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Cryptocurrencies and the Regulators Dilemma
Widely seen as a disruption for the traditional banking and financial institutions, cryptocurrencies have gained significant traction over the last half a decade, at the same time creating a regulatory nightmare for banking regulators across the globe. At present, there are around 969 cryptocurrencies in existence across the globe, with a total market capitalisation close to 116 Billion USD.
What you need to know about the cryptocurrencies?
Founded as a peer-to-peer electronic payment system, cryptocurrencies enable transfer of money between parties, without going through a banking system. These digital payment systems are based on cryptographic proof of the chain of transactions, deriving their name, Cryptocurrency. These employ cryptographic algorithms and functions to ensure anonymity (privacy) of the users (who are identified by an alphanumeric public key), security of the transactions and integrity of the payment systems. “Decentralised Digital Currency” or “Virtual Currency” is also interchangeably used for a cryptocurrency.
How are they used?
Cryptocurrency is fundamentally a decentralised digital currency transferred directly between peers and the transactions are confirmed in a public ledger, accessible to all the users. The process of maintaining this ledger and validating the transactions, better known as mining, is carried out in a decentralised manner. The underlying principle of the authenticity of the present to historical transactions is cryptographic proof, instead of trust; different from how it happens in the case of traditional banking systems.
Cryptocurrencies are gaining popularity for the following reasons:
Privacy Protection: The use of pseudonyms conceals the identities, information and details of the parties to the transaction – perquisites for privacy enthusiasts.
Cost-effectiveness: They have single valuation globally, and the transaction fee is extremely low, being as low as 1% of the transaction amount. Cryptocurrencies eliminate third party clearing houses or gateways, cutting down the costs and time delay. All the transactions over cryptocurrency platforms, whether domestic or international, are equal.
Lower Entry Barriers: Possessing a bank account or a debit/credit card for international usage requires documented proofs for income, address or identification. Banks or financial institutions might have their own set of eligibility criteria for these facilities. Cryptocurrencies lower these entry barriers, they are free to join, high on usability and the users do not require any disclosure or proof for income, address or identity.
Alternative to Banking Systems and Fiat Currencies: Governments have a tight control and regulation over banking systems, international money transfers and their national currencies or monetary policies. Cryptocurrencies offer the user a reliable and secure means of exchange of money outside the direct control of national or private banking systems.
Open Source Methodology and Public Participation: A majority of the cryptocurrencies are based on open source methodology, their software source code is publicly available for review, further development, enhancement and scrutiny. The ecosystem of cryptocurrencies is primarily participation based, as software development, bug reporting and fixing, testing etc. are driven by the wider user base, rather than a closed set of individuals or an institution.
Immunity to Government led Financial Retribution: Governments have the authority and means to freeze or seize a bank account, but it is infeasible to do so in the case of cryptocurrencies. For citizens in repressive countries, where governments can easily freeze or seize the bank accounts, cryptocurrencies are immune to any such seizure by the state.
- Despite these numerous advantages and user friendly processes, cryptocurrencies have their own set of associated risks in the form of volatility in valuation, lack of liquidity, security and many more.
- Cryptocurrencies are being denounced in many countries because of their use in grey and black markets. There are two sets of interconnected risks; one being to the growth and expansion of these platforms in the uncertain policy environment, and the other being the risks these platforms pose to the users and the security of the state.
- They also have the potential use for Illicit Trade and Criminal Activities and can be used for Terror Financing.
- They also have the Potential for Tax Evasion.
Regulation of these currencies:
The acceptability of cryptocurrencies as a legal instrument currently varies from country to country; while some are in the process of formulating laws and measures, others are yet to respond to this disruptive change. The burgeoning use of cryptocurrencies in terror financing, ransomwares, illicit drugs or arms trade and cybercrime has also raised red flags among the security and law enforcement agencies. They may well have the potential to displace the existing financial systems which enable electronic flow of money across different political boundaries.
The Reserve Bank of India has been keeping a tab on the increasing use of cryptocurrencies and it had issued an advisory in this regard in 2013, cautioning users, holders and traders of virtual currencies to its potential financial, legal and security related risks. The Ministry of Finance also held a public consultation on regulating virtual currencies in May 2017.
What can be done?
If authorised as an electronic payment system or designated a legal instrument, cryptocurrencies will fall under the purview of the RBI; capital gains and business transactions will be liable to tax, and foreign payments are also going to fall under the auspices of Foreign Exchange Management Act. Regulated cryptocurrencies will enshrine robust consumer protection provisions. In terms of benefits, this could be a force multiplier in India’s quest for financial inclusion, parallel to the electronic payment modalities such a digital wallets and Adhaar Enabled Payment System. It could further reduce the cost associated with remittances, which brings annual earnings of close to 62 billion USD to India. It would also attract future business entrepreneurs, leading to innovation, generation of job and wealth creation in the due process of payments processing, e-commerce and taxation.
The future and further success of cryptocurrencies depends upon the way regulatory frameworks are devised. Different countries have approached this innovation in different ways, and therefore the regulatory environment remains uncertain. The government will have to take considered steps, given the risks from possible use of cryptocurrencies in terror financing, money laundering and tax evasion.