Cryptocurrencies, once the domain of hi-technology enthusiasts and cypherpunks, is now in the mainstream. With Bitcoin making unprecedented waves in financial markets and other cryptocurrencies blooming around the world, governments and regulators, banks, customers, and traders are all clamouring for a say in the future direction of such cryptocurrencies.

Bitcoin’s use has surged in India, too, despite the rather hostile regulatory atmosphere – the Reserve Bank of India (RBI) has thrice issued statements on the ‘risk’ posed by Bitcoins and a finance ministry panel has proposed to ‘ban’ the virtual currency. Then, November saw a well-intentioned (although misconceived), Public Interest Litigation petition filed in the Supreme Court of India, asking for the court to direct the central government to ‘urgently regulate’ Bitcoin. While the respondents’ responses are awaited, it’s an opportune moment to examine how the government should approach Bitcoin and similar technologies.

This article poses three questions for regulators: first, what should be regulated? Second, what purpose will regulation serve? Third, what form should the regulation take?

The conundrum of control

What is the subject of regulation? This requires a thorough, technical understanding of how Bitcoin operates. A detailed explainer of how Bitcoin technology functions can be found here. It is important to keep in mind that there is no central authority in Bitcoin – the software protocol controls the creation and distribution of Bitcoin, which may be done independently and anonymously. The Bitcoin blockchain is a ledger available with every virtual ‘node’ on the particular network, making it completely transparent and decentralized. Moreover, the blockchain (for most part) cannot be altered. This creates a ‘trustless’ system, which means that transactions taking place through Bitcoin do not need intermediation by a mutually trusted broker. Trust is encoded into the system, as the ledger is transparent and unalterable. Bitcoin has other inherent advantages over traditional systems: its transactions are faster and costs less.

Blockchain has even broader utilisation as a tool for public and transparent record keeping. Several Indian banks such as ICICI Bank are already utilising blockchain functionality for overseas remittances, which are generally expensive and time-consuming. Even the Telangana government has mooted the idea of using blockchain for keeping secure and transparent land records.

Bitcoin’s nature throws up inherent regulatory challenges. Anyone can join the Bitcoin network and mine Bitcoins and transact with others, either independently or through a third-party provider, and even anonymously. As such, the Bitcoin network is too decentralized for any one government or jurisdiction to attempt to directly regulate the technology itself. However, a majority of transactions using Bitcoin take place through intermediaries on the network, which are used to access the network and could be sites for regulation, such as wallets (which store the keys used in Bitcoin transactions) and exchanges (which allow purchase and sale of Bitcoin for conventional fiat currency or other cryptocurrencies). In India, particularly, until the wider adoption of Bitcoin as a currency for day-to-day transactions, Bitcoin’s real-world implications are tethered to the function of exchanges which can convert it into fiat currency for use in payments for goods and services.

From the above, the answer to the first question – what should be regulated? – is apparent: bitcoin technology and transactions themselves cannot be regulated and banning or deeming Bitcoin illegal would serve little purpose except to push it underground. Instead, regulation can focus on intermediaries in order to exert control over the behavior of actors on Bitcoin networks.

Why regulation is warranted

There are two goals which might require regulatory interference: The first is to promote consumer protection and to foster market confidence. The second is to limit negative consequences stemming from the lack of government control over Bitcoin’s use as a currency.

There are several extant laws which could potentially be applicable to Bitcoin in India, subject to the determination of its legal status as a currency, a security, a payment system, or a commodity. Briefly:

• It may fall under the jurisdiction of RBI’s regulation under the Foreign Exchange Management Act, 1999, if notified as a currency under Section 3 of that Act. Notifying Bitcoin as a currency could place its transactions under similar scrutiny.
• It may fall under the definition of ‘movable property’ under the Sale of Goods Act, 1930. This would effectively mean that Bitcoin transactions (for other goods or services) are barter transactions, which would remain unregulated. However, the sale of Bitcoin for money could attract certain consumer protection regulations.
• It could fall under the jurisdiction of the Securities and Exchange Board of India, which regulates security transactions. Securities are defined and comprehensively regulated under the Securities Contracts Regulations Act (SCRA), 1955. Bitcoin does not fall under any of the definitions of the SCRA; however, it may be brought under its purview by way of a government notification.

The status of Bitcoins is unique and does not clearly fall within existing parameters of financial instruments. For this reason, the legal status of Bitcoin is not obvious and has not been clarified by the Government of India, which makes the future of Bitcoin uncertain. The uncertainty, in turn, implies that Bitcoin holdings and transactions are risky, thereby reducing market confidence and discouraging investment and innovation. Moreover, the tax implications of Bitcoin holdings are also unclear.

One negative manifestation of the uncertainty is the lack of consumer protection vis-à-vis Bitcoin intermediaries. An example of this is unregulated ‘Initial Coin Offerings’ (ICOs) which are mechanisms by which cryptocurrencies or tokens are exchanged in return for raising funds for a particular project from the public. This makes transactions similar to issuance of securities but without the same level of regulatory control. This exposes consumers to possible fraud, as was seen in India in the issuance of the MCAP token. Another example is the mismanagement of accounts by intermediaries, and recent history has many examples of exposures to security leaks leading to the loss of Bitcoins worth millions.

Admittedly, cryptocurrencies have been in the public eye for a lot of wrong reasons. Their status as an ‘anonymous’ and unregulated currency has conjured images of its use by the ‘four horsemen of the infopocalypse’ – terrorists, organised crime, drugs and pedophiles. While there are examples of cryptocurrencies being used for more nefarious purposes, the anonymity and possibility of misuse should not blindside regulators to the benefits of new technology and its capability for disruptive innovation across many sectors. Approaching Bitcoin from a pure law and order perspective is unhelpful, as the internet’s inherent features defy regulation and ‘banning’ such innovations will only push its activities underground, further away from regulatory control.

Several jurisdictions have attempted to tackle these problems by ensuring that Bitcoin intermediaries follow anti-money laundering and Know Your Customer norms, along with adopting scientific forensic analysis of transactions. Needless to say, any regulatory tools built for Bitcoin’s surveillance need to respect the privacy of users on the network, which a major factor behind its use and adoption.

Needed: A regulatory sandbox

The 600 Billion-Dollar question (yes, that’s Bitcoin’s market capitalisation) is – how should regulators approach a technology so averse to regulation without negating the value that it has created? The implications of bad regulation could potentially be fatal to innovation in several emerging technologies. Blockchain technology, in particular, is widely seen as a disruptive and transformational technology, which can be utilised horizontally across the economy. Heavy handed regulatory responses to Bitcoin have been criticised for curtailing innovation and stifling competition in the sector, as has been the case with New York State’s licensing mechanism, the BitLicense.

The concept of regulatory sandboxes may come handy here. Sandboxing effectively allows collaboration between regulators and firms in the market to ‘beta-test’ their business models in a controlled regulatory environment. This mechanism allows certain innovative firms (accepted by the regulator) in the sandbox to function without being subject to highly stringent regulations which may be otherwise applicable (say, subjecting ICOs to securities laws). Acting under a relaxed regulatory structure, the scale of testing would be limited in terms of time and consumer base. The models would then be evaluated based upon projected outcomes and values for wider adoption by the public. The learnings of the regulator from the experiences in the sandboxes can be adopted into existing regulations.

A regulatory sandbox for cryptocurrencies could allow firms to innovate while also providing regulators with crucial data required to understand the technology and with appropriate regulations to contain possible failures. Various models for regulatory sandboxes, particularly for the fin-tech sector have been tested in many jurisdictions, including the United Kingdom, Singapore and Australia.

More than “urgent regulation” and an interim ban on cryptocurrencies, as proposed by the petitioners in the Supreme Court, the need of the moment is for the government to carefully reflect on the form that regulation should take – one which can maximize the gains from radical innovation that this technology could enable and minimize the potential risks to consumers. One remains hopeful that it can take a stand soon, so that India isn’t left in the lurch for the next technological breakthrough.

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