Cryptocurrency – A Cautionary Tale for India

Recent Events in the Crypto-world and a Need for Regulatory Oversight

– Subhojit Shome (subhojit@vinodkothari.com)

Introduction

There are two recent events in the world of crypto that warranted this article – the first one, in order of chronology, fundamentally altered the way that a blockchain (the underlying ledger) for cryptocurrency validates transactions while the second exposed how a cryptocurrency, without underlying value, can be used to window dress a balance sheet and lure in investors.

The second incident, of course, refers to the FTX debacle that has received global media coverage and continues to grab headlines. The first event, Ethereum moving to ‘proof of stake’ consensus mechanism, however, may be a more obscure event to the public eye and likely to have caught the attention of only the hardcore crypto enthusiast, fintech departments of financial institutions and the financial stability divisions of financial market regulators and ministries.

This article, to all intents and purposes, is a ‘cautionary tale’ where we use these two events to explore how cryptocurrency, whether deliberately or inadvertently, may build a house of cards and there is an urgent imperative that regulators look beyond PML/ CFT issues, the ‘usual suspects’ when it comes to crypto, and delve into issues surrounding investor protection and market surveillance.

‘Proof of Stake’ – Why we need to take notice

What is proof of stake?

Unlike fiat, there are no central issuing authorities (and, hence, no central accounting agencies) for cryptocurrency and transactions in it are written to a distributed digital ledger after being verified through a ‘consensus mechanism’. The most popular consensus mechanism, and the one still used for bitcoin, is called ‘proof of work’ wherein platform participants (effectively every live node/ computer connect to the platform) verifying the transaction also need to solve cryptographic puzzles in order to submit the entry to the ledger and the participant submitting the entry get rewarded by the platform by way of a small (yet significant) percentage of the transaction (‘mining’).

It needed brute computational force to solve the cryptographic puzzle which led to an ‘arms race’ for computational power with companies investing millions of dollars in hardware to set up ‘mining farms’ and forming cohorts to amalgamate their computational resources. What also followed was a “ginormous”^[1] demand for energy that was needed to run these ‘mining farms’.

Mindful of such an inefficient use of energy, the Ethereum platform, from December 2020, started to  move to a ‘proof of stake’ consensus mechanism first by creating a separate branch of the platform to use this new mechanism and then in September the entire platform got upgraded to adopt this mechanism.^[2]

In the ‘proof of stake’ consensus mechanism, the ‘validators’ (similar to ‘miners’ in the ‘proof of work’ mechanism) verifying transactions on the platform stake a certain amount of the platform’s cryptocurrency (currently, 32 ETH tokens are required for a single stake in the case of Ethereum) and receive reward (paid by way of ‘ETH’ tokens) on top of their stake. Any “misbehaviour” (say, dishonest behaviour or failing to perform their validation task) by the validator leads to confiscation of either the total or some part of their stake.

Adoption of this new mechanism has reportedly led to ~99.95% saving in energy consumption on the Ethereum platform. There are, however, other significant implications, especially for the world of DeFi that we take a look at in the following sections.

Implications

The quantum of reward and the probability of earning such reward depend to a significant level on the the amount of stake (or the no. of stakes) a validator/ or a group thereof has on the platform. This increases their probability of being picked for the task of validation and consequently receiving a reward.

Hence, the arm’s race that was witnessed for the traditional consensus model has now been replaced by a similar race to raise the number of stakes and in order to raise such stake there is a demand generated for ETH tokens (instead of hardware and energy).

This has led to the development of the “pure DeFi” practice of  ‘Lending’ and ‘Staking’, a financial practice that has come into being entirely as a progeny of the decentralised blockchain framework and also relies on such a framework to be carried out.

In ‘Lending’ and ‘Staking’, platform cryptocurrency owners (usually having small/ fractional amounts) lend their tokens (say ‘ETH’ tokens) to a larger DeFi participant (usually a crypto exchange) who pools such tokens and submits a larger stake on the crypto platform (say, the Ethereum Platform). Rewards earned on such stake are then shared amongst the pool participants according to their share in the pool  who again may lend the tokens/ fractional token earned to increase their share in the pool (the entire process process is often referred to as ‘yield farming’). Additional participants may also enter the fray by buying ETH tokens and lending to the pool in the hope of generating income.

Of course, one can easily spot here the ‘self fulfilling’ nature of such a practice – the demand for the cryptocurrency creates its value and the value of the cryptocurrency creates the demand. In the case of the ETH token which has to its credit a certain amount of pedigree and is the largest platform supporting DeFi applications,^{[3] [4]} there are external and real-world factors that substantiate its value. However, one must be vary of this inherent tendency of cryptocurrencies when it comes to new platforms and coin^[5] launches.

While, ‘pure DeFi’ may be a concept new to us, one of India’s largest crypto exchanges had floated a crypto exchange product and their own token based on the concept of yield farming back in 2020.^[6]

The FTX Debacle

On 2nd November 2022, Coindesk reported^[7] that FTX had pumped funds into Alameda by way of its FTT token. FTX and Alameida both being under the control of the same promoter – Sam Bankman-Fried. The Coindesk article went on to state –

While there is nothing per se untoward or wrong about that, it shows Bankman-Fried’s trading giant Alameda rests on a foundation largely made up of a coin that a sister company invented, not an independent asset like a fiat currency or another crypto.

Almost immediately following this Report, was the announcement that Binance had started offloading FTT tokens and had pulled out of a funding deal with FTX  – the FTT token took a nosedive.

Price of the FTT token (in $)

Source: Coindesk

The value of the FTT token was almost entirely based on the perceived value of the services that FTX (the crypto exchange) and its sister company (Alameda – a quantitative trading firm) would provide. The implications of the CoinDesk Report were – FTX-minted FTT tokens were invested in Almeda to bloat its balance sheet, which was used to attract investors and credit providers, and as the balance sheet grew it allowed Alameda to further trade in the FTT token, thus raising the demand for the FTT token and consequently its value which in turn increased the size of Alameda’s balance sheet, and this cycle could continue ad perpetuam. The message in CoinDesk’s Report was clear and it conveyed two significant pieces of information – ‘Conflict of Interest’ and ‘Self Dealing’.

Implications

While there are many lessons to be learned from this incident, in this article we would like to draw focus on a few specific issues.

The DAO Hack

A poorly designed piece of code (‘vulnerability’) allowed malicious actors to illegitimately transfer crypto funds to their own accounts that adversely affected the supply of the crypto currency in circulation leading to an existential crisis. The crypto community with its technocrats were able to rescue the situation through what is referred to as a ‘hard-fork’ whereby through community consensus such transactions were invalidated and there was a return to status quo.^[8]

Although exploiting vulnerabilities in the blockchain itself is rare, incidents of hacking have been frequently reported for crypto exchange applications and wallets and cybersecurity mandates, setting of information security standards and certification, information security testing and audit should be set by regulators for crypto exchanges before they go public. However, this was not the issue with FTX, the code in all probability was working exactly in the manner it should have been.

Beyond PML, CFT and tax evasion

Focus of global regulators have largely been on PML, CFT and tax evasion when it comes to an actionable regulatory framework for cryptocurrency. Recently, the OECD finalised the global framework on Cryptocurrency that provides for a common reporting standards for crypto-assets and related transactions – Crypto-asset Reporting Framework (CARF)^[9] .

CARF sets out:

• Scope of Crypto-Assets to be covered
• Entities and individuals subject to data collection and reporting requirements;
• Transactions subject to reporting
• Information to be reported in respect of such transactions
• Due diligence procedures to identify Crypto-Asset Users and Controlling Persons
• Criteria to determine the relevant tax jurisdictions for reporting and exchange purposes

Publication of the CARF acknowledges the rapid adoption and use of cryptocurrency for a wide range of investment and financial uses, however, it is not a comprehensive regulatory framework for the cryptocurrency market that corresponds to the framework applied to the financial or securities markets.

It is only very recently, following the FTX debacle, that the OECD’s new Chairperson has called for a need to focus on investor protection, address issues of conflict of interest posed by “crypto conglomerates” and announced plans to publish a consultation report on these matters in the first half of 2023.^[10]

Role of CBDC – Will the launch of CBDC reduce interest in crypto?

Popularity of crypto is substantially driven by investor interest and the business use cases^[11] (DeFi or otherwise) that it supports, especially due to the disintermediation benefits that it offers.

If we are to go by the CBDC Concept Paper^[12] published by the RBI, the e₹ will most definitely not act as an investment avenue and is unlikely to witness any trading activity.

When it comes to business use cases, platforms like Ethereum achieved success because it allowed businesses to write and deploy their application (by way of the smart contract framework) directly on top of its blockchain platform. This was largely possible because the platform itself was open source. It is, however, highly unlikely (we will only be able to determinatively state this when the retail pilot commences) that an open source architecture will underlie the e₹  as this will mean that the source code underlying it will become public. The ability for businesses to build on the e₹ platform is, hence, also likely to be limited.

On the flip side, implementation of the  e₹ will make payments more convenient including for the person on the street to make payments to indian crypto exchanges to invest in cryptocurrencies and regulatory attempts to restrict or discourage such transactions will raise thornier constitutional issues than those raised when the RBI placed a ban on banks from holding or facilitating cryptocurrency transactions.^[13]

In Conclusion

One approach to address the issue of proliferation of cryptocurrency, in India, has been to amend the tax code to make it prohibitively expensive in terms of the amount that needs to be paid to the exchequer when trading or otherwise dealing in cryptocurrency. However, the ‘apna time ayega’^[14] nature of marketing cryptocurrency is largely encouraged by the underlying volatility of cryptocurrency which far out-stretches the dampening effects of any incidental tax. On the other hand, an overly broad tax code tarring all forms of crypto assets by the same brush is likely to impede financial and business innovation.

India is a part of the G20 nations and OECD’s recommendations are likely to drive domestic regulators to apply more focused regulations to the cryptocurrency market. And the sooner this happens the better.

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^[1] The first generation of cryptocurrencies like Bitcoin and Ethereum 1.0 consume ginormous amounts of electricity when they are mined – Economic Times (September 3, 2021) – https://energy.economictimes.indiatimes.com/news/power/what-you-must-know-about-cryptocurrencies-and-their-role-in-global-warming/85886512

^[2] The “Merge” – https://www.reuters.com/technology/ethereum-blockchain-has-completed-major-software-upgrade-co-founder-says-2022-09-15/

^[3] As per the IOSCO Decentralized Finance Report, March 2022 – https://www.iosco.org/library/pubdocs/pdf/IOSCOPD699.pdf

^[4] We cover such a DeFi application in our article on ‘Security Token Offerings & their Application to Structured Finance’ – https://vinodkothari.com/2022/04/security-token-offerings-their-application-to-structured-finance/

^[5] The term ‘coin’ has been used to indicate a platform-native token as this behaviour is more likely for such tokens rather than those issued by applications built on top of an existing platform/ blockchain.

^[6] https://coindcx.com/blog/wp-content/uploads/2021/01/Liqueth-Litepaper.pdf

^[7] https://www.coindesk.com/business/2022/11/02/divisions-in-sam-bankman-frieds-crypto-empire-blur-on-his-trading-titan-alamedas-balance-sheet/

^[8] For a more detailed understanding of the Dao hack refer to The Blockchain and the New Architecture of Trust, Kevin Werback (2018, The MIT Press Cambridge, London)

^[9] https://www.oecd.org/tax/exchange-of-tax-information/crypto-asset-reporting-framework-and-amendments-to-the-common-reporting-standard.pdf

^[10] In mainstream finance there is functional separation between activities like broking, trading, banking services and issuance, with each having its own set of conduct rules and safeguards. Is it the case for the crypto market? I would say most of the time not. – Jean-Paul Servais, https://www.reuters.com/article/global-markets-regulator-idCAKBN2SE08G

^[11] We had inspect one such use case in our article – “Security Token Offerings & their Application to Structured Finance” – https://vinodkothari.com/2022/04/security-token-offerings-their-application-to-structured-finance/

^[12] We cover the Consultation Paper in our article – Introduction of the Digital Rupee (e₹)- https://vinodkothari.com/2022/11/introduction-of-the-digital-rupee/

^[13] https://main.sci.gov.in/supremecourt/2018/19230/19230_2018_4_1501_21151_Judgement_04-Mar-2020.pdf

^[14] https://www.businessinsider.in/advertising/brands/article/gully-boys-ranveer-singh-is-back-raps-for-coinswitch-kuber-in-its-latest-ad/articleshow/86932307.cms