On Crypto-currencies and the way forward.
The government of El Salvador recently announced that it would start accepting bitcoin as legal tender in the country. This is the latest development in the on-going debate around crypto-currencies and the road ahead for them. The debate has gained decibels in India too. While the government and the RBI measure the pros and cons of allowing a free play of crypto-currencies, the emergence of crypto-currency exchange apps indicates that the markets are running ahead of the regulation. As we debate the scope and desirability of crypto-currencies here are some of the factors that should be weighed in.
Acceptance of Innovation: The power to issue currency is one of the foundational pillars of a modern nation state. Any innovation that seeks competition with this power is bound to be resisted. Government and RBI should resist the temptation of viewing crypto-currencies as an alternate to fiat currency. In the spirit of Regulatory sandbox, allow private parties to use crypto-currencies for mutual contracts. As the usage of crypto-currencies expands, we stand to learn at the cost of private capital.
Eradicate Anonymity: Blockchains- the underlying technology on which crypto-currencies are based, ride on the power of anonymous participants. If the currency/asset class wants to be included in the formal financial system, the owners and holders of the asset can not be anonymous. Our financial system is based on and strives to identify all participants, under the umbrella of KYC (Know your customer) doctrine. This policy needs to be extended to crypto-currencies. All holders of the currencies should disclose their identity, source of the funds that they are deploying in crypto-currencies and the end use of the currencies needs to be monitored. The KYC disclosures will also bring usage of crypto-currencies under the ambit of existing anti-money laundering rules and regulations. Questions have also been raised on where do crypto-currencies, a US dollar denominated asset, fall in the scope of Foreign Exchange Management (FEMA) act. Government should consider including crypto-currency investments within the ambit of Liberalised Remittance Scheme (LRS). Any investment should fall under the annual LRS permissible limits for resident individuals. These holdings can be clubbed investors global assets and attract current taxation regime applicable to global assets.
Do not Backstop: The importance of formulation of policy of No Backstop if crypto-currencies fail and the communication of this policy cannot be understated. Government should clearly and repeatedly communicate that crypto-currencies are not back stopped by the sovereign, they are not a part of any deposit guarantee programmes, the government does not guarantee any returns on investments made in crypto-currencies and they will not be considered collateral for loans issued by any financial intermediary. Participants of the crypto-currency exchange should be made aware that they are investing in an asset that has its unique risks vis-à-vis pricing and liquidity. Caveat Emptor.
Regulatory Oversight: Treating crypto-currencies as financial assets that operate under the paradigm of private party contracts, implies that they be regulated by capital markets regulator-SEBI. SEBI has extensive experience of regulating a gamut of financial products, overseeing exchanges where these instruments trade. SEBI also has experience of developing and managing independent bodies-depository participants, that provide transparency and risk management frame works for capital market products.
Educate and inform: Any new innovation carries the risk of failure and rewards early adopters in case it succeeds. Crypto-currencies should be considered a financial asset with the risk and returns accruing to investors. As it does for financial products like Insurance and Mutual Funds, government and regulator should focus on informing and educating investors on risks associated with crypto-currencies-specially the risk of no sovereign guarantee or backstops in case the currency fails.
Second order effect on tech ecosystem: Crypto-currencies and blockchain technology are now part of the internet technology space. Technology per se and internet technology specially has the ability to morph itself and work as a building block for solutions and opportunities unforeseen. In the early years of internet data compression technology was invested to make transfer of data, from one university server to another, easier and cheaper. One wonders if the inventors thought one day their invention would enable YouTube and Netflix.
Wider use of Blockchain technology: Crypto-currencies are based on a technology called block-chains. Block-chain, put simply, is publicly recorded, verified, accessible and immutable stack of information. For a country our size and one where the design and structure of the state make accessing information a humongous task, any innovation that helps accessing information more easily should be encouraged. A use case could be digitising and updating land records. The government can create a blockchain and make information on land records more accessible. A blanket ban on the most popular product of the blockchain technology could deprive us of its other-possibly more impactful, uses.
Let the markets play: Crypto-currencies are products of free markets. They are an example of voluntary participation by market players and private capital testing the limits of a new technology. As long as we have ringfenced the stability of the financial system and clearly communicated that all risk of innovation failing is on the participants, we should let the markets play. The government and the RBI should focus on ensuring there are no spill overs from private contracts going bust on public markets and restrict any regulation at this stage only on achieving that.
