Figuring out risks posed by cryptocurrencies

Krittika Chavaly | Updated on March 03, 2020

A regulatory framework aligned with the functions of a product or service, or a “same risk, same rules” principle, makes sense

On April 6, 2018, the RBI issued a prohibition on all dealings in virtual currencies by regulated entities. The move seemed extreme; set against the backdrop of caution exercised worldwide, it marked a stark departure from the relatively non-interventionist stance the regulator had previously adopted. The future of cryptocurrencies now rests with the Supreme Court, where the ban is currently under challenge. Regardless of the outcome, as technology-enabled innovations increasingly permeate the market, it is critical for regulation to react meaningfully.

The money we use (fiat currency) is a product of lending by institutions (commercial banks). What makes it credible or trustworthy is that it is backed by the state through its central bank. What makes its usage ubiquitous is the law, which establishes that our taxes can only be paid in state-issued fiat currency.

The term ‘virtual currency’ (or ‘cryptocurrency’) is a misnomer, as it seems to indicate that these tokens operate like ersatz money. Although cryptocurrencies are intended to function as a means of payment, unlike fiat currencies, they lack a sovereign guarantee and their source of value is not quite clear.

These tokens suffer from technical and economic faults in their core design, rendering them far from pervasive in the financial system as a means of payment. Moreover, they are a poor unit of account, as demonstrated by their frequent and high fluctuation in value. Cryptocurrencies and the cornucopia of digital tokens they encompass therefore have little in common with fiat currency, and are more appropriately referred to and regulated as crypto-assets.

Crypto-assets indeed pose several risks, including anti-money laundering and terrorism financing concerns (AML/CFT) for the state and liquidity, credit, and operational risks for users. Particularly for consumers, the pernicious effects of cryptocurrencies are heightened by the striking paucity of information on their design, use and operation and indications of market manipulation. However, in treating these tokens as currency, the existing regulatory regime misunderstands both the instrument and the attendant risk; and by extension, fails to effectively contain them.

Fixing the loopholes

Concerns are heightened when there are linkages between the crypto-asset economy and the formal banking and payments sector — grey areas in regulation can allow for malaise in the former to be transmitted to the latter. The RBI’s decision to de-link the sectors by disallowing dealings in virtual currencies by regulated entities (banking and payments institutions) solves a part of the problem. But AML/CFT and consumer concerns continue to persist outside the formal system, where trade and dealings are unregulated. Going forward, two changes are required.

First, in the face of growing technological innovation in the financial sector, it is critical to strengthen the supporting regulatory frameworks that operate regardless of the nature of an instrument. Emerging technologies are characterised by steep information asymmetries among the innovators, regulators and users, which limits the potential for pre-emptive action. Re-examining and strengthening the complementary framework allows for, to a certain degree, the creation of a safety net which operates irrespective of the regulatory arbitrage sought to be exploited by new players.

Second, the RBI must set clear parameters on functional grounds to evaluate the appropriate course of action. A regulatory framework that is aligned with the economic functions of a product or service, or a “same risk, same rules” principle, can avoid the pitfalls of policy that narrowly strikes at business models and technologies already observed and consequently risks missing the forest for the trees. Realigning regulation along functional lines allows regulators to draw more meaningful perimeters and expand oversight to cover the system’s current blind spots. New business models and technologies are guided by regulation to the extent that they seek to circumvent it. Striking at function, rather than just form, will aid the umpire in distinguishing the desirable from the undesirable as more new players populate the field.

One of the more useful takeaways from the crypto storm, apart from the popular distributed-ledger technology, is the worldwide proposal for central-bank digital currencies, which could allow for money to be transferred between users without the involvement of a third-party (commercial bank). If implemented, it is not entirely certain what the implications for the financial system will be, although it is possible that the business models of commercial banks may be seriously disrupted. In determining the course of action, the RBI must carefully study the implications before changing status quo.

Like electric vehicles and the Internet, money has also evolved with time. Changes to systemic architecture are iterative and so, the rules must be carefully calibrated.

The writer is project fellow at the Vidhi Centre for Legal Policy

Published on March 03, 2020

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