“There is no specific regulatory framework in the country when it comes to things like risk management, separation of user funds, etc.” Mohit Chawdhry, a technology law and policy researcher with the Esya Centre, told Medianama in an interview. He was asked if there is anything in law which prevents Indian crypto exchanges from dipping into user funds.
Chawdhry explained that the Indian central bank (RBI) has mandates for traditional financial institutions which require them to keep certain reserves with the bank itself. He added that the RBI has been clear that their mandates do not apply to crypto asset service providers (because they remain outside the regulatory purview of the RBI).
“…it would appear that there is very little that would prevent any Indian entity dealing in crypto to dip into customer funds and use it for other purposes,” he concluded.
Aman Nair, Project Coordinator and Researcher, Digital Futures Lab, added that there are no legal requirements for crypto institutions to demonstrate proof of funds or maintain a solvency threshold.
“There would be no need for FTX to have an independent audit that is backed up and verified by a third party if it operated in India,” Nair said.
Why it matters: It is pertinent to examine the robustness of regulations in India in case an FTX-like collapse were to unfold here.
- The collapse of one of the biggest exchanges in the world dealt a huge blow to the prospects of the crypto industry given that FTX was viewed as safe and trustworthy.
- Its downfall has raised concerns among millions of crypto investors in India who have parked crores of rupees in digital assets with the hope of reaping long-term returns.
- They are rightly concerned that if an exchange like FTX cannot be considered safe then is any exchange trustworthy, especially in the absence of regulatory oversight.
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Impact of FTX’s collapse on Indian crypto ecosystem
Brief timeline of events: The collapse of FTX started with a report in Coindesk which found that Sam Bankman-Fried’s trading firm, Alameda’s balance sheet was full of FTT— FTX’s native token which allowed holders to avail a discount on trading fees while trading on FTX. It caused many to suspect that there was something fishy afoot.
- Binance’s CEO Zhao responded to the report by announcing that he will sell his FTT tokens. Zhao did not say how much FTT his firm will sell but it triggered a massive drop in FTT’s price.
- It sparked fears about FTX’s stability and customers rushed to liquidate their assets from the exchange, sparking a liquidity crunch. Many were unable to withdraw their money as all non-fiat withdrawals were suspended altogether. The company had experienced roughly $6 billion of net withdrawals following Zhao’s announcement, The New York Times reported.
- Binance first announced that it will acquire the beleaguered exchange but backed out within 24 hours of announcing the acquisition. Many companies exposed to FTX or Alameda suffered, with many writing off their investment in the exchange.
- FTX was then forced to file for bankruptcy which came on the heels of Bankman-Fried’s resignation. John J. Ray III took over as the CEO of the exchange.
What was the impact on India: The impact of FTX’s fall on Indian crypto exchanges cannot be ascertained in isolation from how it will affect the behaviour of the average Indian retail investor, according to Pratyush Miglani, Managing Partner, MVAC. The collapse of FTX is likely to have affected half a million Indian crypto investors, as per Siddharth Jain, Co-Founding Partner, PSL Advocates & Solicitors.
- He said that investor portfolios have lost over 90 per cent of their value. “It has also led to reduction in spot trading volumes on the Indian exchanges. However, the decline is marginal in reality as exchanges are already in a bearish phase,” he said.
- Chawdhry said that a lot of Indian investors switched to Binance and FTX because they were not applying the 1% TDS. “…it made a lot of sense to trade on these platforms because they were able to exploit tax arbitrage and get reduced fees,” he added.
- These investors are not going to be able to get their funds back, according to Chawdhry. He also pointed out that FTX was involved in several activities promoting the ecosystem which will now see funding dry up.
The extent of damage caused by FTX’s bankruptcy has had a ripple effect across the crypto system forcing crypto exchanges to scramble to instill trust among users.
Evaluating transparency measures undertaken by exchanges
Several Indian crypto exchanges took measures like publishing audit reports of their balance sheets, their proof of reserves, among other things. CoinDCX went ahead and also published its Reserves to Liabilities (R2L) ratio.
Cannot rely on them: Chawdhry pointed out that crypto exchanges have arrived at a realisation that transparency is important owing to which they are publishing their proof of reserves and proof of liabilities. He explained that these reports might give customers an “overview of where their assets are, and allow them to make an informed decision on which exchanges are better collateralised but you can’t completely rely on it.”
- He was circumspect about the efforts of exchanges to undertake independent audits but did not stop short of calling it a positive step.
- His doubts stemmed from the fact that it was an exchange that was approaching the audit organisation whose credentials cannot be verified easily. “There’s always a conflict of interest. It’s similar to what happens with credit rating agencies in this country,” he explained. “…the only way to ensure that consumer funds are protected is through government regulation,” Chawdhry suggested. Rastogi added that the industry should set these standards through self-regulation until there are regulations in place.
- Kharbanda said that exchanges are running around trying to prove their reserves by whatever means necessary in the absence of regulatory supervision. “Would it be in my (exchange’s) interest to publish results of an audit firm which finds problems in my operations?” he wondered. Jain added that the auditing exercise comes with loopholes as exchanges can always transfer funds to other exchanges before the audit, thereby giving a “false sense of security”.
Is there enough expertise: Chawdhry stressed that traditional audit firms are building expertise to conduct audits for crypto firms. “…it’s not necessarily easy because valuation for these assets can be a little difficult from traditional finance,” he argued.
Chawdhry said that established companies are “wary of associating with any kind of audit in a crypto firm because of what they may find out”. He said that a bank run may be triggered if a firm reveals that an exchange does not have backing for its liabilities. “..it could bring negative publicity around these existing consultancies which could be a reason for them to stay away,”
“But given that there’s no uniform standard of audit, the information disclosed in one exchange’s proof of reserves could vary from that of another,” Anirudh Rastogi, Founder and Managing Partner, Ikigai Law, said in a statement.
Rastogi indicated that regulations which help determine how these audits are done will be beneficial to the industry. “(They can) create a panel of empanelled auditors who are recognized and have shown competency and skill in doing crypto-related audits,” he added.
Lack of legal protection: Nair said that an average consumer has to take these companies at their word which is the root of problems in crypto over the last year. “There is not much backing in terms of prevention. You are trusting the company and their third party auditor,” Nair told Medianama.
He added that it would be helpful if exchanges were to go into detail in terms of what assets they hold and their amounts specifically because companies like Tether tend to lump various assets together and all these assets need not be as liquid. “…there’s no verification of what they’re saying,” he said.
What kind of remedies are available to investors?
There was consensus among every expert that Medianama spoke to for this story that there is no clear-cut redressal mechanism for customers to seek relief. However, here are some of the measures available to investors:
Do investors have only judicial recourse as of now?
Vipul Kharbanda, a non-resident fellow at the Centre for Internet & Society (CIS), stated that there is a contractual remedy if there is a clause preventing an exchange from dipping into user funds in its terms and conditions.
“You can go under the Consumer Protection Act, 2019. The advantage under the Act is that you do not have to go to regular civil courts,” he said, adding that investors can also file a criminal case against an exchange for theft and cheating.
Chawdhry said that it’s difficult to say how courts would rule in a given situation in the absence of any specific legislation. He contended that one could make an argument for “a violation of constitutional principles but it would be difficult”. He explained that investors can seek relief under the consumer protection law because it has been amended to cover e-commerce.
“..most of these CASPs are e-commerce entities in the sense that they facilitate the provision of products and services through a digital medium. But there is no precedent in this regard,” he concluded, adding that the ecosystem would benefit if India were to put in place reserve requirements.
Their suggestions were echoed by Aman Nair but he underscored that these processes are tedious. “The only option left with investors is the judicial route which is problematic given that a complaint against these companies implies that one has lost money. And now you have to bear the burden of lawyer fees and take out time to go to court in order to recover that money,” he explained.
Relying on the Consumer Protection Act
Aman Nair and Vipul Kharbanda wrote an article for Medianama in August 2022 pointing out the definition of e-commerce would be applicable to a number of crypto-exchanges as well as certain entities offering decentralized finance (DeFi) services. They had contended that crypto exchanges fall within the ambit of consumer protection legislation in India.
“This is because crypto tokens—be it cryptocurrencies like Bitcoin, Ethereum, or Dogecoin—are not considered currency or securities within Indian law, but can be said to be digital products since they are digital goods,” read the article.
They wrote that a consumer who is the victim of a fraud or scam in the crypto space would have two primary remedies:
- Lodging a criminal complaint with the police, usually the cyber cell, regarding the fraud. It then becomes the police’s responsibility to investigate the case, trace the perpetrators, and ensure that they are held accountable under relevant legal provisions.
- Lodging a civil complaint before the consumer forum or even the civil courts claiming compensation and damages for the loss caused. In this process, the onus is on the consumer to follow up and prove that they have been defrauded..
What needs to be done?
“India’s ad nauseam endorsement for more regulation of the crypto industry stands vindicated with the recent FTX collapse. Of course, regulation must not mean indirect control, but certain regulations, such as declaration of proof of reserves, proof of liabilities, etc., may contain, if not completely prevent a situation like FTX,” Miglani told Medianama.
It is clear that a regulatory framework providing uniform oversight is the need of the hour. It will offer investors with some degree of security whereas crypto companies will be able to enjoy regulatory stability. But what should this regulatory framework look like? Here are some of the proposed measures:
Limit the ambit of companies: Chawdhry recommended that an exchange should be limited to its functionality. “You can’t have a sister organisation using customer funds to do margin trading and arbitrage trading,” he told Medianama. He also batted for regulation to stipulate that consumer assets cannot be used by exchanges in their terms of service. He was of the opinion that it would be better to do it with the help of new regulations.
Sustained supervision: Kharbanda said that regulators need to supervise the exchanges constantly because you don’t want the customers to be at the mercy of the entire legal system wherein every individual has to go after the company. He also called for a registration mechanism, capital adequacy requirements, regular audits by an auditor.
Draft a new law: Kharbanda said that the Indian government could piggyback on existing laws as far as KYC and money laundering is concerned but the country will need new regulations to prevent large-scale scams and consumer frauds. Kharbanda, along with Aman Nair and Aryan Gupta, wrote a report for the CIS in 2021 which recommended that the government should explore giving jurisdiction to either the SEBI or the RBI over crypto assets.
What did the CIS report say: The report advised against a ban on crypto assets and called for a specific framework as crypto assets “do not fit into any of the existing classifications of financial instruments”. It recommended that any potential licensing system must place mandatory obligations on crypto-asset service providers to ensure that consumer rights are protected. Here are some of them:
- Obligation to act in good faith: It suggested that CASPs must be “obligated to operate honestly, fairly, and in the best interest of consumers”.
- Informing consumers and governing authorities: Their obligations should ensure that all information
related to the crypto-asset/service is easily accessible to consumers in a simple and easy to understand format such as a whitepaper.
- Marketing and advertising: All marketing and advertising done by CASPs must be identified as such. “All information included in the advertisements must be in line with that provided in the service provider’s whitepaper. All marketing must also clearly articulate the rights of the crypto-asset holders and any associated risks – including whether there is any right to redemption,” read the report.
Opt for licensing: Nair was also a part of the team which wrote the report along with Kharbanda. He echoed Kharbanda’s recommendation to bring crypto assets under the purview of either the SEBI or the RBI. Here are some of his recommendations:
- Outline definitions: Nair called for a comprehensive set of definitions. “…definitions are rarely perfect; they are too broad or narrow. India has to be particular, focused and think through a definition of crypto asset that encompasses what we’re seeing in the market and allow for some room in the future,” he advised.
- Explore licensing: Nair believes that the government should introduce a licensing system. “We have licensing systems for other financial exchanges,” Nair stated, adding that these licensing systems have to be done in a way that requirements placed on institutions are “consumer-first” and “investor friendly”.
Nair said that an investor’s problem is that their decision to invest boils down to their risk appetite and their belief in what the companies are telling them.
“When you have a set of rules and a regulator whose job is to make sure that all players in the market are abiding by a set of rules, you as a consumer know that there is an entity whose job is to protect me and enforce rules that are in my interest,” he concluded.
You can read the entire report by the CIS here.
*Disclaimer: The headline was edited on January 13, 2023, at 17:25 in order to remove redundancies.
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