CRYPTOCURRENCY: REGULATING THE FUTURE
Posted on : June 10, 2020Author : AGA Admin
Introduction:
Crypto-Currency is an alternative form of money which serves the purpose of not only speculation but also provides utility tokens for service platforms. With more and more countries opening up their economy for cryptocurrencies of various forms, these have become a subject of scrutiny, especially the regulators role in this emerging market which is characterised by decentralised operators.
Post the Reserve Bank of India’s notification of April 2018[i], there were introduced restrictions on the use of banking channels for any transaction of cryptocurrency like Bit-Coin. Further, the discussions of a bill in the Parliament to prohibit trade in cryptocurrency had painted a gloomy picture for the sector.
Amidst all this, Supreme Court’s overturning of this notification on 4th March 2020, paves the way for a new market to be created. The Internet and Mobile Association of India, is expected to work with RBI and the government to create the larger regulatory regime, thereby hinting a more participatory approach in designing the regulations.
Concept:
Cryptocurrencies are digital currencies which operate on block chain technology where the technique of encryption is used in the generation of each unit of currency. In simpler terms, in such a transaction a sender’s cryptographic credentials are used to sign the transfer, which is recorded on the master ledger and can also be verified by the other users[ii].
One of the first cryptocurrency ‘Bitcoin’ was launched in 2009 and as per the white paper, Nakamoto (2008)[iii] the main objective being ensuring direct trading between parties without third party interventions. Many cryptocurrencies have been introduced since then, bridging the gaps of the existing cryptocurrencies like improvement in scale and operations, somewhat centralised form of governance and permission based access, e.g. ‘Ripple’ aims at improving the settlement efficiency.
Scope:
The scope is multi-sectoral and multi-dimensional. Cryptocurrencies basically have the capacity to empower the end users to be their own banks.
In light of India’s progression towards a cashless economy, the advantages that could be reaped can be numerous, like block chain focussed start-ups and subsequent increase in employment and government revenue.
It also spells potential gains for the banking sector in the form of improvement in efficiency, lesser bureaucratic hurdles, increased transparency and more secured environment since a cryptocurrency cannot be counterfeited. Another benefit that could come is lowering of transaction cost vis-à-vis the traditional transfer of money.
Financial Action Task Force’s stand as per the new guidelines also supports the opportunities cryptocurrencies have for the world. It has submitted a crypto standard regulation report to the G20 countries and India being one of the G20 members could delve into the findings and look out for opportunities. There is immense possibility of the fiat and crypto currencies to co exit and aid banks to solve the problem of banking to the unbanked.
Challenges:
This new asset class with all its possibilities and opportunities comes with its own risks. Acknowledging and understanding the risks and challenges associated with crypto would ensure that the economy, markets and moreover banks are better prepared to tackle risks posed by the new asset class and act as an obstacle for its smoother acceptance and stability.
The risks can be clubbed under 3 main heads of Technology, Criminal and Regulatory. On the Technological front this new innovation came up with its own know how and considering the pace with which technology across the globe is evolving crypto becoming obsolete and its replacement with an advanced technology would involve huge disruption cost if this is not taken into consideration by the regulatory model.
Cryptocurrencies ever since the discussion stated have come under the worldwide scrutiny for the risks of it being used for the purposes of money laundering, terrorism and scams since the traceability becomes difficult when cross border transactions are involved.
The regulatory risk emerges from the fact that cryptocurrencies are not backed by a lot of central banks. These risks include tacking the unprecedented speculation, cross border complex governance models and taxation issues.
Do we need regulation at all?
Answering this question normatively, any regulation of cryptocurrencies is justified to an extent to where is leads to achievement of a legitimate public policy objective.
Justifying it in economic perspective: cryptocurrencies need to be regulated to tackle the situation of it leading to a market failure or else acting as an obstacle in efficient outcomes. Though there exist concerns about regulation itself like different scenarios of failure of regulation[iv], regulatory approach is needed to identify market failures that take place due to the transactions related to cryptocurrency.
However, Regulations cannot solely be justified by reiterating the fact that cryptocurrencies are by nature risky since operational failure and financial frauds cannot be seen in the same light. Risk absorption capacity for every market participant is different. For example an investor could be skewed towards a riskier transaction in the expectation of a higher return but consumers and nonprofessional participants are exposed to the risk of asymmetric information and other behavioural biases thereby making the role of regulation vital in this context. Thus, there is equal importance of gauging the systemic risks involved alongside risk absorption capacity.
But perhaps the single greatest argument in favour of Regulation for this market is the inherent tendency and potential of cryptocurrencies to affect the balance sheet of systematically important institution. In some unfortunate scenario, where such currencies are financed by a debt and a price crash occurs then the negative impact of it in terms of losses would be borne by these important institutions also.
Thus, a robust regulatory regime becomes the need of the hour with the cryptocurrency space in India whirring back into action.
What could be the Regulatory instruments?
Regulation cannot be understood as homogenous term since it has several dimensions to it, and in order to analyse regulatory possibilities of cryptocurrency in context of India, it becomes important to first have a brief theoretical understanding the regulatory instruments that are available in this regard.
- Standard based regulation:
This is usually based on the intensive cost benefit analysis or risk based assessment. It incorporates both ex ante or liability based ex post analysis.
- Rule based regulation:
Here the responsibility of enforcement of rules could be given to either government bodies (more of Command and Control) or else to private bodies (self-regulation)
In this context this needs to be kept in mind that if the existing regulations are not sufficient to govern cryptocurrencies, then an ad hoc set of regulations could be devised to ascertain its impact for example.
Thus, the following could be regulatory responses to regulate cryptocurrency:
- Informal Suasion
- Existing Regulations
- Alter current regulations
- Ban/Prohibition[v](though this is not the absolute form of regulation)
In India, suppose, post lifting of this ban, cryptocurrencies become part of the overall financial system which already includes exchanges, customer wallets etc., then they would be comparable to banks and market infrastructure, and for Indian Banking system this could lead to the challenge of money supply distortions as operators cannot control the supply (no interest rate policy).
On the other hand, some cryptocurrencies would also try to develop certain protocols to be able to be attractive for banks (systemic risks involved). Systemic risks could be distillated in the form of financial risks[vi]related to important institutions and operational risk of using cryptocurrencies in actual operations. Financial risk could be regulated by capital and liquidity management and Operational risk, for example: clearing of transactions, by ring-fencing crypto activities from the normal business activities.
Thus, there will be a very prominent role for RBI. The RBI Act,1934 and the Banking Regulation Act 1949 would need to have a superseding role over these regulations and it should cover all entities- public and private.This would ensure a contextualised and predictable framework with lesser shocks for the macroeconomic setup. It should devise a payment system wherein the aim is to provide Licenses, Management of risk, Consumer Protection and Redressal of disputes in an efficient manner and align with the Banking Regulation Act and KYC norms.
One thing which becomes quite evident is that this innovative platform has the capacity to facilitate improvement in efficiency and inclusiveness of the overall financial system of our country. It would result into a digitally empowered society and a subsequent impetus to Digital India Program and knowledge economy.
This therefore is the right time and opportunity for the concerned regulators to draft regulations on Cryptocurrency trading, which incorporates policy for the technological platform and its intermediaries to deliver efficient financial services.
This new asset has a lot to offer in terms of growth in banking industry, job opportunities and economy as a whole. This payment ledger system should be seen as an opportunity for our country to overcome socio-economic barriers and provide wider financial access.
Prerna Mathur
(Prerna has done her post graduation from Delhi School of Economics and holds a Bachelor’s degree in Commerce from Delhi University. She is currently pursuing her Masters in Regulatory Governance from TISS, Mumbai. Prerna has interests studying monetary policy, marketing, regulation, politics and international business.)
Disclaimer: This document was originally submitted to Dr. Ganesh Munnorcode at Tata Institute of Social Sciences, Mumbai.
ENDNOTES
[i](The Economic Times, 2020)
[ii]Ostbye, Peder, Will Regulation Change Cryptocurrency Protocols? (April 9, 2018)
[iii] Nakamoto, S. (2008).Bitcoin: A peer-to-peer electronic cash system
[iv] Yale Journal on Regulation Vol. 32, 2015
[v] Baldwin, R., Cave, M., & Lodge, M. (2012). Understanding regulation: theory, strategy, and practice. Oxford University Press.
[vi] Ali, R., Barrdear, J., Clews, R., & Southgate, J. (2014a). The economics of digital currencies. Bank of England Quarterly Bulletin, 54(3), 276-286.
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