sanctions screening, VASPs may put in place the following safeguards.
- Putting a wallet on hold until screening is completed and confirmed that no concern is raised.
- Arranging to receive a VDA transfer with a provider's wallet that links to a customer's wallet and moving the transferred VDA to their customer's wallet only after the screening is completed and has confirmed that no concern is raised. 22
Reporting obligations - The FIU Guideline also mandates the VASPs to report under rule 8(2) read with rule 3(1)(D) of the PML Rules which provides for prompt reporting of a suspicious transaction, which includes an attempted suspicious transaction, large or suspicious transactions to the authorities, such as the FIU-IND. Upon receiving complaints FIU-IND can begin its inquiry by collecting all the data relevant for the investigation. This is also in line with the CERT-in directions dated April 28, 2022 to VASPs to collect and provide prompt reporting of suspicious transactions.
The requirements under PML Rules read with FIU Guideline also resonates with the Recommendation 18 of FATF i.e., "to implement group-wide programmes against money laundering and terrorist financing apply to Designated Non-Financial Businesses and Professions (DNFBPs)" ... "with its overall objective of improving the effectiveness of AML measures". 23
Specific obligations - The FIU guidelines outline some specific obligations for VASPs beyond the general AML/CFT requirements. These include due diligence obligations for Initial Coin Offerings/Initial Token Offerings (ICOs/ITOs) where VASPs are involved in issuance, offer, sale etc. of VDAs. For virtual digital asset transfers, the guidelines mandate compliance with the 'Travel Rule' for obtaining and transmitting originator and beneficiary information. Additional due diligence is specified for transfers involving unhosted wallets. The guidelines also cover requirements for correspondent relationships between VASPs and other financial institutions. Overall, the specific obligations aim to address the unique risks and complexities involved in virtual digital asset activities like anonymity, cross-border transfers, unhosted wallets etc. VASPs are required to have policies and procedures tailored to fulfill these specific obligations related to VDA transactions and services.
D. Conclusion and challenges ahead
Over the past decade, cryptocurrency regulations have evolved significantly, with an increased focus on combating criminal activities. While progress has been made, challenges persist due to the global nature of cryptocurrencies and the rapidly changing landscape. As we move forward, a balance between innovation and regulation is essential to harness the potential benefits of cryptocurrencies while minimizing their criminal misuse. While the decentralized and pseudonymous nature of blockchain can make it an attractive tool for illegal activities, it also presents opportunities for detection and prevention.
The recent amendment to PMLA to include virtual digital assets is a major step towards regulating cryptocurrencies in India. It demonstrates the intent to monitor crypto transactions, bring transparency and boost accountability. While there are challenges in implementing these regulations, this move is a positive step towards combatting money laundering in cryptocurrencies. It is interesting to see that even before the recent notification, enforcement agencies had initiated actions against bad actors including VASPs. This inclusion of VDA transactions and VASPs under PMLA will further empower the government and enforcement agencies to curb money laundering in cryptocurrencies.
However, effective implementation requires overcoming several key challenges. As decentralized, borderless assets, imposing territorial regulations on cryptocurrencies has practical difficulties. The government understands the global nature of cryptocurrency and has taken steps towards global collaboration for regulating cryptocurrencies. However, achieving international consensus on cryptocurrency regulation is a complex and time-consuming process. Evidently, there is a lack of clarity regarding the timeframe and extent of the PMLA rules that will be applicable on the VASPs. Stakeholders in the industry require clear guidance on the implementation of these regulations to facilitate compliance and avoid confusion. Though, the FIU-IND has provided some clarifications with respect to the registration process, we are yet to see a guidance on timeframe for implementation of compliance by VASPs.
While framing regulations for emerging technologies like cryptocurrencies poses complex challenges, effective enforcement and oversight raises even greater difficulties. Robust implementation of the PMLA regulations for virtual digital assets would necessitate significant investments in enforcement mechanisms and capabilities. Deploying advanced forensic systems, providing specialized training, building tech-savvy enforcement manpower, and developing sophisticated transaction monitoring tools are crucial to detect potential abuse amidst the complexity of blockchain-based systems. The decentralized and pseudonymous nature of cryptocurrencies presents particular challenges for enforcement authorities to unravel the audit trails of illicit financial flows. Adequate budgetary allocation and inter-agency coordination is vital to enforce the amended PMLA provisions on cryptocurrency service providers in letter and spirit.
While the amendment increases compliance for Indian VASPs, managing cross-border transactions remains tricky. Ambiguities in applying PMLA to complex crypto transactions and decentralized platforms remains unclear. Another challenge is the lack of public awareness about VDAs. The government will need to educate the public on how cryptocurrencies work and associated risks and benefits to protect consumers from frauds, scams, bad investments and other industry specific issues, educating the consumers about effective dispute resolution mechanism is also vital.
As the VDA space evolves rapidly, stakeholder consultations can help frame balanced regulations without hindering innovation. India has the opportunity for global leadership in progressive crypto regulation. But long-term success will depend on proactively addressing the challenges. The path to balancing innovation and regulation will require sustained efforts.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
Footnotes
1 https://www.oecd.org/finance/2019-OECD-Global-Blockchain-Policy-Forum-Summary-Report.pdf last visited on 28.10.2023
2 https://www.forbes.com/advisor/in/investing/cryptocurrency/advantages-of-cryptocurrency/
3 Akartuna EA, Johnson SD, Thornton AE. The money laundering and terrorist financing risks of new and disruptive technologies: a futures-oriented scoping review. Secur J. 2022 Sep 19:1–36. doi: 10.1057/s41284-022-00356-z. Epub ahead of print. PMCID: PMC9483896.
4 https://www.justice.gov/usao-sdny/pr/tornado-cash-founders-charged-money-laundering-and-sanctions-violations
5 https://pqals.nic.in/annex/1710/AU1938.pdf
6 https://economictimes.indiatimes.com/news/india/cryptocurrency-scam-economic-offences-wing-exposes-rs-1000-crore-fraud-spanning-across-india/articleshow/102517942.cms?from=mdr
7 (47A) "virtual digital asset" means—
(a) any information or code or number or token (not being Indian currency or foreign currency), generated through cryptographic means or otherwise, by whatever name called, providing a digital representation of value exchanged with or without consideration, with the promise or representation of having inherent value, or functions as a store of value or a unit of account including its use in any financial transaction or investment, but not limited to investment scheme; and can be transferred, stored or traded electronically;
(b) a non-fungible token or any other token of similar nature, by whatever name called;
(c) any other digital asset, as the Central Government may, by notification in the Official Gazette specify:
Provided that the Central Government may, by notification in the Official Gazette, exclude any digital asset from the definition of virtual digital asset subject to such conditions as may be specified therein.
Explanation.—For the purposes of this clause,—
(a) "non-fungible token" means such digital asset as the Central Government may, by notification in the Official Gazette, specify;
(b) the expressions "currency", "foreign currency" and "Indian currency" shall have the same meanings as respectively assigned to them in clauses (h), (m) and (q) of section 2 of the Foreign Exchange Management Act, 1999 (42 of 1999);
8 Titled "RBI cautions users of Virtual Currencies against Risks," Press Release: 2013-2014/1261.
9 Titled "RBI cautions users of Virtual Currencies," Press Release: 2016-17/2054.
10 Titled "Prohibition on dealing in Virtual Currencies (VCs)," RBI/2017-18/154.
11 MANU/SC/0264/2020
12 Supra at 7
13 https://incometaxindia.gov.in/communications/circular/circular-no-13-2022.pdf
14 https://www.cert-in.org.in/PDF/CERT-In_Directions_70B_28.04.2022.pdf
15 Prevention of Money Laundering Act, 2002
16 Notification No. S.O. 1072(E)., Dated 07.03.2023.
17 Supra at 7
18 https://fiuindia.gov.in/pdfs/AML_legislation/AMLCFTguidelines10032023.pdf
19 Financial Intelligence Unit - India (FIU-IND) is the central, national agency responsible for receiving, processing, analysing and disseminating information relating to suspect financial transactions to enforcement agencies and foreign FIUs.
20 https://fiuindia.gov.in/pdfs/AML_legislation/AMLCFTguidelines10032023.pdf
21 https://fiuindia.gov.in/pdfs/downloads/VDASP04072023.pdf
22 ibid
23 https://www.fatf-gafi.org/content/dam/fatf-gafi/recommendations/Explanatory-Materials-R18-R23
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
