Cryptocurrency and it’s regulation in India – Recent SC Verdict

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The Supreme Court, on March 2020, had struck down RBI’s controversial circular that prohibited any central bank regulated entities from providing banking services to anyone dealing with virtual or cryptocurrencies. This ruling allows banks to handle cryptocurrency transactions. Though this may threaten the country’s financial system, it does provide an opportunity for the government and the central bank to form regulatory frameworks and laws that, while allowing the use of cryptocurrencies, can ensure preventive measures that can counter private cryptocurrencies.

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What is cryptocurrency?

  • Cryptocurrency is an internet-based medium of exchange that uses cryptographical functions to conduct secure financial transactions.
  • The common characteristics of all the cryptocurrencies are as follows:
  • Digital: Cryptocurrency only exists on computers. There are no coins or notes.
  • Decentralised: Cryptocurrency does not have a central computer or server. It is usually distributed across a network of thousands of computers. The decentralised control of each cryptocurrency works through distributed ledger technology, typically a blockchain that serves as a public financial transaction database.
  • Trustless: Cryptocurrencies are passed from person to person online. Users usually deal with banks, PayPal or any such institutions during financial transactions. These institutions are trusted third parties that people trust to safeguard their personal information. There are no trusted third parties in cryptocurrency system, which means that the users are in complete control of their money and information at all times. The system allows transactions to be performed in which ownership of the cryptographic units is changed. The transfers are secured by the use of public keys, private keys and other security systems. In the modern cryptocurrency system, a user’s “wallet” or account address has a public key, while the private key is known only to the owner and is used to sign the transaction. This ensures a secure peer-to-peer transaction.
  • Pseudonymous: This means that there is no need to give any personal information to own or use cryptocurrency. There are no rules about who can own or use cryptocurrencies.
  • Encrypted: Each user has special codes that stop their information from being accessed by other users. This is called cryptography and it is nearly impossible to hack. Thus, “crypto” is part of the term. The term “Crypto” means “hidden”. In cryptography, when the information is hidden, then it is encrypted.
  • Global: Each country has its own currency called fiat currency, whose value is backed by the government that issues it. Cryptocurrency, in contrast, does not have any sort of backing from any governments and does not have any borders. The ownership of the cryptocurrency units can be proved exclusively through cryptography, making it difficult to hack, counterfeit or double-spend.

How are cryptocurrencies different from virtual currencies?

  • Virtual currency is the larger umbrella term for all forms of non-fiat currency that are being traded online.
  • It is mostly created, distributed and accepted in local virtual networks.
  • Cryptocurrencies, on the other hand, have an extra layer of security in the form of encryption algorithms. Cryptographic methods are used to make the currency and the network on which they are being traded securely.
  • Currently, most cryptocurrencies operate on the blockchain or distributed ledger technology, which allows everyone on the network to keep track of the transactions that are occurring globally.

What are the types of cryptocurrencies?

  • The first blockchain-based cryptocurrency was Bitcoin. It still remains the most popular and most valuable.
  • It was launched in 2009 by an individual or group known only by the pseudonym “Satoshi Nakamoto”.
  • As of November 2019, there are about 18 million bitcoins in circulations with a total market value of around $146 billion.
  • Currently, there are thousands of alternate cryptocurrencies with various functions and specialisations.
  • Some of these are clones or forks of Bitcoin, while others are new currencies that were built from scratch.
  • Some of the competing cryptocurrencies include Litecoin, Peercoin, Namecoin, Ethereum, Cardano etc.
  • Currently, the aggregate value of all the cryptocurrencies in existence is around $214 billion, with Bitcoin representing more than 68% of the total value.

What are the advantages of cryptocurrencies?

  • Difficult to manipulate: Cryptocurrencies use blockchain technology, which is used to keep an online ledger of all the transactions that have ever taken place. This provides a data structure for this ledger that is quite secure and is shared and agreed upon by the entire network of individual node or computer maintaining a copy of the ledger. Every new block generated by each node (computer) must be verified before being confirmed, making it almost impossible to forge transaction histories.
  • Lowers transaction costs: Many financial institutions like J.P.Morgan Chase see the potential of blockchain technology as it can minimise transaction costs by streamlining payment processing.
  • Decentralisation is one of the major benefits of cryptocurrency as it can increase the transaction speed and let users avoid paying fees to the banks and other traditional financial institutions.
  • Political independence: For fiat currencies, a government has the power to easily freeze or seize a bank account located within its jurisdiction. However, it cannot do the same to cryptocurrency users even if they are its citizens and within its jurisdiction.

What are the disadvantages of cryptocurrencies?

  • Cryptocurrency system, due to the use of blockchain technology, has the potential to disrupt many vital industries like finance and law.
  • Cryptocurrency transactions, due to their semi-autonomous nature, can also be used for illegal activities like tax evasion, money laundering, terrorism However, at the same time, it can also protect whistleblowers and activists living under authoritarian governments.
  • As market prices for cryptocurrencies are based on supply and demand, the rate at which cryptocurrencies can be exchanged for another currency can fluctuate widely, since the design of many cryptocurrencies ensures a high degree of scarcity. Thus, cryptocurrencies are criticised for being a short-lived fad or speculative bubble.
  • Vulnerable to hacking: Cryptocurrency blockchain is highly secure. However, other aspects of the cryptocurrency ecosystem like exchanges and wallets are not immune to the threat of hacking. Several Bitcoin transactions have been subject of hacking and theft, sometimes with millions of dollars worth of “coins” stolen.
  • As cryptocurrencies are virtual and not stored in a central database, a digital cryptocurrency balance can be wiped out by loss or destruction of a hard drive if a backup copy of the private key does not exist.
  • Regardless of the numerous criticisms, many observers see potential advantages in cryptocurrencies, like the possibility of preserving value against inflation and facilitating exchange while being easier to transport and divide than precious metals and existing outside the influence of central banks and governments.

What did the Supreme Court say about cryptocurrencies?

  • On 4th March 2020, the Supreme Court struck down an RBI circular that bans financial institutions from enabling deals in virtual or cryptocurrencies.
  • The top court called the notification unconstitutional.
  • The said notification, which came to force in April 2018, banned entities regulated by the RBI from facilitating banking transactions related to virtual currencies.
  • This ban was challenged by the Internet & Mobile Association of India (IAMA) in the Supreme Court.

IAMA arguments:

  • It argued that cryptocurrencies are not strictly a currency and were more like a commodity.
  • Thus, the RBI does not have powers to impose such ban, as no law focuses on the prohibition of cryptocurrencies.

RBI’s arguments:

  • The RBI countered the argument by stating that it considered cryptocurrencies to be a digital means of payment, which has to be controlled so that the country’s payment system is not jeopardised.
  • The top bank also argued that it has the power to ban cryptocurrencies.
  • This ban aimed at segregating the country’s financial system from the private virtual currencies that are considered to be illegal by the government.
  • It had argued that cryptocurrencies could not be treated as currencies as they are not made of metal or exist in physical form, nor were they approved by the government.

SC Judgement:

Broadly, the Supreme Court had looked into three important questions. These are as follows:

  • Whether virtual currencies amounted to money
  • Whether the RBI had the power to regulate matters pertaining to virtual currencies
  • Whether this particular circular was a proper exercise of this power
  • The court ruled the first two questions as affirmative, and if not for the central bank failing to provide empirical evidence of harm, the third would have been as well.
  • On the first question, the court was faced with the argument that virtual currencies did not amount to money, but were instead just goods. This led to an argument that the RBI had no jurisdiction in regulating the transfer of goods between private individuals. After looking into the functions and definition of “money”, the court ruled that “if an intangible property can act under certain circumstances like money, then RBI can definitely take note of it and deal with it”. This judgement did not answer whether cryptocurrencies were legal or not.
  • While dealing with the second question, it was found that the RBI, through its circular, did not directly prohibit transactions in virtual currencies, but merely directs entities regulated by it to not provide banking services to those involved in trading or facilitating trade of virtual currencies.
  • This led to the banning of cryptocurrencies from being converted into fiat currencies.
  • This, in turn, resulted in the severing of the interface between the alternative economy of cryptocurrency and the nation state’s economy, rendering virtual currencies illusory in value. This in effect amounts to a prohibitive measure on the trading of virtual currencies.
  • The argument in court was that the consequence of this circular amounts to RBI indirectly regulating aspects outside its jurisdiction.
  • The apex court responded to this argument by observing that:
  • RBI merely directed the entities within its jurisdiction and did not prohibit all trade in virtual currencies, which continues to be permitted even if rendered near-illusory.
  • Furthermore, the scope of the RBI’s powers extends to regulating “anything that may pose a threat to or have an impact on the financial system of the country”.
  • The court also stated that the RBI has the power not only to regulate virtual currencies but also include powers to prohibit them.
  • While answering the third question, the SC found that the RBI has not shown any proof that there was a damage that led to the suffering of its regulated entities. Thus, the prohibition was not proportionate to the harm that it attempted to address. Additionally, the court also ruled that there is no proof of the need for pre-emption in this particular instance.

What are the consequences of the SC judgement?

Negative:

  • There is a growing concern that this decision could pave the way for trading in virtual currencies, putting the banking system at risk.
  • Previously, several cryptocurrency platforms have shifted base to Singapore and elsewhere after the RBI circular was issued on April 2018. Currently, they are looking to move back to India.
  • This may mean that there will be an increase in the number of illegal activities within the country.
  • Many cryptocurrency platforms have also come under the lens of the Income Tax Department, which issued notices to 500,000 investors, asking whether they had paid taxes on rising in valuation after a surge in prices.

Positive:

  • The lifting of the ban on cryptocurrency may act as alternative investments. It may prevent traders from being affected by global volatility.
  • It may hasten India’s move towards becoming a digital economy.
  • It can minimize the transaction time and reduces the involvement of banks, which are currently becoming less trustworthy.

What can be the way forward?

Proactive government:

  • Instead of banning cryptocurrencies, there is a need to spread awareness about the risks while dealing with these currencies.
  • The government must proactively monitor trades for potential fraud, scams and other criminal activities.

Regulation:

  • The RBI, Centre and Fintech industry must join together to provide law that regulates cryptocurrencies within the country.
  • The apex bank must formulate a detailed regulatory framework to licence virtual currency intermediaries like exchanges.
  • These local cryptocurrency exchanges should adhere to the KYC norms like in the stock exchanges.
  • The government must designate virtual currency intermediaries as reporting entities under the Prevention of Money Laundering Act so that there are transparency and accountability.
  • The government must also set up an expert regulatory body manned by experts in the fields of technology, economics and finance.

Central Bank Digital Currency:

  • Presently, at least 18 central banks are developing digital currencies, which are called Central Bank Digital Currency (CBDC).
  • However, until recently, it was just done on an individual stand-alone basis.
  • This was done to counter private cryptocurrencies like Bitcoin.
  • This method has proven to be less efficient.
  • Thus, the most effective way to counter private digital currencies is through a collaborative approach.
  • Currently, central banks are collaborating to think about the impact of such a digital currency on monetary policy and financial stability and the optimal design of such currency.
  • This allows banks to find the optimal design of a central bank digital currency and prevent unforeseen international consequences.
  • Collaboration can also reduce tensions among central banks and regulators as private cryptocurrencies make it difficult to manage foreign exchange controls and implement sound monetary policy.
  • Additionally, it can also ensure that there is an increase in the understanding of the impact of the central bank digital currency (CBDC).

Optimal CBDC design:

  • Central Bank Digital Currency has the potential to affect the financial system exponentially.
  • However, these currencies must have good cost-benefit balance and must mitigate potential unintended side-effects as much as possible.
  • Central Bank Digital Currency could be implemented in two alternative ways:
  • They could be offered in the form of deposit amounts with the central bank to all households and corporates.
  • The central bank could offer a digital token (currency) that would circulate in a decentralised way without a central ledger.
  • However, due to security and privacy reasons, the latter alternative does not favour the central banks.
  • The development of virtual currency ecosystem must focus on law enforcement concerns and the stability of the finance system.

Conclusion:

The cryptocurrency though has shortfalls, can be developed and modified so that it can favour the banks while also providing its services to the cryptocurrency users. This will ensure the providing of new value to India’s financial sector. There is also a need for strengthening of the regulatory framework that prevents any of the illegal activities from taking place. In doing so, it can provide an alternative to the traditional medium of exchange that ensures a faster transaction.

Practice question for mains:

The Supreme Court’s recent scrapping of RBI’s cryptocurrency ban gives the opportunity to strengthen the country’s financial system. Elucidate. (250 words)

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Santhosh
Santhosh
1 month ago

good

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