Building a Regulatory Framework for Cryptocurrency

Author: Shradhanjali Sarma


Background

India’s cryptocurrency market has witnessed steady growth. With growing interest towards cryptocurrency, investments shot up from about $923 million in April 2020 to nearly $6.6 billion in May 2021. Amidst this burgeoning interest, India has struggled to put into place a regulatory regime in as much as the present legal framework provides for no clear definitions of cryptocurrency, crypto-assets and virtual currencies.

Owing to the global responses around cryptocurrencies, India too has taken measures to establish a regulatory framework. RBI’s primary concerns were regarding the absence of a central agency for regulation of payments, volatility of virtual currencies and the scope of illicit financial activity. The cautionary measures were soon replaced by stringent measures by RBI vide its circular dated April 6, 2018. The Circular directed all entities regulated by RBI to refrain from dealing with virtual currencies from immediate effect. The circular was challenged by the Internet and Mobile Association of India (IAMAI) before the Supreme Court.

On March 4, 2020, the Supreme Court after considering the submissions of the parties, held that RBI’s circular is liable to be set aside on the groundof proportionality. There was no adverse impactcaused by the use of virtual currencies, and hence such a ban was considered unreasonable. However, the Court did agree that RBI has jurisdiction to regulate virtual currencies as virtual currencyhas the potential of creating a parallel monetarysystem.

Recently, the Regulation of Official Digital Currency Bill, 2021 (Bill) was sought to be introduced in the Budget Session of the Parliament. The Bill intends to create a facilitative framework for creation of the official digital currency to be issued by Reserve Bank of India (RBI) and prohibit all ‘private cryptocurrencies’ in India. However, it allows for the promotion of technology underlying cryptocurrency in India and its uses, with certain exceptions. The Bill has not been made public yet and is stillunder deliberation by the Government.


India’s Elusive Stand?

The measures taken by India portray a very elusive stand, primarily because India has not been able to completely ban cryptocurrency nor has it been able to carve a sound regulatory structure for it. The elusiveness stems from the fears around cryptocurrency and the manner in which it is designed to function.

Unlike fiat currencies, cryptocurrencies are outside the realm of the Government control. The absence of any central authority in regulating cryptocurrency is one of the major reasons behind the skepticism towards it. Governments use control over fiat currency to keep a check on recession, inflation and on investments. However, in case of cryptocurrency, the Government cannot keep a tab on its flow as it is not issued by any central agency, thus instilling fear in most people towards its use.

Another concern of the Government regarding cryptocurrency is regarding its potential to be used for financing of terrorist activities. The Financial Action Task Force (FATF) in 2015 released a report titled ‘Emerging Terrorist Financing Risks’, where it was stated that the technology around virtual currencies is such that it allows anonymous transfer of funds internationally. While the original purchase of the currency may be, other subsequent transfers of the virtual currency might be difficult to detect. Due to this nature, cryptocurrency can be easily used for financing terrorism. In IAMAI, while arguing against cryptocurrency, it was stated that certain people have used their Twitter accounts to explain jihadists about the manner in which virtual currency can be used to fund terrorism. However, it is important to note that even fiat currencies can be easily used for financing of terrorist activity, and has always been used even though it is heavily regulated by a central agency. Under such circumstances, it is important to create a compelling case for cryptocurrency and its tendency to encourage terrorism in order to support any kind of ban on it.

In IAMAI, it was stated that the widespread use of virtual currencies and substitution of bank note could lead to a ‘decline in central banks’ non-interest paying liabilities and that if the adoption and use of digital currencies were to increase significantly, the demand for existing monetary aggregates and the conduct of monetary policy could be affected”. On similar lines, the Financial Stability Report by RBI in 2016 stated that the rapidly developing fintech space has generated risks ad concerns about data security and consumer protection on one hand, and has also raised questions on the effectiveness of monetary policies.

The lack of a central authority, volatility, potential of misuse by terrorist organizations and its impact on conventional monetary policies has led India to maintain an elusive stand on this issue. Neither has India been able to provide for a strong regulatory framework, nor has it been able to completely ban the use of virtual currencies, thus creating ambiguity.


Existing Legislative Framework in India

In IAMAI, Supreme Court discussed about whether virtual currency should be classified as a good or commodity. The Supreme Court concluded that it is an intangible property, which under certain circumstances acts as money. Owing to the ambiguity in its legal status, no legal regulatory framework has been established as of yet in India. Nonetheless, there are certain enactments such as Foreign Exchange Management Act, 1999 (FEMA), Payments and Settlements Act, 2007 (PSSA), Prevention of Money Laundering Act, 2002 (PMLA), Income Tax Act, 1962 (ITA) and the Goods and Service Tax Act, 2017 (GST) which provides guidance on the regulation of cryptocurrency in India, primarily the ones issued by entities governed by RBI.


a. Payments and Settlements Act, 2007 (PSSA)

PSSA was introduced with the intention to provide regulation and supervision of payment methods in India and to designate RBI as an apex institution for purposes related to payment systems in India. Under Section 2(1) of the PSSA, a payment system is defined as a “system that enables payment to be effected between a payer and a beneficiary”. Therefore, if virtual currency systems form part of payment system, authorization will be required from RBI under Section 4(1) of the PSSA. However, owing to the decentralized nature of virtual currencies, it might be difficult to have a payment system operator in existence. In such cases, it is important to refer to Supreme Court’s view in IAMAI, where the Supreme Court clarified that in absence of a payment system, virtual currencies can still be regulated under the PSSA by considering them as ‘payment instruction’ or ‘payment obligation’ under Section 2(g) and 2(h) respectively.


b. Prevention of Money Laundering Act, 2002 (PMLA)

Due to its pseudonymous character, it is often difficult to track transactions relating to virtual currencies, thus raising concerns around money laundering. In India, in order to keep track of financial transactions, different legislations have been enacted along with a few RBI directions. The PMLA and Know Your Customer (KYC) Direction 2016 apply only to entities that are regulated by the RBI and Securities and Exchange Board of India (SEBI). In such cases, only security-related virtual currencies and operating payment systems will be regulated under the anti-money laundering and KYC norms.


c. Foreign Exchange Management Act, 1999 (FEMA)

FEMA do not provide for any definitions for virtual currencies. Under such circumstances, it is important to take a look at Foreign Exchange Management (Exports of Goods & Services) Regulations, 2015 (Regulations). The Regulations treat both software and goods in the same manner. In the landmark case of Tata Consultancy Services v. State of Andhra Pradesh, the Court held that the term ‘goods’ under the Constitution is wide and thus includes all types of movable properties irrespective of tangible or intangible. It went to hold that a transaction sale of computer software is a sale of goods within the meaning of the relevant state sales tax acts. While the judgment does not concern virtual currencies, it can provide interpretational guidance for classifying them as goods under FEMA. Similar to software, virtual currencies, especially Ethereum and Bitcoin, are made, marketed and stored on physical servers and also intangible. Thus, we can conclude that cryptocurrencies can be classified as goods in order to regulate it under FEMA.

In matters relating to trading of virtual currencies, outward remittances of fiat currencies for purchase of virtual currencies will fall under Section 2(j) of FEMA and will therefore be classified as current account transaction. Further, if virtual currencies are sent from India to somewhere outside India by Indian residents for purchase of goods, it will be considered as an export under FEMA.



Concluding Remarks

Recently, the Ministry of Finance stated that the entities which are regulated by the central authority has to comply with certain norms under KYC standards, PMLA and FEMA. While there was no hint towards a blanket prohibition on cryptocurrency, the Minister of State clarified that the government does not consider cryptocurrencies as legal tender or coin, and will take necessary measures to eliminate any form of illegitimate activities concerning it.

However, one significant issue that requires clarity is that of the definition of private cryptocurrencies. Cryptocurrency is a public good and cannot be privately owned by anyone, just like the internet. One assumption can be that the Government intends to allow only those cryptocurrencies which are issued by entities regulated by RBI and to ban all other forms of virtual currency. While this might be the intention of the Government, a clear picture regarding it will be possible only after the Government clarifies it stand.

Till then, regulated entities dealing with cryptocurrencies in India has to follow the guidelines and norms provided for under PMLA, FEMA, PSSA and KYCdirections.





Shradhanjali Sarma has recently completed Daksha Fellowship, Chennai, with Technology Law and Policy as her dedicated pathway. She graduated from National Law University and Judicial Academy, Assam in 2017. She has three years’ experience of working in policy, advisory and litigation.

Recent