By Yashesh Ashar, Partner, Bhuta Shah & Co LLP
Internationally, the application of Distributed Ledger Technologies (‘DLT’) is being explored in the areas of digital identity management or KYC requirements, cross-border fund transfers and clearing and settlement systems, insurance, collateral and ownership (including land) registries, e-stamping, securities and financing. DLT allows the recording, sharing and transfer of data or value without the need for a central record keeping as in the case of a traditional ledger. Such records are immutable and non-repudiable. This obviates the need for keeping data centralised as in a traditional ledger.
The advantages of using DLT are mainly seen in terms of reducing administration and transaction costs, obviating duplication and improving accuracy of data, improving the speed and efficiency of transactions and detecting fraud.
Blockchain is a specific type of DLT, which uses linearly connected blocks to record transactions. Thus, all Blockchains are DLTs but all DLTs are not Blockchains.
The Indian Government has also adopted the Blockchain technology in many areas with Niti Ayog working on building India’s blockchain network, RBI experimenting with use of Blockchain technology in banking and financial sector, various state Governments experimenting with the idea of digitising land records, use of Blockchain technology to certify start-ups and recent use of Blockchain technology in the issue of Uni-Pass using Aadhaar authentication for travel in local trains in Mumbai.
A virtual currency (‘VC’) is a digital representation of value that can be digitally traded and functions as (a) a medium of exchange, and/ or (b) a unit of account, and/ or (c) a store of value but does not have a legal tender status. A VC therefore may be a private medium of exchange but does not in any way reflect a sovereign guarantee of the value or legal tender status. Cryptocurrencies are a subset of virtual currencies and get their name from the underlying encryption technique called “cryptography.” Bitcoin is the first form of cryptocurrency and also the most popular and widely used of the more than 5,000 cryptocurrencies existing today.
Globally countries have accorded different legal treatment to VCs – barter transactions (Russia and Canada), mode of payment (Japan, Switzerland and Thailand), Legal tender (El Salvador), complete ban (China). Due to its volatility, recently, the International Monetary Fund (‘IMF’) recommended El Salvador not to use Bitcoins as its legal tender.
The VCs have also evolved into other forms such as initial coin offerings (‘ICOs’) and digital tokens (investments as well as asset tokens – i.e. non-fungible tokens (‘NFTs’)). Further, given the volatility, a new breed of VCs, known as ‘stablecoins’ have emerged which are backed by and / or pegged to real world financial assets such as USD, gold etc.
The Grey areas
Though VCs do not have a backing of a sovereign and also do not have any underlying intrinsic value, they usually derive its worth from the value attributed to it by the participants, such as in the case of gold or any other valuable asset. Thus, since inception, VCs have been highly fluctuating in its value and extremely volatile.
Though VCs have a potential to spur innovation and escalate financial inclusion and several financial sector regulators and standard-setting bodies are exploring its application, there are also several risks and regulatory and legal challenges that create grey areas which require attention. Technologically, scalability and transaction speed as also interoperability and integration into existing financial systems remain a challenge. Other key technological risks concern cyber security and data protection. Further, given the anonymity it provides to a transaction makes it vulnerable to money laundering and financing of unlawful activities.
Post the ruling of the Hon’ble Supreme Court in 2020, which held that the in the absence of any legislative ban on VCs, the Reserve Bank of India (‘RBI’) cannot impose disproportionate restrictions on the trading in VCs setting aside the Circular of the RBI in 2018, India witnessed as spur in crypto related activities with a dramatic rise in crypto transactions by Indians, specifically, the younger generation and various Indian start-ups setting up crypto exchanges.
The primary concerns and challenges for the Government of India (and for that matter any Government around the world) in dealing with VCs are absence of intrinsic value and sovereign backing, volatility, protection of retail customers / investors, creation of an anonymous decentralised parallel economy, its use in money laundering and terror financing activities.
The Government of India constituted a High-level Inter-ministerial Committee (‘IMC’) to study the issues concerning VCs on November 2, 2017 which submitted its report on February 28, 2019 (‘IMC Report’). The IMC Report recommended a complete ban on the private VCs in India and issuance of a Central Bank Digital Currency (‘CBDC’). A CBDC, with all the important and beneficial characteristics of a VC, can also function as an extended version of the ‘stablecoins’ backed by sovereign guarantee.
The Banning of Cryptocurrency and Regulation of Official Digital Currency Bill, 2019 (‘2019 Bill’) echoed the intention of the Government of India to ban transactions by Indians in private cryptocurrencies and only allow transactions in official digital currency. The 2019 Bill made provisions for transition by mandating declaration and disposition by existing cryptocurrency investors / holders within a 90 day period from the date of enactment. The penalties for non-compliance of the 2019 Bill were made similar to non-compliances with money laundering regulations and exchange control regulations in India. The agenda for the new proposed Bill (‘2021 Bill’) also appears to be on the similar lines.
The way forward on the Bill
However, the situation on the ground is much different in 2021 than in 2019. The number of Indians with cryptocurrency transactions has increased manifold, the crypto exchanges have emerged in India with substantial foreign investment, many Indians also in overseas crypto exchanges and possess multiple wallets of different crypto currencies. A forced winding of all these infrastructure and investments may not be feasible from the Government standpoint from the economy as well as political standpoint. Further, creation of the infrastructure for the CBDC and its integration with the fiat currency may have its own challenges.
Thus, though India may patronise the use of a CBDC as a legal tender and peg it to Indian rupee, banning other cryptos as asset classes may not be completely feasible as it may delink India from the rest of the world using other popular / widely used crypto currencies. At best, from a regulation standpoint, India may need to allow the conversion of other cryptocurrencies (in soft wallets) into a CBDC (in India wallet as proposed) for regulating the same in the Indian market. This could bring in the required certainty (though not complete flexibility) if the CBDC is compared to USD in the international market in the same way as the physical rupee. Though India may not be expecting an immediate global acceptance of its CBDC like the Bitcoins, it can work as a great monitoring mechanism for the Government to track transactions in other VCs and also ensure adequate trail to create checks and contain its use for the money laundering and other unlawful activities. Also, it is highly likely that the government will prohibit (or at best discourage) its application until a framework for regulation of exchanges is put in place as well as to provide investor education and awareness in VCs.
The larger question emerges on the use of cryptocurrencies as tokens for the digital token with securities as underlying and non-fungible tokens (‘NFTs’) with assets such as digital arts, paintings, and other valuables as underlying. As per the 2019 Bill, tokens are treated as cryptocurrencies and are banned. However, there is need to have a fresh look at these use cases of cryptocurrencies as they can more likely be classified as ‘assets’ signifying ownerships of other underlying assets and deriving value therefrom as against crypto currencies with no intrinsic value.
The tax aspects
The clarity on taxation aspects in relation to transactions in cryptocurrency needs more clarity that what meets the eye. The issues as regards characterisation of VCs as assets classes – investment vs. stocks, the characterisation of the income from such activities as investment, business or speculative, the trigger event or point of taxation, the obligation to withhold and / or collect taxes by various intermediaries, whether cryptocurrencies be considered as goods for the purposes of GST – remains unanswered. Multiple complexity in the cryptocurrency transaction such as objective of transacting in cryptocurrencies, transfer from one wallet to another, conversion into fiat, roles of the intermediaries, etc., add more complexity to the above issues. Clarity in all these would go a long way in bringing certainty in crypto transactions.
To conclude, the issue of a CBDC appears to the way forward for India and other countries to monitor and regulate the cryptocurrency transactions in the economy. However, needless to say that introduction of CBDC will come with its own baggage of issues in relation to integration, inoperability, technology and infrastructure. The way forward on private cryptocurrencies is not a complete ban but to treat them as an asset class (as against legal tender). The cryptocurrency exchanges need to be regulated to monitor and govern the ecosystem as well as bank instill confidence and wider participation by the retail investors.
Having said the above, the use of Blockchain technology by the Government in other areas of fintech and digital economy should continue. Blockchain technology should be viewed as sector agnostic with all the key regulators such as RBI, SEBI, IRDA, PFRDA and IBBI should also focus on DLT to explore building of appropriate regulations for development of DLT and Blockchain in their respective areas.