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The legal anatomy of cryptocurrency regulation in India

This article addresses the legal and practical ambiguities in understanding the complex crypto ecosystem in India.

By Sanjay Notani and Akash Manwani

Asking the right questions

The cryptocurrency industry kicked off with the popularisation of Bitcoin around the year 2008. The crypto landscape has exponentially grown since, wherein currently over 10,000 cryptocurrencies are being traded across the world. India, infact already has the most significant number of crypto investors in the world. The Government of India has imposed tax on cryptocurrencies and at the same time clarified that tax on cryptocurrencies does not mean it has been legalised. Traders and investors in this arena are seeking clarity from governments and demanding for cryptocurrencies to be recognised, legalised and/or regulated so that more serious investments can be made. However, the underlying problem with such a demand is as challenging from a technological perspective as it is from a legal one.

Is legalising/recognising all cryptocurrencies a legal possibility to consider?

Conceptually, cryptocurrencies are based on decentralised blockchain technology and, there are many cryptocurrencies in circulation today. Cryptocurrencies can be launched, mined and/or distributed by any private person. For the sake of argument, if cryptocurrencies are to be recognised/legalised/regulated or, in general parlance, made a legal tender, then the question arises, would all the cryptocurrencies/coins, digital tokens and/or non-fungible tokens (“NFTs”) be recognised/legalised/regulated? If such a situation should occur, suddenly it would lead to 10,000 odd legal tenders available for transactions in the market. Even if some prominent cryptocurrencies and not all of them, are recognised, every person would be able to generate legal tenders as most cryptocurrencies (including Bitcoin) are based on permissionless blockchain technology. In other words, anyone can mine bitcoins today and if recognised, in effect anyone would be able to create legal tenders from any part of the world. This is certainly not a viable or even a possible option to consider.

Is recognising some prominent cryptocurrencies a legal possibility to consider?

Most certainly, a blanket demand of recognising/legalising/regulating cryptocurrencies will not sustain. In 2021, El Salvador became the first country to recognise Bitcoin as a legal tender. In that context, one could argue that there is sufficient creative legislative configuration at the disposal of the governments to recognise a few major coins like Bitcoin, Ethereum, Dogecoin, and so on. Further, there are a few quantifiable factors such as volatility, volume of trade, market capitalisation, identification of inventor, etc., which could make legal recognition of select coins plausible. In furtherance of this suggestion, legislatures are sufficiently empowered as the same has already been tested and implemented in Intermediary Guidelines, 2021, wherein major social media websites (YouTube, Twitter and Facebook ) are accorded a status of “significant social media intermediaries” thus having to comply with a different set of regulations. However, recognising a few major coins may also not be a perfect solution because the main bone of contention here is not the attributes of recognition but the underlying technology supporting the crypto ecosystem.

In light of the above, the right questions are not whether cryptocurrencies will be “allowed” to be used for trading (See Technological Impediments to a ban on cryptocurrencies below)? or whether it will be legally recognised? Rather, truly correct questions and viable demands are camouflaged in trends of taxation, allowance of advertisements, recognition of centralised crypto-exchanges and intensity of crackdowns (if any) on the crypto-ecosystem. Set against this context, this article addresses the legal and practical ambiguities in understanding the complex crypto ecosystem.

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Comparative analysis of tax on cryptocurrencies around the world

The entire legal, regulatory, and policy action around cryptocurrencies is an evolving, responsive, and at times a reactive process. The United States has imposed tax on exchange, use, and holding of cryptocurrencies without recognising any specific coin as a legal tender. The United Kingdom, on the other hand, considers cryptocurrencies as capital assets, thus imposing capital gains tax on the basis of the existing tax slabs with respect to exchange, paying for goods/services and giving away cryptocurrencies. Canada and Germany have been more liberal with cryptocurrencies. The former considers it as a digital asset and imposes tax only on sale, while the latter considers it as private money and imposes tax if swapped or sold within one year. Being fully aware that Bitcoin is just one coin in the cryptocurrency ecosystem, rather than recognising select coins as legal tender, most countries have thought it best to impose tax, grant a controlled recognition, and introduce self-disclosure mechanisms in dealing with users/investors of cryptocurrencies.

The Indian Government’s stance on cryptocurrencies exhibits a word of caution as is evident from the proposed tax regime and the administration of the same. As per the Finance Bill, 2022 (“2022 Bill”), consequent proposed amendments to the Income Tax Act 1961 (“IT Act”) have been made wherein inter alia income arising from transfer of virtual digital assets (cryptocurrencies and NFTs) shall be taxed at the rate of 30%. (Read ELP’s Union Budget 2022 Analysis for detailed understanding on tax implications with respect to virtual digital assets in India.)

Cryptocurrency and RBI’s Digital Rupee

In the 2022 Budget, by way of the 2022 Bill, the definition of virtual digital asset has been introduced to set the regulatory machinery in motion with respect to all cryptocurrencies and NFTs. The government has retained the power to classify or declassify any cryptocurrency and/or NFT from the casting net of this definition. This saving provision is inserted potentially to avoid India’s Digital Rupee or Central Bank Digital Currency (“CBDC”) i.e. the proposed digital currency to be introduced by the Reserve Bank of India (“RBI”) being made a subject of tax/ regulation under the 2022 Bill.

Technological difference between cryptocurrencies and CBDC: permissioned and permissionless blockchains

There is a fundamental difference between proposed CBDC and private cryptocurrencies apart from the government backing. The CBDC will be based on a permissioned blockchain technology, unlike the permissionless blockchain technology generally used by other private cryptocurrencies like Bitcoin and Ethereum. Permissionless blockchain technology is an open network where any private person can contribute (create/mine coins) by adding nodes to the blockchain. Due to this reason, any private person can mine Bitcoins with enough technological support. However, with permissioned blockchain technology and, more specifically, CBDC, only the Central Government and other agencies authorized by the Government will have the authority to mine, tweak the volume and/or control the supply of the CBDC. Technically speaking, permissioned blockchains have an access-control layer built into the blockchain nodes, which restricts unauthorised users from creating/adding nodes. This technology proves very beneficial for banks, governments and/or entities using blockchain technology whereas in this case it is certainly to secure the Government of India’s own Digital Rupee.

CBDC will be a Stablecoin

Another difference between a private cryptocurrency and CBDC is that the CBDC will have an intrinsic value or market value backed by the Government itself, unlike the notional-value-based cryptocurrencies. From the information at hand, it appears that CBDC Digital Rupee will be a Stablecoin whose value will be pegged to the value of Rupee, i.e. same as 1 INR/Rupee. Stablecoins are cryptocurrencies whose value is pegged to a collateral (often fiat currency of a country) but at the same time provides utility and mobility of a cryptocurrency. For instance, Binance USD (“BUSD”) is a private cryptocurrency having the same value as a Dollar/1 USD. Ultimately, the CBDC is intended to join the pond of several value-based assets, including cash. It is a viable solution for the Government as cash-related management and circulation problems are expensive to tackle. The Government is looking forward to CBDC as a convenient, easy and accessible solution as noted by Finance Minister Mrs. Nirmala Sitharaman:“Introduction of CBDC will give a big boost to digital economy… [and] will also lead to a more efficient and cheaper currency management system”.

Technological impediments to a ban on cryptocurrencies

The present draft of the Cryptocurrency and Regulation of Official Digital Currency Bill, 2021 (“draft Bill”) inter alia seeks to prohibit all private cryptocurrencies in India. However, it is pertinent to understand that the entire crux of the cryptocurrency ecosystem is that it is decentralised. The industry cannot be banned/regulated from the source as there is no centralised entity or authority operating the ecosystem. What can be regulated/banned is the use, holding, transactions etc. which appears to have been sought from the draft Bill as well. The Government favors banning cryptocurrency mainly for 4 reasons viz. volatile fluctuation in prices, risk to consumers with cyber attacks and ponzi schemes, impact on power consumption (a study estimated that about 19 households in USA can be powered for one day with electricity used for a single transaction of Bitcoin) and finally its potential use in criminal activity i.e. for money laundering, terrorism, etc.

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Decentralised ecosystem

Being fully conscious of the existing technological impediments to banning crypto, the Indian Government’s intention to take that road will require a dedicated team, policy building, crackdown mechanisms, law up-gradation, and so on. Technological impediments exist because of a decentralised ecosystem as set out below.

Broadly speaking, there are three ways one can transact in cryptocurrencies viz through:

  • Centralised exchanges (“CEX”): Trading on CEXs would require one to share personal information, link his/her bank account and duly abide by KYC norms in order to transact in cryptocurrencies. This is one of the most legitimate methods to transact in cryptocurrencies. Users with the help of CEXs can directly exchange their fiat currency linked to their bank account with cryptocurrency. To put it candidly, through this method, the Government at all times is fully aware of one’s cryptocurrency holdings and transactions. There are many domestic CEXs today like CoinDCX, WazirX and so on. Imposing tax on transactions will also be possible simply because of the transparency and compliance offered by CEXs.
  • Decentralised exchanges (“DEX”): On the other hand, there are many DEXs like Uniswap, Metamask, pancakeswap etc.where creating an account does not require any compliance with KYC norms and does not even require one to disclose one’s identity/personal information. One does not even need a bank account to start trading on DEXs. On creating an account, the platform would independently generate a digital wallet/address (unique to every person) with an alphanumeric code which is used as the sender/receiver’s address to conduct transactions of cryptocurrencies. Identities are protected in DEXs, and in most cases, even the platform does not know the users’ identities. Usually, crypto users trade in cryptocurrencies on DEXs using/swapping stablecoins bought through P2P, a centralised exchange, or directly from the DEXs itself.
  • Peer-to-peer (“P2P”) exchanges: A simple search online would reveal that there are several groups on telegram and other messaging websites/apps where crypto communities are formed for direct p2p transactions in cryptocurrencies with the help of DEX’s digital addresses/wallet. Traders can directly exchange their cryptocurrency holdings against cash, other cryptocurrencies and/or any other valuable asset. P2p exchange is merely a networking method for cryptocurrency traders to exchange their holdings on DEXs.

If a ban is imposed on private cryptocurrencies, the implementation of such a ban will be a hurdle because digital wallets created on DEXs which are holding cryptocurrencies are not easily traceable. Although from implementation perspective, websites of DEXs can be banned within the country, possessing and transacting private cryptocurrencies in such digital wallets will also become illegal. As part of the investigation process, impounding of users’ phones and devices could be undertaken; however, it is still a vexed legal question whether compelling an accused to disclose passwords/digital wallet address would amount to self-incrimination. It will most likely develop a new jurisprudence ab initio. Law enforcement agencies would accordingly have to update their knowledge base and work with more ethical experts while at the same time develop assistive softwares for investigations as well as crime detection in this arena.

In the most rudimentary sense, cash, assets, and possessions derive their notional value from an organized imagined reality that defines our entire sophisticated existence. As Yuval Noah Harari in his Sapiens: A Brief History of Humankind notes, from joint-stock company to human rights, all form a part of our organized structural imagined reality. Cryptocurrencies are no different, so why should its volatile notional-worth be deemed notorious? Not to mention, every imagined reality has its pros and cons, cryptocurrencies also should be traded with a hint of cautiousness.

There are legitimate reasons for the Government to be insecure about cryptocurrencies. In most cases, one doesn’t know who is in how much control of the ecosystem/specific coins? Where are the servers located? Whether India’s fiat currency is being exchanged through crypto for terrorism/illegal purposes? Trades are also taking place in huge volumes and on a daily basis, but that is not a guiding force for the Government to come to a decision on banning/not banning. In today’s context, the main guiding force is transparency which fortunately or unfortunately is also most crucial for the crypto ecosystem to protect, considering that the element of confidentiality itself is the fountainhead of the ecosystem. It will be interesting to see the future stance of the government on private cryptocurrencies but as of publishing this article, cryptocurrencies are not banned in India.

*

Sanjay Notani is a Partner and Akash Manwani is an Associate at Economic Laws Practice. Views expressed are personal and do not necessarily reflect the views of MediaNama. 

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