The Cryptocurrency and Regulation of Official Digital Currency Bill, 2021, to be introduced in the Lok Sabha soon, aims to prohibit all private cryptocurrencies in India while seeking to create a facilitative framework for adopting a central bank digital currency (CBDC).

The Bill is likely to classify mining, generating, holding, selling, or dealing in private digital currencies as a cognisable offence. Reports suggest that the government may introduce stringent regulations in line with the 2021 Financial Action Task Force (FATF) guidance for cryptocurrencies held as assets by imposing investment ceilings, stringent disclosure norms, and levying taxes on gains earned from such assets.

Understanding the exuberance

Globally, the cryptocurrency market is growing rapidly with the impetus from several trading platforms, mostly app-based. They are enticing investors with the lure of abnormally high returns at a time when both the conventional investment avenues, debt (including bank deposits) and stocks have been providing low yields. In November 2021, the global cryptocurrency market, constituting more than 6,000 cryptocurrencies, touched a market capitalisation of $3 trillion.

There has been a sudden flurry of cryptocurrency trading platforms in India over the past year. Latest industry estimates suggest that cryptocurrencies holdings of nearly 20 million investors amount to approximately ₹400 billion in India, suggesting that the country is emerging as the new frontier for the numerous virtual asset service providers (VASPs) dealing in cryptocurrencies. What explains such sudden exuberance?

A plausible reason is that cryptocurrencies are being treated as speculative assets. In the case of such limited-supply assets, since there are no cash flows from the asset and its turnover, the only future cash flow is the capital gain or appreciation in the asset’s value. Any asset in limited supply is bound to increase in value when more people demand it. In a time of low yields, leaders’ money flowing to such speculative assets would create a buzz in the market, and followers will join the bandwagon in fear of missing out (FOMO). In a recent interview with CNBC, Raghuram Rajan very aptly commented that “…a lot of cryptos have value only because there is a greater fool out there willing to buy”.

For such speculative assets to increase in value, finding a new set of followers is necessary. Like a Ponzi scheme, as new money flows in, it allows the price to rise. Whenever the prices are worthy of profit booking, leaders exit. Subsequently, there is fear or recognition of an illusion on the part of the followers. When they exit, prices crash, which allows the leaders to again enter at low price levels and the cycle of bubble continues.

The US and other developed markets have been more or less saturated. People who have suffered losses are unlikely to become new followers. Hence, the Indian market, with its young and aspirational populace, moderately high savings rate and propensity towards technology adoption, creates an ideal setting for a new frontier for the cryptocurrency trading business.

So far, cryptocurrencies are a set of unregulated assets in India. The exponential investment growth in cryptocurrencies is not comforting as the risks inherently associated with a highly volatile anonymous digital currency could be severe both at the micro and macro levels.

First, cryptocurrencies are not an alternative to traditional currencies as fiat money. Cryptocurrencies are not units of account, and their conversion rates to traditional currencies are volatile enough to be not called a stable store of value. Recent research suggests that the volatility of Bitcoin (the cryptocurrency with the largest market cap) is ten times higher than that of major exchange rates (US dollar against the euro and the yen).

Second, cryptocurrencies are significantly illiquid in terms of higher transaction costs. Between 2020 and 2021, fees ranged from $2-60 per transaction.

Further, the inefficiency of the distributed ledger system limits the speed of transactions, making them unsuitable as an efficient mode of exchange. A recent Deutsche Bank report reveals that the Bitcoin network can process only about 600,000 transactions per day compared to Visa’s two billion transactions. The slow clearing process can substantially increase the quantum and spread of transaction fees.

Third, cryptocurrencies are too risky, even as speculative assets. All speculative assets, real or financial, have some intrinsic economic value that cryptocurrencies do not have. Such high volatility renders cryptocurrencies a poor risk-diversifier in portfolios. Hence, comparing them with bullion as a risk-diversifier is also wrong.

Fourth, cryptocurrencies can be a social evil as well. Their usage as currency on the dark web, in the trade of illegal goods (such as drugs) and even in funding terrorism is now known.

They are touted as the revolutionary agents that will end the central bank’s monopoly in printing money and democratising financial and monetary space. However, cryptocurrencies are also issued by individuals, privately. Therefore, the critical question is whether to trust an anonymous group of people who may be exploitative without accountability or a sovereign government accountable at the end of the day, at least in a democracy.

Fifth, in a time of excessive monetary liquidity, speculative mania for cryptocurrencies may promote inequality. It can be conjectured that savvy investors — typically wealthier, more connected ones are likely to be leaders while the poorer, less connected ones are likely to be followers. The information asymmetry will let the smart money profit at the expense of naive investors. With severe disparity in financial literacy and easy digital access, India could be the hotbed of financial exploitation.

Points to ponder

Indian investors should not gamble in such speculative assets where they can only lose money in the long-term. The Bill to regulate cryptocurrencies should therefore be tabled without delay. The government should also ponder the reasons behind the speculative exuberance. The answer may lie in the failure of the formal financial system and small saving schemes to cater to the aspirational needs of new-gen investors.

Critical reforms are needed to bring back faith in our banking services. Otherwise, like previous examples of money flowing into chit funds and Ponzi schemes, savings will be channelled into cryptocurrencies that are non-productive for investment and economic growth.

Kundu is Assistant Professor, Finance Area, Praxis Business School, Kolkata, and Nandy is Assistant Professor, Economics Area, IIM Ranchi