The much-awaited Cryptocurrency and Regulation of Official Digital Currency Bill did not find a mention in the Budget. The Finance Bill only clarifies the tax treatment of “virtual digital assets”. For now, the government seems to have sidestepped the issue of the regulatory status of crypto assets.

For a sector, that is witnessing an exponential rise in market capitalisation, high volatility, speculative trading coupled with concerns relating to security and financial crime risks, a 'wait and watch' approach is no longer an option for India. Bringing crypto assets within the regulatory perimeter is necessary to leverage the potential of its underlying technology and to mitigate risks to investors.

As the crypto market evolves, India has refrained from bringing crypto assets under any regulatory framework, perhaps for the fear of legitimising them — without understanding the market well. However, with this regulatory forbearance, India runs the risk of allowing the reckless growth of the crypto market. Without any regulatory oversight, the risks posed by crypto assets may be heightened, should they gain widespread adoption.

Fear of parallel system

The wide adoption and proliferation of an unregulated market also raise concerns about the creation of a parallel financial system that may be difficult to manage or regulate later. By not regulating, India is also not in compliance with the guidance issued by the Financial Action Task Force (of which India is a member) on the need to regulate "virtual asset service providers" against money laundering and terrorist financing risks.

The taxation of crypto assets as introduced by the Budget leaves the biggest question on the regulatory status of crypto assets unanswered. It is critical that India pursues a more comprehensive regulatory response as a matter of urgency. When it comes to crypto asset regulation, policymakers either attempt to regulate the same using existing laws (primarily securities, anti-money laundering laws) or create a bespoke regulatory framework.

In its recent working paper on ‘Blueprint of a Law for Regulating Cryptoassets’, the Vidhi Centre for Legal Policy analyses both these approaches and concludes that existing laws are not well-equipped to cover all types of crypto assets, thereby leading to regulatory arbitrage. Therefore, the paper argues that India must enact a standalone law to regulate crypto assets as a separate asset class.

The classification of financial instruments is critical for financial regulation as it determines the applicable law and supervisory powers necessary to regulate such instruments. One of the first hurdles that policymakers face in regulating crypto is its classification. Rapidly evolving designs, use cases, and business models often pose a challenge to the classification of crypto assets.

Any regulatory response to crypto asset must examine key features of crypto assets relevant for designing regulations. This includes issues relating to the identification of the issuer, right conferred by the crypto asset, underlying asset (if any) and the functional use case of the crypto asset.

To begin with, crypto asset regulation should distinguish between crypto assets that are backed by assets or fiat currencies (i.e., stablecoins) from other types of crypto assets (such as payment tokens and security tokens). Given the innovation potential of stablecoins (particularly for cross-border payments) coupled with the greater possibility of large-scale adoption, countries like the US and the UK are prioritising stablecoin regulation. Further, stablecoin arrangements raise distinct issues relating to its issuer, stabilisation mechanism, underlying assets, redemption rights, etc.

The next issue for crypto asset regulation is to identify the subject of regulation. Multiple players participate in the entire lifecycle of a crypto asset. While it may not be possible (or even necessary) to subject all entities to regulation, policymakers must consider regulating entities that act as gatekeepers to the crypto economy to monitor transactions and fix accountability.

Therefore, most countries seek to regulate service providers (such as exchanges, custodian wallet providers), with some countries also focusing on the regulation of issuers. This is particularly relevant for countries focusing on stablecoin regulation.

Another important consideration for crypto assets is the determination of the concerned regulator. For India, given that the crypto asset market is still evolving, it may not be feasible to create a new regulator for crypto assets. Instead, India needs to draw up the expertise of existing regulators like the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) to regulate the crypto asset market and its participants. While SEBI may take a lead in regulating the market conduct aspects (by regulating service providers), RBI may be involved in prudential regulation (especially for stablecoin arrangements and other crypto assets that may pose systemic risks).

Any law to regulate crypto assets must focus on other issues relating to investor protection, prevention of market abuse, prudential regulation of regulated entities, safekeeping of consumer funds, customer due diligence, anti-money laundering and risk management. Along with regulations, India must invest in equipping enforcement authorities with the necessary skillset and tools for enforcing the provisions of the law.

Financial innovation must support public policy objectives, and any meaningful innovation in the crypto asset sector cannot strive by remaining outside public policy frameworks.

The writer is the Fintech Lead at the Vidhi Centre for Legal Policy