Regulating Bitcoin in India

While most currencies in the real world have the backing of a central authority of some kind (such as a sovereign or a Central Bank) infusing them with an air of legitimacy, Bitcoin has no such central authority which issues or controls it. Additionally, the distributed and decentralised nature of the Bitcoin network makes regulation a tricky issue. This article seeks to touch upon the issue of Bitcoin regulation and makes certain broad suggestions for the future. It is a follow-up to a previous article by this author discussing the legal treatment of Bitcoin under Indian law, available at http://cis-india.org/internet-governance/bitcoin-legal-regulation-india.

The Reserve Bank of India (RBI) has not exactly been shy in recognising and even regulating technological advances in the financial sector as is evident from their detailed guidelines on Internet Banking,[1] Prepaid Payment Instruments[2] Account Aggregator Regulations,[3] and the consultation paper on proposed regulations for P2P lending platforms,[4] etc. However, though the RBI has acknowledged the existence of Bitcoin (it issued a note cautioning the public against dealing in virtual currencies including Bitcoin way back in 2013[5] and again in 2017[6]), there have been no clear guidelines regarding the same. Nevertheless, Bitcoin has come a long way since its inception and a consensus is emerging amongst the more technically inclined individuals that Bitcoin is infact here to stay.

Even if a sceptical view is taken that Bitcoin may not last for a long time, that does not mean that regulation is useless as there is already a large amount of money invested in Bitcoin entities in India and Bitcoin exchanges seem to be betting big on this sector really taking off - especially in the backdrop of the government’s recent push towards a more digital and less cash dependent economy.

While the Indian government is trying to hard sell the idea of digital payments, primarily using existing banking channels as well as the relatively new National Payments Corporation of India (NPCI) and the various applications that are cropping up around the NPCI’s UPI platform, one must note that going digital could involve high administrative costs. These costs are typically charged by banks and intermediary merchants, and may not be palatable to all stakeholders, as was evident in the recent fracas between petrol pump owners and banks over proposed transactional charges on card payments.[7]

It is this vacuum that alternatives such as prepaid payment instruments and virtual currencies can fill while addressing the concern of high administrative charges, which is likely to be a major hurdle in going digital. Administrative charges for most of these instruments are significantly lower than what existing payment channels charge for digital transactions.[8]

Legality of Bitcoin and the need for Regulation

Bitcoin technology is being widely embraced all over the world, including neighbouring China which has become one of the biggest markets for the uniquely decentralised currency. However the biggest hurdle that Bitcoin enthusiasts see in mainstreaming this technology is the fact that most countries are treading too cautiously around Bitcoin and therefore do not have regulation governing them.

The creation and transfer of Bitcoin is based on an open source cryptographic protocol and is not managed by any central authority.[9] It is the decentralized nature of this virtual currency that makes regulation a major challenge. This does not mean that regulators are not capable of regulating Bitcoin, in fact attempts have been made in several jurisdictions but these are mostly in the discussion stage, for eg. the Washington Department of Financial Institutions (“DFI”) introduced a bill in December, 2016 which proposes amendments to certain portions of the Washington Uniform Money Services Act and includes provisions specific to digital currencies;[10] the U.S. District Court for the Southern District of New York has in a decision in September, 2016 taken the view that Bitcoin is money under the plain meaning of Section 1960, the federal money transmission statute.[11]

This article does not intend to undertake a discussion on how Bitcoin is dealt with in various jurisdictions, but instead is aimed at suggesting a possible way forward for Indian regulators to regulate Bitcoin in a manner that satisfies the regulatory zeal towards security as well as ensures that the technology does not get stifled through overregulation. It is important that the regulators create a balanced regulation because an impractical ecosystem for Bitcoin exchanges and their users, may lead to traders seeking alternative methods of purchasing Bitcoin such as P2P trading, over-the-counter (OTC) markets and underground trading platforms, which are significantly more difficult to regulate.[12]

Suggestions for Regulation

Since Bitcoin is a decentralised cryptocurrency, it is impossible to regulate it through one single centralised point for all transactions. Neither is it feasible to regulate each and every Bitcoin user. A pragmatic compromise between these two extremes could be to regulate the points at which fiat currency or valuable goods enter the Bitcoin system, i.e. the Bitcoin exchanges where people may buy and sell Bitcoin for actual real world money, or websites which offer Bitcoin as a means of payment. Such an approach would reduce the number of points of supervision and lead to effective enforcement of the regulations. The regulations may require any entity providing services such as buying and selling of Bitcoin for actual money, trading in Bitcoin (such as non-cash exchanges) or providing other Bitcoin related services (such as Bitcoin wallets, merchant gateways, remittance facilities, etc.) to be registered with a central government agency, preferably the Reserve Bank of India.

One legal issue regarding the regulation of companies transacting in Bitcoin is whether the RBI has the authority or jurisdiction to regulate Bitcoin in the first place. Without getting into the arguments regarding whether it is a dangerous trend or not, an easy way in which the RBI could ensure it has the authority to regulate Bitcoin would be to follow the path that the RBI adopted while regulating Account Aggregators under the Non-Banking Financial Company - Account Aggregator (Reserve Bank) Directions, 2016 wherein the RBI declared Account Aggregators as Non Banking Finance Companies under section 45-I(f)(iii) thereby getting the authority to regulate and supervise them under section 45JA of the Reserve Bank of India Act, 1934.

The Regulations, once issued by the Reserve Bank of India, can prescribe mandatory registration, capital adequacy provisions, corporate governance conditions, minimum security protocols, Know Your Customer (KYC) requirements and most importantly provide for regular and ongoing reporting requirements as well as supervision of the Reserve Bank of India over the activities of Bitcoin companies.

Any proposed Bitcoin regulatory framework would seek to address certain issues; for the purposes of this article, we will assume that the following three issues are the ones that must necessarily be addressed by a regulatory framework:

• Security of the consumer’s property and prevention of fraud on the consumer. In the technology sector this translates into specific emphasis on increased security (against hacking) for accounts that the consumers maintain with the service provider.
• India has robust exchange control laws and the inherently decentralised and digital nature of Bitcoin can enable transfer of value from one jurisdiction to another without any oversight by a central agency, potentially violating the exchange control laws of India.
• Bitcoin has for long been associated with criminal and nefarious activities, infact many believe that the famous black market website “Silk Road” played a big role in making Bitcoin famous[13] and therefore preventing Bitcoin from being used for illegal activities (or creating a mechanism to ensure a digital trail to help investigations post facto) would be a major issue that the regulations would seek to tackle.

Given the above assumptions, let us examine whether the Regulations suggested above can satisfactorily address the concerns of security of consumers, exchange control, and keeping a tab on criminal activities.

If the regulations provide for minimum capital adequacy requirements as well as registration by the RBI or some other central agency, then the chances of consumers being duped by “fly-by-night” operators would be significantly reduced. The Regulations can also provide for minimum security protocols to be maintained by the companies, which protocols can themselves be developed in concert with Bitcoin experts. Critics may point to the hacking of various Bitcoin exchanges in the recent past, including that of MtGox, in which Bitcoin worth millions of dollars were siphoned off, and argue that the security protocols may not be enough to prevent future instances of hacking. But that is true even for the current security protocols for online banking; and that has not prevented a large number of banks from providing online banking facilities and the RBI regulating the same. The other vital issue that legally mandated security protocols would address (and potentially solve) is the issue of liability in case of hackings. Regulations may provide clarity on this issue and protect innocent customers from negligent companies while at the same time protecting entrepreneurs by defining and limiting the liability for bona fide and vigilant companies.

The other issue that may be of major concern to the authorities is exchange control. India has extremely specific exchange control laws, and if any person in India wants to transfer any amount to any person overseas, the only legal way to do so is through a bank transfer, which requires filling paperwork giving the reason for the transfer (although the RBI and banks usually don’t ask for any proof for small amounts upto a few lakhs). This means that all transfers outside India are done through proper banking channels and are therefore under the supervision of the RBI. However the decentralised nature of Bitcoin enables individuals to transfer money outside the borders of India without going through any banking channels and hence stay completely outside the purview of the RBI’s supervision. Such a system which lets users transfer money beyond national borders outside legal banking channels could be easily misused by nefarious actors and this is exactly what happened as international drug cartels turned to Bitcoin and other digital currencies to move their ill gotten wealth beyond the borders of various countries.[14] Regulating the entities which provide Bitcoin wallets and Bitcoin exchanges will ensure that the RBI can exercise its supervisory jurisdiction over Bitcoin transactions of individual customers even though these transactions do not go through the regular banking channels. The Regulations could impose an obligation on the companies to provide information on any suspicious activities or provide greater information about accounts which see very high volumes, etc. to ensure that Bitcoin is not used to finance organised crime. Thus, the regulations could have provisions that would require the companies providing the Bitcoin wallets or exchanges to flag and monitor customers whose trading accounts or Bitcoin wallets have transactions of an amount greater than a specified limit. This would provide the RBI with the ability to enquire as to the reasons for such high volumes and weed out illegal transactions while at the same time allowing bona fide transactions to continue.

Very closely linked to the issue of exchange control and supervision of transactions is the issue of checking the furtherance of criminal activities using the apparent anonymity offered by Bitcoin. However if the RBI has regulatory oversight over all the Bitcoin companies that are operating in India, then it would be possible for it to keep an eye on most Bitcoin transactions in India as long as the wallet that originates or terminates the transaction has been provided by a Bitcoin service provider located in India. An argument may be made that a criminal may use the services of Bitcoin wallet services provided by companies outside India and therefore outside the purview of the RBI and its regulations. However this argument may not be as plausible as it may seem at first look; if we assume that for any criminal activity the ultimate goal is to get the money in the form of recognizable legal tender (preferably cash or money in a bank account) then it stands to reason that the Bitcoin in the wallet would be exchanged for currency at some point or the other in the chain, which can only be done through a Bitcoin exchange if the transaction is of a fairly high value (which most criminal transactions are) and these exchanges as well as the accounts maintained by them will be under the purview of the RBI, thus providing the law enforcement agencies with the final link in the chain of transactions. Further, the public nature of the blockchain (the ledger where each Bitcoin trade is registered and verified) also makes it possible for the enforcement agencies to follow the trail of money for each and every Bitcoin or part thereof.

Conclusion

From the discussion above, we see that the major arguments that have been given by sceptics regarding Bitcoin and its attractiveness to criminals due to its decentralised nature are actually not very viable on a closer look. Bitcoin and the blockchain technology are extremely important steps in the direction of better and more efficient financial transactions in the global economy, which is why a number of mainstream banks are also showing a keen interest in the blockchain technology.[15] Regulations governing Bitcoin or virtual currencies would clear the air regarding their legal status so that consumers as well as entrepreneurs and investors can invest more money in this technology which could potentially change the way financial transactions are carried out across jurisdictions.

[1] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=414&Mode=0

[2] https://rbi.org.in/scripts/NotificationUser.aspx?Id=10799&Mode=0

[3] https://www.rbi.org.in/scripts/BS_ViewMasDirections.aspx?id=10598

[4] https://rbidocs.rbi.org.in/rdocs/content/pdfs/CPERR280416.pdf

[5] https://rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=30247

[6] https://rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=39435

[7] http://timesofindia.indiatimes.com/business/india-business/petrol-pumps-wont-accept-cards-from-monday-to-protest-banks-transaction-fee/articleshow/56402253.cms

[8] For example, currently the network fee for a person to person Bitcoin transfer is 0.0001 Bitcoin, which comes to roughly Rs. 6 per transaction irrespective of the amount involved.

[9] The processing of Bitcoin transactions is secured by servers called Bitcoin “miners”. These servers communicate over an internet-based network and confirm transactions by adding them to a ledger which is updated and archived periodically using peer-to-peer filesharing technology, also known as the “blockchain”. The integrity and chronological order of the blockchain is enforced with cryptography. In addition to archiving transactions, each new ledger update creates some newly-minted Bitcoins.

[10] https://www.virtualcurrencyreport.com/2017/01/washington-department-of-financial-institutions-proposes-virtual-currency-regulation/

[11] https://www.virtualcurrencyreport.com/2016/09/sdny-opinion-re-bitcoin/. For a discussion on how different States and agencies in the United States deal with Bitcoin, please see Misha Tsukerman, “THE BLOCK IS HOT: A SURVEY OF THE STATE OF BITCOIN REGULATION AND SUGGESTIONS FOR THE FUTURE, Berkeley Technology Law Journal, Vol. 30:385, 2015, p. 1127, available at http://scholarship.law.berkeley.edu/cgi/viewcontent.cgi?article=2084&context=btlj .

[12] http://themerkle.com/why-china-isnt-interested-in-banning-bitcoin-importance-of-regulation/

[13] See generally, Nathaniel Popper, “Digital Gold: Bitcoin and the Inside Story of the Misfits and Millionaires Trying to Reinvent Money”, Harper Collins, 2015.

[14] https://www.bloomberg.com/view/articles/2013-11-18/are-bitcoins-the-criminal-s-best-friend-

[15] http://www.morganstanley.com/ideas/big-banks-try-to-harness-blockchain.