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Cryptocurrencies in India: Only cryptic and no currency

By: Sharanya Ranga, Laxmi Joshi and Probal Bose

The evolution of ICOs

Bitcoin, and the ideas behind it, will be a disrupter to the traditional notions of currency. In the end, currency will be better for it”, said Edward C. Moy (former director of the US Mint) way back in 2014[1].

With the mysterious Mr. Satoshi Nakamoto publishing a paper called “Bitcoin – A Peer to Peer Electronic Cash System” followed by the first public blockchain trading of Bitcoins in 2009, there has been no looking back for cryptocurrencies. Although the value of Bitcoins has been volatile the past few months, the overall interest in non-fiat cryptocurrencies like Bitcoins, Ethereum and Litecoins continues unabated. Growth in trading of digital currencies also opened up avenues for cryptocurrency and blockchain- based startups to raise funds for their ventures through this medium by issuance of an Initial Coin Offering (ICO). Cryptocurrency based startups across various countries have so far managed to raise around USD 3.7 billion funding through ICOs[2].

ICO is a hybrid between crowdfunding and the traditional Initial Public Offering of shares and securities (IPOs). It involves raising capital on a blockchain platform through sale of cryptocurrency of the issuing entity in the form of “tokens” for payment of established cryptocurrencies such as Bitcoins or Ethereum. ICOs are governed by the terms of smart contracts entered into between the issuer and the purchasers and unlike IPOs, ICOs are generally based on ideas/concepts and not actual products or businesses. Thus, all that is offered through an ICO is an opportunity for the investors to own cryptocurrencies of the issuing entity, when and more importantly “if” the proposed project takes off. The protocol generally followed for issuance of the ICOs is publication of a white paper on public forums setting out synopsis of the project, the underlying technology, funds sought to be raised and key terms governing the purchase and sale of the tokens. This is followed by sale of tokens on the pre-announced date usually through a dedicated software application that permits investors to purchase the tokens in exchange for the specified cryptocurrency. Once the payment for the tokens is made to the issuing entity, the sale transaction is consummated by deployment of the smart contract and issuance of tokens to the purchasers.

The key advantage of ICOs for most startups is that it eliminates the lengthy process and high costs involved in raising capital through traditional sources such as venture capital or IPOs. While this works in favour of startups, it is a risk for investors, with the lack of disclosures and absence of actual assets/business or customer base to back up the prototype described in the white paper. This loophole has been exploited by scamsters who have defrauded investors by floating ponzi schemes and fraudulent ICOs. With the increase in ICO related scams and cryptocurrency thefts, there has been a growing concern on the use of the funds raised through ICO for money laundering, drug trafficking and terror financing. Such apprehensions in tandem with the increasing popularity of ICOs has brought to fore the contentious issue of how best to regulate this fintech innovation.

Commodity or Security? : Treatment in key jurisdictions

While countries such as China and South Korea have placed a blanket ban on ICOs, other countries Japan, Singapore, USA and Switzerland have adopted a relatively progressive approach. Japan is one of the few countries that officially accepts Bitcoins as legal tender and currently permits issuance of ICOs through the blockchain exchanges registered with its financial market regulator. In the United States, Bitcoin has been designated as a ‘commodity’ by the Commodity Futures Trading Commission (CFTC) that also regulates Bitcoin trade and the Securities & Exchange Commission (SEC) has permitted ICOs under the regulatory ambit of securities laws governing fundraising activities. The Internal Revenue Service (IRS) considers Bitcoin as taxable property, treated like inventory if it is held for resale. Singapore has taken a stand that if the tokens issued through ICO fall within the meaning of securities, then they will be subject to securities regulations and if not, they can continue to operate largely unfettered. The European Union is deliberating expanding the scope of its anti-money laundering and terrorism financing directives while mulling the regulatory overview over the usage of digital currencies. Given that anonymity would be a ‘hindrance than an asset for virtual currencies’, a draft proposal by the EU Parliament members[3] proposes to enable competent authorities to monitor the use of virtual currencies and allow watchdogs from individual EU countries to identify Bitcoin users by their Bitcoin addresses.

In Switzerland, the Swiss Financial Market Supervisory Authority (FINMA) has clarified that the Swiss financial market laws and regulations will not be applicable by default to all ICOs and a decision in this regard will be taken on a case-by-case basis. As per FINMA’s guidelines in this regard, the guiding factor would be the economic function and purpose of the tokens as well as whether they are tradeable or transferable at the time of issuance itself. To aid such assessment, the FINMA Guidelines has also classified tokens as payment tokens (such as Bitcoins), utility tokens and asset tokens. Payment tokens are subject to the Swiss anti-money laundering regulations and not treated as securities. Utility tokens (such as ECR20 tokens[4]) do not have an intrinsic financial value and provide access to users to some blockchain based infrastructure. They will be treated as securities if such tokens have an investment purpose attached to them. Asset tokens being tokens that guarantee debt or equity claims to the purchasers by the issuer in the future on the issuing company’s earnings/capital flows, qualify as securities. While these are some of the common types of tokens issued under ICOs globally, FINMA is perhaps one of the few regulators to formally recognise this categorization in a progressive manner.

Caution, caution and more caution? : The Indian Position

To its credit, India’s central bank, the Reserve Bank of India (RBI) has been mulling over introducing a fiat cryptocurrency/virtual currency but has time and again voiced its concerns over the use of non-fiat cryptocurrencies like Bitcoins, Ethereum and Litecoins. The Government of India (GOI) has continued to take a conservative approach stating that non-fiat cryptocurrencies are not legal currency or licensed/regulated in any manner in the country and are akin to ponzi schemes. Along these lines the RBI has also regularly issued caution notes to alert dealers about the prospective perils and exposure from a financial, operational, legal, customer protection and security perspective of virtual currencies.[5] This concern over Bitcoins (and other non-fiat cryptocurrencies) emanates largely because of the decentralized and unregulated system that Bitcoin operates (or rather thrives) in, and whose valuation is determined primarily on a demand-supply basis as against other stabilizing factors.

In December 2017, the Ministry of Finance, Government of India issued a warning[6] on the use of Bitcoins and other virtual currencies, urging consumers to be extremely cautious about using/trading in such currencies as they are not legal tender or currency or licensed/regulated in any manner in the country. The press release also refers to the potential dangers of such encrypted transactions that may be used for illegal/subversive activities such as terror-funding, smuggling, drug trafficking and other forms of money-laundering. There is also an ongoing unofficial clampdown of sorts on the few cryptocurrency exchanges and their payment gateways operating in India with banks shying away from processing their transactions.

The conservative stand taken by Indian regulators is not too surprising considering how the value of a Bitcoin has soared from USD 200 in June 2015 to an all-time high of USD 17,900 in December 2017 and continues to plunge and rise through the first quarter of 2018 in a volatile fashion.

In his budget speech in February 2018, the Finance Minister in a carefully worded statement declared that GOI will take measures to eliminate the use of cryptoassets not just in financing illegitimate activities, but also as part of the payments system, as cryptocurrencies are not legally recognised in India. Following this, with a view to restrict all unregulated “deposit taking activities”,[7] The Banning of Unregulated Deposit Schemes Bill, 2018[8] (Bill) was introduced in the Lok Sabha (lower house of Parliament). The term “deposit” has been defined in the Bill to mean “the receipt of money, by way of advance or loan or in any other form, to be returned, whether after a specified period or otherwise, either in cash or in kind or in the form of a specified service, by any Deposit Taker, with or without any benefit in the form of interest, bonus, profit or in any other form”. Depending on the nature of the interpretation (and the nature of the token), this may include cryptocurrency transactions within its purview. The Bill also prescribes stringent punishment for promoting or operating an unregulated deposit-taking scheme and will be presented before the legislature for its approval for enactment.

While India’s capital markets regulator, Securities and Exchange Board of India (SEBI), has been examining this issue ostensibly from a coin offering perspective, recent media reports also indicate that the Income Tax Department has found that there are 600,000 active cryptocurrency traders in 9 cryptocurrency exchanges across the country and crypto- currency worth USD 2.8 billion has been traded on these exchanges[9] and that such gains may be taxed as income from capital assets.

Way Forward: A regulatory sandbox approach?

Virtual currencies have taken the world by storm across jurisdictions and it is important for India’s regulators to come up with a progressive regulatory framework that protects consumers, users as well as other stakeholders. While the fears of tracing of sources of money, money laundering and terrorist financing are indeed legitimate especially in a developing economy like India, regulators in the digital age have to proactively facilitate innovation through creative measures. One such initiative may well be the regulatory sandbox approach, i.e., regulatory exceptions are provided in ‘sandbox’ environments where innovative technologies related to virtual currencies may be incubated on an experimental basis and allowed to operate under a limited license. This will be useful to evaluate the feasibility of the business model, and the likely risks emanating from such virtual currencies and eventually bring about appropriate amendments to the regulatory framework”.[10] Typically, regulations relating to the provision of a sandbox environment maintain clearly defined test scenarios and outcomes, appropriate conditions for consumer/investor protection and mechanisms to frame acceptable terms of exit and transition, including the incorporation of feedback into possible regulatory changes.

While accepting cryptocurrencies as currency or legal tender, like in the case of Japan, seems a little far-fetched for India at present, a start may be made by bringing in cryptocurrencies under the ambit of securities laws thereby permitting ICOs under limited conditions.

Despite regulatory ambiguity in the country acting as a major deterrent against raising funds through this route in India, some Indian startups have opted for issuing overseas ICOs in favourable destinations such as Singapore and Japan. WandX, a blockchain based startup is one such example having successfully raised funds through ICO issued in Singapore through its Singapore based entity.[11] Similarly, Drivezy yet another Indian startup engaged in the business of operating a peer-to-peer bike- and car-sharing platform raised a targeted USD 5 million through an ICO launched in Japan with support from its investor AnyPay, a Japanese financial-technology company.[12] However, most Indian companies are adopting a wait and watch attitude till there is regulatory clarity on the issue.

On an unrelated note, it is interesting how another fintech innovation of our times – peer to peer lending and digital payments systems have been brought by the RBI under its regulatory ambit, displaying a marked shift in its earlier approach that frowned upon such business models. While these regulations do adopt a cautious stance, it is hoped that over time they are made robust enough for innovations to flourish. 2018 will hopefully be the turn of cryptocurrencies then!

[2]http://www.ey.com/gl/en/newsroom/news-releases/news-ey-big-risks-in-ico-market-flawed-token-valuations-unclear-regulations-heightened-hacker-attention-and-congested-networks#note1

[3]https://www.coindesk.com/eu-draft-law-plan-monitor-bitcoin/

[4]https://wandxdapp.gitbooks.io/wandx-whitepaper/content/

[7]‘Deposit’ is defined in the Bill (as originally presented in the year 2016) as “receipt of money, by way of advance or loan or in any other form, to be returned, whether after a specified period or otherwise, either in cash or in kind or in the form of a specified service, by any Deposit Taker, with or without any benefit in the form of interest, bonus, profit or in any other form”.

[9]http://indianexpress.com/article/india/i-t-turns-gaze-to-cryptocurrency-finds-6-lakh-active-traders-most-under-35-yrs-5019765/

[11]https://economictimes.indiatimes.com/small-biz/startups/newsbuzz/startups-test-a-brand-new-crypto-currency-ico/articleshow/61938744.cms

[12]https://economictimes.indiatimes.com/small-biz/startups/newsbuzz/startups-test-a-brand-new-crypto-currency-ico/articleshow/61938744.cms

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