By Srinath Sridharan and Shashidhar KJ

The Indian government is planning to ban all operations of cryptocurrencies in the country, except for a state-backed digital currency. The ban will be operationalised with a new law coming to effect. The Cryptocurrency and Regulation of Official Digital Currency Bill of 2021 is slated to be introduced in the budget session of the Parliament. In context of evolving digital finance globally, the Government of India should reconsider its thinking about these new financial systems that are being developed.

The move is expected to hit the nascent field in India and impact 342 companies and an estimated 5 million users involved in trading and holding cryptocurrencies. Reports also suggest that users holding on to these cryptocurrencies could be fined, once the new law comes into effect, with probability of them being given time to liquidate their holdings.

Cryptocurrencies like Bitcoin, Ethereum, Bitcoin Cash, Monero and Litecoin etc, are digital assets designed to function as a medium of exchange and records of ownership and transactions are kept on a decentralised-ledger called blockchain with strong cryptography. But these digital assets are known as tokens are not issued by a central monetary authority and are not backed by any physical asset. These tokens are "mined" by users who contribute computer processing power and are rewarded for their efforts. The price of these tokens is simply ruled by the forces of demand and supply.

The genesis for the idea for cryptocurrencies is older than people believe. The 1980s saw the rise of the Internet and along with it the idea of a sovereign cyberspace, which would transcend borders and free from all controls of nation states. But this utopian vision of a cyberspace still needed a currency for people to carry out transactions and conduct commerce. Following numerous experiments to create this system, the first cryptocurrency, Bitcoin, was created in the aftermath of the 2008 global financial crisis. But its development was a culmination of various digital peer-to-peer payments experiments.

Bitcoin's enigmatic creator(s?) Satoshi Nakamoto noted a fundamental issue problem with fiat currency and the centralisation of finance. "The root problem with conventional currency is all the trust that's required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust," he (or they). The distrust of central banks by early adopters of Bitcoin was probably fuelled by the actions of central banks which ultimately bailed out the erring investment banks which caused the 2008 financial crisis.

India & CBDC

Contrast this with what the government is attempting to do with its virtual currency. Essentially, the government of India is looking to introduce the idea of Central Bank Digital Currency (CBDC) where it acts as a digital representation of a country's fiat currency and will be backed by a suitable amount of monetary reserves like gold or foreign currency reserves. These digital fiats will be regulated by the country's monetary authority.

In India's case, this would fall in the jurisdiction of the Reserve Bank of India (RBI). Both CBDCs and cryptocurrencies use blockchain technology as their backbone for maintaining an immutable ledger for the transactions that take place using these tokens. However, while the blockchain on cryptocurrencies are open to public where everyone can view and authenticate transactions, the blockchain on CBDCs are permissioned where limited entities can carry out the functions of authenticating and viewing transactions.

CBDCs are a ‘virtual store of value' and they can be converted to cash in local currency at a fixed rate. CBDCs tokens also would bear interest on the central bank's balance sheet. Currently there are two modes of CBDCs being developed in the world – a retail token (meant for direct use by savers) and a wholesale token (meant to be used by banks and lenders subject to central bank regulations).

The modalities are still being worked out, but it could also serve as an excellent vehicle to push the central bank's plan to increase retail investors participation in the Government Securities. However, there is a risk to them. The yield on government securities is a little higher than bank deposit interest rates and savers might find the returns on CBDCs more attractive than what banks are offering, thus banks could lose of their primary means of funding.

As more savers move their money from demand deposits, it will force them to rely on costlier means of funding. Central banks also would be on the risk on their balance sheet in the event of another financial crisis and will have to function as a crucial financial intermediary in those times. And if CBDCs also take shape as a viable payment system, it raises several privacy issues with the state being allowed to see all transactions by a user.

CBDCs do bring interesting potential uses for the Indian economy in general and it's heartening to see India join a growing list of countries like The Netherlands, China, Sweden, the United States, Canada and Norway are looking to introduce a digital version of their currency. It is a worthwhile experiment to follow, but it doesn't make sense on why they cannot co-exist with existing cryptocurrencies.

"Money for nothing?"

Reading of the proposed crypto ban indicates that the government might believe that there is no intrinsic value in cryptocurrencies; and also might not like the way its value is pegged to market mechanism. In its first attempt to eliminate cryptocurrencies was reactionary as many people fell prey to shady operators posing as cryptocurrency companies and the RBI issued a circular where it said that while cryptocurrencies were not banned, it did bar entities regulated by it, including banks, from providing services to any person or firm dealing with cryptocurrencies.

The Supreme Court of India had quashed the RBI's cryptocurrency order in March 2020 giving a brief respite to cryptocurrencies holders in the country and saw the resumption of services by different players.

Fundamentally, the Indian government thinking is ruled by the mantra that "Blockchain is good, but cryptocurrencies are bad." It's evident by the bulletin it put on the Lok Sabha where it said that it would allow "certain exceptions to promote the underlying technology of cryptocurrency and its uses." This seems contradictory statement when it is looking to stop all research into this space and innovations that it is creating.

This policy might have originated in protecting the interests of the common man. But this raises the question on who invests or cryptocurrencies? Is it the common man who buys Bitcoin or HNIs?

While it is true that few cryptocurrencies might be inflated and there could be few Ponzi schemes posing as crypto businesses, the Indian government can issue detailed signposts and guidelines for investors planning to invest in them, like what the Australian government has done. The Indian government's policy thinking to ban cryptocurrencies might also stem from the narrative that they are used for terror financing and money laundering. While during its inception, Bitcoin might have been as used for conducting illicit deals on the dark-web, today the cryptocurrency-related crime is on the decline.

In 2020, the ‘criminal share' of all cryptocurrency activity fell to just 0.34 per cent, or $10.0 billion, in transaction volume, according to a report by Chainalysis, a company the specialises in cryptocurrency investigations for governments, exchanges and financial institutions. The report also shows that cryptocurrencies are almost never used for terror financing and most cryptocurrency-related crimes are scams, ransom ware, darknet market deals, and stolen funds.

It stands to reason of course. A mal-actor would have to be extremely stupid to conduct terror financing on an immutable ledger which can be seen and must be authenticated by all nodes on a blockchain. In India, traditional offline assets like real estate and gold still account for most money laundering operations and financing mal-actors.

Real estate is still not covered under the Money Laundering Act while purchasing gold does not even require KYC. Legitimate cryptocurrencies in India have been pushing for better KYC to open wallets for cryptocurrency transactions. Government can extend these requirements formally to cryptocurrencies as well.

The paucity of understanding can also be seen in the language the government is using to describe non-CBDCs as "private cryptocurrencies" and not using established nomenclature. Cryptocurrencies like Bitcoin, Litecoin, Ethereum etc. are considered public cryptocurrencies as users can view and verify all transactions and their details using these tokens on a public ledger and the blockchain used is open-sourced.

Cryptocurrencies such as Monero, Dash and Zcash on the other the hand are designed to be private where transaction details are hidden. However, these cryptocurrencies are still public in the sense that they have public open ledgers, but transaction information is obfuscated in varying degrees to protect the privacy of the end users. And then there are efforts like Facebook's Libra, now re-named Diem, that use a private or permissioned blockchain where only a few trusted entities can keep a track of the ledger and allowed to mine the tokens for its transactions.

There are varying degrees of complexity and innovation that can be beneficial people in general, but the government is dismissing and banning all of them by using a catch-all phrase called "private cryptocurrencies".

Who should regulate Crypto in India ?

The reluctance to engage with cryptocurrencies in India could emanate from deciding on which regulator will have to deal with them. If it is treated as a currency, the burden of regulation would fall on the RBI. If it is considered a security or a commodity, the Securities and Exchange Board of India (SEBI).

Contrary to misperception that there are no regulatory frameworks for them now, the way how cryptocurrencies are being used and traded, is more akin towards a digital commodity. Cryptocurrencies are traded directly through exchanges and even through financial derivatives like ETFs, options and futures, and contract for differences (CFDs). Indeed, with the uncertainties in the world right now, cryptocurrencies and decentralised finance were the best performing asset class, beating gold, stocks, and other global commodities in 2020.

Cryptocurrencies are unviable as a currency right now due to the massive changes in corrections and the time it takes for a transaction to get authenticated by the various nodes on the blockchain. Take for example the online games marketplace Steam's decision to stop purchases using Bitcoin. The company explained that Bitcoin transaction fees to buy a game shot up to $20 in 2017.

Also due to the price volatility, if the price of Bitcoin shot up at the time of transaction, Steam had to refund the difference to the user and conversely, if the price went down the users had to pay the difference again. There is also an engineering concern to consider as every transaction needs to be authenticated by every node on the blockchain thus the time for a transaction increase.

Currently, the time for confirming a Bitcoin transaction is about 10 minutes. Though there are efforts being made by different cryptocurrencies to speed up the process of authentication for more real-life use cases. But still, it is nowhere close where users can buy a cup of coffee using a cryptocurrency.

With this in mind, the burden for regulating this new form of finance could fall in SEBI's court. Ideally, SEBI should strongly consider allowing cryptocurrencies as part of its regulatory sandbox and combine its learnings from jurisdictions like the United States, Japan and Australia.

Learnings from US, Japan, Australia

Though the United States does not consider cryptocurrencies as legal tender but recognizes crypto exchanges as money transmitters as the tokens are other value which substitutes currency. While the Securities and Exchange Commission (SEC) recognises them as securities and is working on enacting securities law on them. Meanwhile, the Internal Revenue Service (IRS) recognises them as property and have guidelines for the same.

The United States also takes a pragmatic approach to different offerings and takes a case-by-case approach. For example, the SEC cracked down on Facebook's Libra cryptocurrency project. As Libra used a private permissioned blockchain and controlled the number of nodes, it was able to drive down the time for a transaction and was also able to control its price volatility.

Essentially, it functioned more like are a stable private currency which could rival the US Dollar and less like a security. Hence, the project did not take off. However, it clarified how it was treating Bitcoin and said that they are not treating it as a security but rather as a store of value and noted that its rise was driven by the inefficiencies of the payment systems in the country. But in both cases, it was made clear that they are not legal tender.

Japan takes a longer view of the ecosystem. It does not consider cryptocurrencies as a security, nor does it treat it on par with fiat currency. Considering the many use cases by different tokens, it defines them under the broader umbrella of Crypto Assets. Exchanges are required to register themselves as payment service providers under its Payment Services Act.

Further, it requires these exchanges to maintain strict Know-Your-Customer (KYC) records of investors and users and comply with all anti-money laundering and combating terror finance rules (AML/CFT). In addition, the property rights framework will apply on these crypto assets.

Australia stated particularly that Bitcoin and other tokens which share its characteristics are considered property and will be subject to Capital Gains Tax. In addition, it has now come out with detailed signposts and guidelines for investors planning to invest in Initial Coin Offerings (ICOs) with clear warnings about these risks along with case studies.

Don't be cryptic or critical of Crypto yet!

The government's push to ban all cryptocurrencies in the country is simply throwing out the baby along with the bath water. It is ironic that the Indian government is following the same policy decisions as China, which banned all cryptocurrencies as well in favour of its digital fiat currency. The Indian government should in all manners should emulate the idea that it is an alternative to China and not follow the same policy prescriptions set by Beijing.

There is a risk that India will lose out in the billions of dollars in the new cryptocurrency –led world of finance by enforcing the ban. There might be another brain-drain as more minds who believe in cryto-finance will leave India to set up shop in friendlier countries.

Thus, the underlying asset of all cryptocurrencies is the failure of governments globally and central banks to provide better financial outcomes for citizens. Thus, the best way to handle the proliferation of private cryptocurrencies is to make sure that state institutions and fiat products work well for retail participants. The Indian government's ban on cryptocurrencies is overprotective at best and at its worst, it could be viewed as an attempt to maintain an iron grip on how its citizens use their money.