Crypto regulation offers India an opportunity that must be seized

The Cryptocurrency and Regulation of Official Digital Currency Bill, 2021, is under review and likely to be tabled in Parliament shortly. The contours of the bill are not public yet. However, market commentary suggests that it will permit the issuance of a central bank digital currency (CBDC) and the use of blockchain and distributed ledger technology that underlies a cryptocurrency. As for private digital currencies, recent comments by finance minister Nirmala Sitharaman indicate that rather than an absolute ban, there may be experimentation, exploration and encouragement of the emergent technology behind these.

Given the rapidly-evolving crypto developments, policymakers and regulators appear to have taken an opportunity to proactively embrace a promising technology. Global use cases are growing, as cryptos go mainstream with widespread applications. Applications of blockchain include its use in ‘regtech’ for regulators to capture and store data, in automated risk management, and for the facilitation of regulatory reporting as well as supervisory processes. Central banks around the world, from the European Central Bank to China’s and Turkey’s, are in the process of issuing CBDCs. This could be done in India, too. A recent Reserve Bank of India (RBI) report on currency and finance for 2020-21 rightfully recognizes the potential of CBDCs for financial inclusion and improving aggregate demand in emerging markets, as also for enhancing the speed of monetary policy transmission. RBI did indicate that a CBDC is a “mixed blessing”, as it would risk disintermediation of the banking system.

In this context, any policy, legislative or regulatory approach to private cryptocurrencies must embody the principles or proportionality and proactiveness. When RBI banned crypto purchases through Indian banking channels, the Supreme Court struck it down, stating that while RBI was empowered to regulate cryptocurrencies, such power must be exercised with proportionality, backed by adequate empirical evidence. According to the Basel Committee, among others, the proportionality principle stems from the need to ensure that any state intervention—in the form of rules, sanctions and oversight—is aimed sharply at the achievement of a desired policy objective. A regulatory strategy for cryptos must not be excessive, but oriented towards mitigating the specific risks they present. There are several risks associated with cryptocurrencies, including their lack of backing by a tangible asset. It means they may have no intrinsic value from a traditional perspective, but a virtual market value. Their price discovery is in uncharted territory, which heightens the risk of market manipulation and has implications for consumer protection. They also raise concerns of information asymmetry, hacking vulnerability and fire sales, and thus of potential threats to systemic stability. Some of these risks are unique to cryptos, while others attend other financial products too, but each must be addressed through sound regulation.

RBI governor Shaktikanta Das’s recent statements must therefore be heeded, particularly on consumer protection and financial stability. A report of the Financial Action Task Force (FATF) underlined crypto anonymity and layering as intensifying the risks of money laundering, but the FATF also provides risk-based guidance to mitigate such risks through a combination of traditional and non-traditional methods, including customer identification, verification and transaction-monitoring prerequisites. We need a well-conceived regulatory framework that facilitates transparency, and the responsible democratization of market participants could guard against digital invasion and coercive behaviour. Pre-emptive regulation can monitor and prevent such undesirable outcomes.

A virtual ban without a market-linked regulatory architecture, however, may lead to unintended consequences and prove counterproductive. Research demonstrates that outright bans tend to push an activity underground, which allows for abuse. Further, bans are almost impossible to implement in a digital world where regulatory islands cannot exist. Given cross-border flows, what is needed instead is a multilateral platform for regulation, even as countries protect their own jurisdictions. The absence of this will result in circumvention and cross-border arbitrage.

Cryptocurrencies also present opportunities that the government and regulators must catalyse. There is adequate empirical research on how decentralized, peer-to-peer finance through blockchain-based cryptos can make financial services more accessible, cost effective, efficient and interoperable. The FATF had as far back as 2014 highlighted the potential for financial inclusion through appropriately-regulated virtual currencies. India could use them to deepen its financial markets.

Letting RBI issued a CBDC while limiting or restricting private cryptos is well intentioned from the perspective of monetary sovereignty—the exclusive power of the state over legal tender. Multilateral agencies like the International Monetary Fund (IMF) have indicated that private and public money can coexist, and in complementary rather than contradictory roles. According to the IMF, just as we value innovation and diversity in all spheres, we must do so in the monetary system as well, though without compromising stability.

Public-policy objectives, from consumer protection to systemic safety, can be addressed through micro and macro prudential regulation of private digital tokens, with an eye kept on market conduct, data privacy and operational resilience.

As a matter of good regulatory governance, any legislative or regulatory prescription should be participative. Private cryptos can be tested in a controlled environment, such as a regulatory sandbox or RBI’s Innovation Hub. This would allow the experimentation mentioned by Sitharaman, not only for market participants, but for regulators as well. This will allow policymakers to examine and monitor crypto applications and provide an iterative learning process through which more robust regulations could evolve.

In conclusion, the proportionate, proactive, participative and process-driven regulation of cryptocurrencies will aid the success of Digital India. The regulation and acceptance of cryptos can be done in two stages. A CBDC can mark the start of India’s journey into the world of digital currencies, but must not be an end in itself. Private cryptos may well be sustainable under regulation and could also help the government and central bank meet key policy objectives. Today, India has a chance to be a global leader in framing the regulatory architecture for a new digital world. The democratized and appropriately-regulated use of cryptocurrencies is an opportunity that the country must seize.

These are the authors’ personal views.

Sunil Mehta and L. Viswanathanare, respectively, chairman, Yes Bank and CMD, SPM Capital Advisers; and partner, Cyril Amarchand Mangaldas