It is more than 13 years since the creation of the first cryptocurrency, Bitcoin, in the aftermath of the 2008 global financial crisis. Satoshi Nakmoto, Bitcoin’s mysterious creator, was critical of central banks and financial intermediaries saying that the conventional fiat currency requires enormous trust to make it work. 

As cryptocurrencies have evolved, these financial instruments have seen their share of controversy causing severe distrust between governments and people alike. From earlier days when it was used as a currency on the online black market website Silk Road from 2011-2013 to a rash of fraudulent initial coin offerings (ICOs), the crypto equivalent of an initial public offering (IPOs), a long shadow of suspicion has been cast over cryptocurrencies.

Despite this, cryptocurrencies emerged as the best performing asset class in 2021. The pandemic waves have grounded economic activities and as most governments experienced the effects of global inflation, investors (both retail and institutional) are looking for alternative assets to invest their money in. 

Against this backdrop, cryptocurrencies are being used as a tool to hedge against inflationary pressures. Cryptocurrencies have a strong vein of libertarian thought which seeks to bypass all forms of government control. Cryptocurrencies also rely on public goods provided by governments such as cheap electricity for mining and are beholden to corporations that provide Internet connectivity that must abide by rules set by the government.

But, when people’s money and savings are being tied up with cryptocurrencies, it is better for the government to bring some oversight. It should be noted that not regulating a sector is a form of regulation itself. But this decision will lead to wide-spread issues of trust with many players making dubious investment schemes and offering it to the general public who will have no recourse in the law.

Global government responses range from a complete ban of cryptocurrencies in favour of a state-mandated digital currency like in China to more liberal regimes in Japan which permit cryptocurrency operations governed by its Payments Services Act.

The rising calls for regulations

In India, the regulatory landscape is hostile with the Reserve Bank of India (RBI) leading the opposition for their usage in India. In 2018, the RBI issued a circular to all banks and related regulated entities to cut ties and refuse services related to cryptocurrencies. However, this decision was overruled by the Supreme Court of India allowing crypto operations again in March 2020.

But adding to the regulatory muddle, legislation has been introduced in Parliament which is seeking to ban all “private cryptocurrencies” in favour of a central bank digital currency (CBDC). 

CBDCs are digital representations or tokens of a nation’s fiat currency using blockchain technology but the supply of these tokens is regulated by the central bank. 

Meanwhile, in September 2019, an inter-ministerial committee submitted its findings on cryptocurrency and regulating fintech related issues. The report recommended that cryptocurrencies should be regulated on a case-by-case basis and compartmentalize them to different regulators.

In contrast, and curiously, the Securities Exchange Board of India (SEBI) has mostly stayed out of the cryptocurrency debate. Meanwhile, there are rumblings that the task of regulating would be given to the newly created government body International Financial Services Centres Authority (IFSCA).

What is the scenario in other major countries?

Regulators need to plug into global discussions on cryptocurrencies to find a right solution for India and take their learnings to other international forums. Several countries have begun some form of regulatory scaffolding.

The United States does not consider cryptocurrencies as legal tender but recognises crypto exchanges as money transmitters as the tokens are another 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 has guidelines for the same.

The SEC’s approach to cryptocurrency is instructive and the RBI should consider these arguments rather than it’s continued belligerence on these new instruments. Take the case of Facebook’s Libra cryptocurrency project (now named Diem). 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 a stable private currency which could rival the US dollar and less like a security. Hence, the project did not take off. 

However, the nation clarified that it was treating Bitcoin as a commodity and would be regulated by the US Commodity Futures Trading Commission (CFTC).

US regulators have been applying the “Howey Test” legal doctrine to determine if a cryptocurrency is a security or not. This test tries to determine if any contract:

1) Is an investment of money;

2) There is an expectation of profits from the investment;

3) The investment of money is in a common enterprise; and

4) Any profit comes from the efforts of a promoter or third party.

The SEC reasoned that since Bitcoin did not seek public money or investment to develop its technology, it cannot be construed as a security.

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.

Are CBDCs the answer?

Central banks around the world are concerned over the rise of cryptocurrencies because they fear the increased usage and if the price stabilizes, they would effectively challenge the state’s monopoly on currency as the supply of cryptocurrency tokens is not under their control. Concern over the creation of “stable coins” similar to Facebook’s Libra is justified and perhaps was the catalyst for the creation of CBDCs.

A growing list of countries — Netherlands, Sweden, Norway, Canada — are looking to introduce CBDCs with China being an early adopter, but that doesn’t mean that this experiment is not without risk.

If CBDCs are a ‘virtual store of value’, 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 a central bank’s plan to increase retail investors participation in the Government Securities. This would be particularly advantageous to people in countries which have a negative interest rate regime. Negative interest rate regime encourages spending from citizens and encourages credit growth where banks will not have to charge larger interest rates for customers. However, the downside to this regime is that deposit savings products and asset creation tools by banks will not be able to offer better rates of return for customers.

However, encouraging retail investors to buy CBDCs might create more macro economic problems. Since the yield on government securities is a little higher than bank deposit interest rates, savers might find the returns on CBDCs more attractive than what banks are offering, and thus banks could lose their primary means of funding.

As more savers move their money from deposits, it will force banks to rely on costlier means of funding and in turn make credit products more expensive.

Moreover, 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.

For a country like India, which has an advanced mobile payments system like the Unified Payments Interface (UPI), retail CBDC tokens do not make sense and would require an entire overhaul of the existing payments infrastructure. Further, cash usage in India is still king, despite the demonetisation exercise of 2016. There are again concerns about financial literacy of the population to use new digital payments. But the government could consider using CBDCs as a means to increase retail participation in government bonds.

But as new use cases of cryptocurrency, such as non-fungible tokens (NFTs), come to fore with many global technology companies like Facebook and Twitter exploring options to integrate them into their services, outright ban of these new financial technology is not advised and India will lose its edge to innovate. Friendlier shores with more welcoming regulation will lead to a brain-drain as more talent moves there. 

(Shashidhar K.J is a Visiting Fellow at Observer Research Foundation, Mumbai. The views expressed here are personal.)