This explainer of cryptocurrency regulation has been prepared on the basis of the discussion led by Tanya Sadana of Ikigai Law at our #NAMA Bootcamp on Understanding Cryptocurrencies, supported by Zebpay, in New Delhi on August 23. Ajeet Khurana from Zebpay gave industry insights. Read the rest of our coverage of the Bootcamp here.

When does money become a viable form of currency?

When it is backed by the central government and has social acceptance from people.

“For instance, just before World War II, the value of the German Reichsmark had plummeted. You needed to pay a million Reichsmark to buy a loaf of bread. Thus, even thought it was a fiat currency backed by Central Government, the value of the government or the value of the trade had depreciated so drastically that people could no longer put their faith in the currency. So even thought it was a legal fact, it was not a socially accepted fact. And the same is true even today. For instance, the Zimbabwean dollar is drastically undervalued.” — Tanya Sadana

Where are cryptocurrencies a viable alternative?

In nations where national currency has been undervalued, cryptocurrencies are a very viable alternative. “This is something which is decentralised, accepted worldwide. In those countries, if people start accepting cryptocurrencies as a mode of payment, it then becomes a social fact,” Sadana explained

Status quo in India

Cryptocurrencies are not banned currently, but you cannot hold it either. You may not be able to open a bank account, but you will not be put in jail, presently at least, for having cryptocurrency. And you can accept payments in the form of cryptocurrency. There’s nothing that bars you. Thus, if two people decide, I will pay you on certain goods in cryptocurrencies, that is perfectly legal. Crypto-to-crypto trade today is perfectly legal.

Why has cryptocurrency not replaced fiat currency?

  • Legally, it is not backed by a central bank
  • Socially, it is not accepted as a form of payment by enough people. Its volume and acceptability are very low.

Is cryptocurrency a commodity?

Just as a good can be an intangible commodity, such as an intellectual property, it can also be a cryptocurrency. If we, as individuals, decide to exchange a Bitcoin for a pizza, then a cryptocurrency is more like a good, a commodity which can be exchanged.

Is cryptocurrency a security?

Cryptocurrency’s function as in the case of Initial Coin Offerings (ICOs) gives cryptocurrency a danger of being called a security. In an ICO, you take a token with the expectation that the end product, whichever it is, will gain some value and this token will be my ability to monetize that. In those aspects it comes across as a security.

Cryptocurrencies are an asset class in themselves

Cryptocurrencies have characteristics of money, commodity and security. They should be treated as an asset on to themselves and specialised regulations ideally should govern them.

Dangers of an ICO

Unlike a traditional listing on a stock exchange, where there are a number of regulatory requirements to be fulfilled, an ICO doesn’t require anything. All it needs it a white paper, and a press release asking people for money. That money needn’t even come from India, if the ICO is made in India. This is why it is of concern to regulators and which is why it is important for them to understand exactly what cryptocurrency is and how it can be regulated properly.

How do regulators view cryptocurrencies?

As of now, regulators are trying to squeeze cryptocurrencies in the pre-existing buckets, depending on the kind of function they perform in a specific case. Despite low volume of transactions in ‪cryptocurrency, a regulator has to be far-sighted. A regulator will think that just because not in vogue now, doesn’t mean we don’t prepare for the future.

“For instance, when the Silk Road case happened and they found that illicit trade worth $6.6 billion was taking place through cryptocurrencies, regulators treated it like money. When they are used as a means for raising money for a particular enterprise, then they are treated as a security. When they are used as an instrument of barter, then they are treated as a commodity. Thus, depending on the way cryptocurrency is used, that is the way regulators will view it and the way the regulations will hit you.” — Tanya Sadana

Is the term ‘cryptocurrency’ misleading?

To a great extent yes, especially given their multifaceted nature. None of the 7-8 countries which have come up with specific cryptocurrency regulations call it ‘cryptocurrency’. In Malta, they are called VFAs, or Virtual Financial Assets. Many countries call them DLAs or Distributor Ledger Assets.

What are the risks associated with cryptocurrencies according to Indian regulators?

Risks associated with cryptocurrencies are true for other digital assets (such as credit card, debit card, demat account, etc.) as well, but it is a combination of these risks that troubles the regulators.

  1. Means of financing illegal activity: While cryptocurrency transactions may eventually do away with all anonymity, but at present, given the way they are, unless you can associate a person with their public key, the transaction remains anonymous. It allows you a great deal of anonymity to transmit value across borders and it is a potent mean of funding anti-terror and money laundering activities. Aadhaar linkage might be considered as one of the ways to counter money laundering.
  2. Undermines the payment and financial system: If the economy nosedives tomorrow and people lose faith in the Indian Rupee, the fact that you have an alternative currency might just further undermine the payment system that we already have.
  3. Lack of accountability: With all other commodities, when something goes wrong, you have someone to back it, but nobody governs Bitcoins. Miners are strewn across the world and if something goes wrong, you have no person to hold accountable for it.
  4. Lack of consumer protection: If you lose your private key, your account is lost forever. In every other sector, there would be a grievance officer to file a complain with to get your money back.
  5. Completely out of the purview of RBI: Unlike the Indian Rupee, which is not fully convertible (that is, need permissions to convert it into a foreign currency), cryptocurrency is. RBI has no oversight over it.

What is the Indian regulators’ opinion of blockchain?

Government has categorically said that the underlying technology, that is, blockchain, is good. It can be used in KYC verification, insurance claim verification, etc.

Why are exchanges hacked?

The root problem is that unlike other assets that are transacted, cryptocurrencies are actually held by individuals. Shares are held with a third party.

  1. Exchanges act in a mala fide way: This can be solved by not letting exchanges have control over the assets that are traded on the exchange. They become just trading platforms.
  2. Inadequate security protocol
  3. Lack of secure implementation of protocols: Even the most secure software are compromised by irresponsible practices. For instance, if you leave your email password scribbled on a piece of paper, next to your desk, your account can be easily compromised.

What have regulators ignored?

Regulators tend to ignore the nuances of cryptocurrencies:

  1. Some cryptocurrencies, like Facebook’s Libra, have intrinsic value. A stable coin, such as Libra, has a central regulatory authority for which you can hold some person accountable. This has been completely ignored by the regulator. However, Facebook backing is not fiat backing.
  2. Bitcoin was always meant to be a record of a transaction taking place.
  3. Gas, which is used on Ethereum, is used for executing smart contracts.

How has cryptocurrency been regulated across the world?

  1. Regulated (Japan, Canada, Australia): Countries with regulations tend to regulate the points of entry and exit of cryptocurrency into the formal economy. Thus, they regulate the exchanges. Exchanges are mandated to carry out KYC processes. Exchangers might also be instructed to have insurance for the value that they are storing.
  2. No regulations (France, South Africa): These are the countries that have adopted an off-hand approach. They are observing it, but haven’t outlawed anything.
  3. Ban (China, Pakistan, Ecuador, Saudi Arabia, Bangladesh): They have outrightly banned it.

Where does India fall?

The draft bill banning cryptocurrencies has concerned numerous people as then India is echoing nations whose national ethos aren’t democratic.

Global regulatory approaches to cryptocurrency

  1. Dedicated regulation: These have crypto-specific regulations that tell you how to deal with cryptocurrencies. Include Estonia, Malta, New York State
  2. Disclosure-based regulation: There is no regulation for cryptocurrencies, but you have to make certain disclosures. For instance, in Australia, you have to register with AUSTRAC, in Canada, with FINTRAC.
  3. Adopt existing regulation: They use existing regulations. For instance, in the US, barring NY State, you use existing regulations such as the money transmitter’s licence. Certain countries within Europe use e-money licence.

Differences between cryptocurrency regulation in New York State and Australia

New York State: To start a financial company, there are a lot of rules about disclosure and transparency. They actually give you a set specifically for cryptocurrencies. These are the rules you want to have.

Australia: No cryptocurrency specific regulation. Instead, there is a 100 point KYC for financial institutions. To adhere to that, crypto-exchanges have had to alter their entire software. For things such as anti-money laundering,  you need proof of income, etc.