Crypto Crazed: Regulating digital assets

It’s always the same old story. Computer nerds develop disruptive technologies that threaten to upend traditional economics and alter human conduct. Legal regulators then clamber to make sense of shifting market forces and domesticating the animal. In recent history, Cryptocurrencies are the latest of troublesome creations that have been vexing the financial world’s unregulated frontier.

The proliferation of crypto exchanges and widespread interest in digital assets has prompted broader questions about its classification, regulation and ultimately impact on sovereignty.

In 2018, India proposed to regulate crypto-exchanges with the introduction of the Crypto-token Regulation Bill. In the same year, the Reserve Bank of India (RBI) issued a circular banning banks from dealing with virtual currencies, resulting in a series of challenges before the Supreme Court. In 2020, the apex court struck it down as disproportionate and violative of Article 19(1)(g) of the Constitution.

In its latest attempt, Parliament has reportedly reworked the previous Bill, now called the Cryptocurrency and Regulation of Official Digital Currency Bill, 2021. In all this dithering, how should the India’s legal regulations make sense of the crypto craze?

Take classification. Back in 2008, in the wake of financial crises, when Satoshi Nakamoto invented Bitcoin, he was disillusioned with conventional banking systems and wanted to create an electronic currency that was free from any kind of central control. If users could replace a governmental authority with trust in mathematics and code, individuals could cut the middleman and transact directly with one another.

But despite over a decade of existence, crypto has fallen far short of its envisioned purpose: an electronic version of cash or gold. Valuations can vary widely on any given day. Exchanges have been hacked in the past. Principally, volatility and insecurity make for poor currency. With this in mind, regulators wonder: should they still be considered a currency (like money but with no legal sanctity), a security (like shares but with no inherent value), or a commodity (like gold but with no real-world application)?

Perplexed by these difficulties, governments have come to widely different conclusions. El Salvador fearlessly recognizes Bitcoin as legal tender. Canada views it as a commodity; its purchase and sale are viewed as barter transactions and profits are treated as business income. Australia, on the other hand, considers it a digital asset and levies capital gains.

As a logical start, the first set of regulations should look at supervising the platforms on which virtual currencies are exchanged with conventional money. Several countries already implement such measures: Australia and South Korea were early adopters of robust laws. Bearing this in mind, crypto exchanges in India already voluntarily implement Know Your Customer (KYC) standards, such as asking users to prove their identities. In October this year, the Financial Action Task Force, an inter-governmental body that combats money laundering, recommended a series of new rules for crypto-services providers, including the specific user data they must store to combat transactions linked to criminality.

Governments naturally worry most about taxation. Since crypto trading can be incredibly lucrative, they see a new source of potential revenue. Some jurisdictions treat them like property, resulting in capital gains on the sale. Others see them as foreign exchanges, meaning unrealized gains may also be taxed. Authorities are also scared of losing existing income: crypto currency could be used to hide earnings. As most crypto exchanges work in the shadows, reliable data on crypto evasion is hard to gather.

Lawmakers disagree about consumer protection too. Authorities feel obligated to protect investors from harm, while others think people should be at liberty to gamble away their money if it does not result in any wider risk. On average, global consensus suggests that comprehensive disclosure requirements and licensing crypto businesses would protect consumers from fraud and reduce institutional risk.

From a competition law perspective, legal experts are debating whether cryptocurrencies classify as securities, thus requiring stringent disclosure obligations from issuers, or they should be considered commodities, where the main concern is market manipulation. The European Union is already preparing a set of rules that compel crypto companies to secure licenses and ban social media posts that distort market incentives.

A few crypto organizations are pre-empting stricter rules and offering proposals of their own. Andreessen, a venture capital firm, is lobbying for self-regulation. Coinbase, an American crypto exchange is pressing for a central regulatory authority. Indian experts recommend existing regulators like RBI or Securities & Exchange Board of India (SEBI) be entrusted with the responsibility of framing policies for the crypto asset market. To complicate matters, technology law experts have recommended different regulations for different sets of tokens based on their ultimate usage. A blanket approach would not capture the shape-shifting nature of these digital assets.

In the end, with so many poorly understood risks, some authorities have taken the view that the only safe response is to shut down the whole crypto-world. China, for instance, banned crypto exchanges and initial coin offerings, a method of raising funds in which investors in startups are issued with virtual tokens. India’s own attempts to ban cryptocurrencies have so far been met with hostility and a spate of challenges before the Supreme Court.

India’s recent Crypto Bill of 2021 as of now is not available in the public domain. According to the bulletin, the Bill intends to “create a facilitative framework for creation of the official digital currency to be issued by the Reserve Bank of India.” The Bill also bans all private cryptocurrencies except “for certain exceptions to promote the underlying technology of cryptocurrency and its use.” Curiously, by definition, Bitcoin, Ether and other cryptos are created by developers and available in centralized and decentralized exchanges. Are these considered private? Without clear thinking and precise language, what the government intends to ban will doubtless result in confusion that India’s Supreme Court will ultimately be called upon to clarify.

Regulating digital assets is no easy task. Too much, and you hamper innovation. Too little, and criminals roam free. Crypto-fanatics frequently compare the crypto world to the younger days of the world wide web. Authorities endeavoured to control it with heavy regulation and declared it a cesspit of criminality. Most of the world has now decided that the benefits of the internet far outweigh the costs. And while it is much too early to say if that is true of cryptocurrencies, it would be a tragedy to outlaw them before even learning the answer.

Rohin Dubey is a practicing lawyer at the Gurgaon based law firm N South, Advocates.