By Aayush Jain and Devansh Parekh, fourth year law students at GLC, Mumbai.
On 21st April, 2021, for the first time ever, a completely paperless trade transaction between Tata Steel and HSBC India was executed using blockchain technology. The genesis of the technology which enabled this transaction can be traced back to 2008, when a pseudonymous white paper was uploaded online, which envisioned a new way to transfer value over the internet – and thus commenced the era of cryptocurrencies, blockchain and Bitcoin. While they pose significant controversy, fear and caution, cryptocurrencies have attracted immense interest from businesses, consumers, monetary authorities and governments across the world, as they have a promising future to replace the need for the trust in long-standing institutions such as banks.
The Draft Banning of Cryptocurrency & Regulation of Official Digital Currency Bill, 2019 defines cryptocurrency in a broad manner as, any information, code, number or token, generated through cryptographic means or otherwise, which has a digital representation of value and has utility in a business activity, or acts as a store of value, or a unit of account. A more comprehensive definition has been given by the Financial Action Task Force as a math-based decentralized, convertible virtual currency which is protected by cryptography.
Companies across the globe have begun raising capital through initial coin offerings – where the company sells cryptocurrency either for money or for another cryptocurrency. The time frame and the costs are greatly reduced when compared to a regulated Initial Public Offering. Another important characteristic associated with initial coin offering is that they do not come with voting rights. Today, crypto assets boast a combined market capitalization of over $1.75 trillion.
Could we have ever imagined a completely paperless transaction? Just as it was hard to guess in the early 1990s how the internet would help sell products across the world, an attempt to precisely understand the use of blockchain technology today is challenging. The advantages and disadvantages vary depending on the nature of the transaction. This nascent technology has several characteristics as discussed below.
Instant, Low-Cost, Secure Settlement: Crypto-assets, such as Bitcoin, solve the problem of counterparty risks by creating a single, decentralized distributed database, accessible to everyone, but controlled by no single entity. The technology has the potential to bring about safe, real-time trade verification and settlement, through simplification of administrative processes in settlement, which has the ability to handle high volumes at low costs. Since all parties agree on a single database, without the presence of a financial intermediary, transferring money from one account to another is effortless, cost effective and quick as against a banking transaction that would otherwise require confidence that the payment would happen risk-free. The presence of a more secure payment mechanism has the potential to improve access to credit.
As per a recent report by the innovation fund of Santander Bank, blockchain technology would result in a cost-savings of USD 15 to 20 billion by 2022 as it reduces financial infrastructure costs and time period for the transactions, as compared to traditional transfer of money, which can be done only during banking hours which would take at least a day or two with fees ranging from 1% to 8%.
Tokenization: Cryptocurrency has a convenient way of tackling the problem of counterfeiting and fraudulent transactions. Tokenization involves maintaining a record of ownership of physical assets in a secure electronic manner. The only way for someone to ‘own’ a digital asset was if a trusted third party recorded the ownership in a database. Because the database is accessible by everyone and controlled by no one [also called permissionless network], crypto assets can provide ownership guarantees that were previously non-existent in the digital world Therefore, the risks arising from a controlling third party are eliminated. For example, blockchain could provide specific financial services without the need of a bank through distributed ledgers. In fact, one could argue that cryptocurrencies have more secure record-keeping capabilities, providing better ownership assurances, than most of the physical ones, while providing an efficient cross-border payment system.
Smart Contracts: Other potential applications in finance include smart contracts – electronic contracts that are designed to execute automatically upon fulfilment of terms as agreed to by the counter-parties. For example, an options contract could be set up to be exercised automatically if certain defined conditions exist in the market. Such a ledger could potentially replace the paper real estate deeds currently filed at government offices.
Key Issues and Analysis on India’s Stance towards Cryptocurrencies
“Why ban when you can regulate?” New possibilities of cryptocurrencies are being discovered as the trading and usage increases day by day. As recent as March 2021, the Finance Ministry made it clear that it has no intentions of banning cryptocurrency in its entirety after witnessing several benefits of fintech and its dependance on blockchain technology. Interestingly, to battle the COVID-19 pandemic, the Government of Maharashtra has been using blockchain technology to store and maintain COVID-19 test results. .
In 2018, the Reserve Bank of India (“RBI”) materialized a circular (“RBI circular”) which required all entities within its purview to stop dealing in cryptocurrencies and rendered it illegal to initiate any such dealings or services in cryptocurrencies.
Amidst concerns of high volatility and risky venture, what perturbed RBI the most was the anonymity of transactions. This raises significant concerns for consumer protection. No Indian regulation specifically targets cryptocurrencies. They have no sovereign guarantee and are of a speculative nature, hence making them very volatile. For instance, Bitcoin lost nearly 80% of its value between December 2017 and November 2018. Interestingly, recently Elon Musk and his tweetshave made some important headlines that led to fluctuation in rates of certain cryptocurrencies like Bitcoin and Doge to the sky and back to the ground. The essence of money has always been to trust in the strength of its worth.
Another particular concern with cryptocurrencies is that private keys (a ‘key’ which allows access to a user’s cryptocurrency) are stored by cryptocurrency exchanges, which are prone to hacking, malicious activities, human errors or operational problems of exchanges. On 22 April 2021, one of Turkey’s largest cryptocurrency exchanges had to cease operations due to lack of financial strength, leaving hundreds of thousands of investors in panic as their savings worth $2 billion would evaporate.
Since cryptocurrencies are pseudonymous and decentralized, they could facilitate money laundering and other illicit criminal activities (such as tax evasion), providing a means for criminals to hide their financial dealings from authorities. It also raises the issue whether existing regulations can appropriately guard against this possibility.
If cryptocurrency becomes a widely used form of money, it could affect the ability of central banks to implement and transmit monetary policy in the country.
The RBI circular aims to tackle the above issues by temporarily holding off trading in cryptocurrencies until a suitable legislation is enacted. However, the same was challenged and struck down by the Indian Supreme Court declaring it a violation of fundamental rights vested in Article 19(1)(g) of the Constitution of India. The Court applied the test of proportionality and concluded that RBI failed to consider the availability of least-restrictive alternatives. It must be noted that though the Supreme Court rejected the RBI Circular on the ground of proportionality, it does not rule out the presence of other risks that come along with this order.
The entire growth and foundation of Financial technology (“Fintech”) lies upon the initiative of a Sandbox. The United Kingdom and its regulatory body, the Financial Conduct Authority commenced this to reduce time and cost to get ideas to market, enable greater access to funding for innovators and allow more products to be tested and introduced in the market. Arizona was the first state to adapt this in the USA.
Although growing at an exceptional speed, the fintech industry is still young. This has put some pressure on the regulators to adapt to the inevitable changes time and again. For instance, the USA has a fragmented structure of regulations that govern fintech. The Initial Coin Offering must fulfill the Howey Test in order to be regulated by the SEC. There is not one but several rules and regulations differing from state to state that govern Fintech in the USA. The State Licensing Requirements ensure that there are annual audits, record keeping as well as examination by regulators. Some of the recent initiatives include: In 2015, New York State Department of Financial Services approved the NY BitLicense that issues business licenses for virtual currency activities. In 2017 the Uniform Law Commission released the Uniform Regulation of Virtual Currency Businesses Act that ascribes certain extensive requirements for a virtual business currency to adhere to before it can engage in business activities with the residents of the state. Even though this act has not been enacted by any of the states so far, it is an exhaustive framework that details the transfers, exchange, definitions, licensing and other requirements as well as potential liabilities that can be enacted in the future.
As it stands, there is an urgent need to provide clarity on the status of cryptocurrencies. India is working on its own law to regulate cryptocurrencies. However, the approach taken is severe, even more stringent than China. It would be interesting to see where India takes the project of Digital India from here on. If the draft cryptocurrency bill is passed, India would be first prominent economy to ban any form of engagement with cryptocurrency – including its mining.
Like other nations, India should regulate rather than ban cryptocurrencies. The aim should be to develop industry standards, promote transparency, work with regulators to detect fraud and misconduct. Crypto firms in India have experienced a successful phase during the pandemic as the volume of trading on crypto exchanges increased manifold. There is an increased inclination towards accepting cryptocurrencies. Around the world, companies such as Starbucks, Visa and Microsoft now accept certain cryptocurrencies as payment for their products/services. Although the crypto market is highly volatile in nature, regulators can introduce margins, limits, circuit breakers as well tax the transactions to ensure open competition in the market.
It is well established that the nature of the cryptocurrencies is evolving continuously in the global economy. Due to its increasing acceptance, it should not come as a surprise if India publishes its own set of guidelines or regulations. As to which stand it takes is a question which remains to be answered.