-Kanakprabha Jethani | executive
A high-level Inter-ministerial Committee (IMC) (‘Committee’) was constituted under the chairmanship of Secretary, Department of Economic Affairs (DEA) to study the issues related to Virtual Currencies (VCs) and propose specific action to be taken in this matter. The Committee came up with its recommendations recently. These recommendations include, among other things, ban on private VCs, examination of technologies underlying VCs and their impact on financial system, viability of issue of ‘Central Bank Digital Currency (CBDC)’ as legal tender in India, and potential of digital currency in the near future.
The following write-up deals with an all-round study of the recommendations of the committee and their probable impacts on the financial systems and the economy as a whole.
Major recommendations of the Committee.
The report of the Committee focuses on Distributed Ledger Technologies (DLT) or blockchain technology and their use to facilitate transactions in VCs and their relation to financial system. Following are the major recommendations of the Committee.
- DEA should identify uses of DLT and various regulators should focus on developing appropriate regulations regarding use of DLT in their respective areas.
- All private cryptocurrencies should be banned in India.
- Introduction of an official digital currency to be known as Central bank digital currency (CBDC) which shall be acceptable as legal tender in India.
- Blockchain based systems may be considered by Ministry of Electronics and Information Technology (MEITY) for building low-cost KYC systems.
- DLT may be used for collection of stamp duty in the existing e-stamping system.
Why were these recommendations needed?
- DLT uses independent computers (called ‘nodes’), linked together through hash function, to record, share and synchronise transactions in their respective distributed ledgers. The detailed structure of DLTs and their functions and uses can be referred to in our other articles.
Among its various benefits such as data security, privacy, permanent data retention, this system addresses one major issue linked to digital currency which is the problem of double-spend i.e. a digital currency can be spent more than once as digital data can be easily reproduced. In DLT, authenticity of a transaction can be verified by the user and only validated transactions form a block under this mechanism.
- Many companies have been using Initial Coin Offerings (ICO) as a medium to raise money by issuing digital tokens in exchange of fiat money or a widely accepted cryptocurrency. This way of raising money has been bothering regulators as it has no regulatory backing and such system can collapse any time. The regulators also fail to reckon whether ICO can be even considered as a security or how it should be taxed.
- Some countries allow use of VCs as a mode of payment but no country in the world accepts VCs as legal tender. In India, however, no such permissions are granted to VCs. Despite the non-acceptability of VCs in India, investors have been actively investing in VCs like bitcoin, which is a sign of danger for the economy as it is draining the financial systems of fiat money. Further, they pose a risk over the financial system as they are highly volatile, with no sovereign backing and no regulators to oversee. It has been witnessed in the recent years that there have been detrimental implications on the economy due to volatility of VCs such as bitcoins. the same has been dealt with in detail in our report on Bitcoins. They are also suspected to have been facilitating criminal activities by providing anonymity to the transactions as well as to the persons involved.
- The future is of digitisation. An economy with everything running on physical basis will not survive in the competitive world. A universally accepted system for digital payments would require digitisation of currency as well.
What is the regulatory philosophy in the world?
As a mode of payment: Countries like Switzerland, Thailand, Japan and Canada permit VCs as a mode of payment while New York requires persons using VCs to take prior registration with a specified authority. Russia allows only barter exchange through use of virtual currency which means that such exchange can only take place when routed through barter exchanges of Russia. China prohibits use of VCs as a mode of payment.
For investment purposes: Russia, Switzerland, Thailand, New York and Canada permit investment in VCs and have in place frameworks to regulate such investments. Further, countries like Russia, Thailand, japan, New York and Canada have also allowed setting up of crypto exchanges and have a framework for regulating the setting up and operations such exchange and subsequent trading of VCs on them. On the other hand, China altogether prohibits investments and trading in VCs and the law of Switzerland is silent as to allowing setting up of crypto exchanges.
Further, China has imposed a strict ban on any activity in cryptocurrencies and has also taken measures to prohibit crypto mining activities in its jurisdiction. No country in the world has allowed acceptance of virtual currency as legal tender. It is noteworthy that though Japan and Thailand allow transactions in VCs, such transactions are restricted to approved cryptocurrencies only.
Tunisia and Ecuador have issued their own blockchain based currency called eDinar and SISTEMA de Dinero Electronico respectively. Venezuela has also launched an oil-based cryptocurrency.
Issue of official digital currency
Sensing the keen inclination of financial systems towards technological innovation and witnessing declining use of physical currency in various countries, the Committee is of the view that a sovereign backed digital currency is required to be issued which will be treated at par with any other legal tender of the country.
Various legislations of the country need to be reviewed in this direction. This would include amendments to the definition of “Coin” as per Coinage Act for clarifying whether digital currency issued by RBI shall be included in the said definition. Further, on issue of such currency, it must be approved to be a “bank note” as per section 25 of RBI Act through notification in Gazette of India.
Various regulators would also be required to amend their respective regulations to align them in the direction of allowing use of such digital currency as an accepted form of currency.
Key features of CBDC are expected to be as follows:
- The access to CBDC will be subject to time constraints as decided in the framework regulating the same.
- CBDC will be designed to provide anonymity in the transaction. However, the extent of anonymity will depend on the decisions of the issuing authority.
- Two models are under consideration for defining transfer mechanism for CBDC. One is account-based model which will be centralised and other one is value-based model which will be decentralised model. Hybrid variants may also be considered in this regard.
- Contemplations as to have interest-bearing or non-interest-bearing CBDC are going on. An interest-bearing CBDC would allow value addition whereas non-interest bearing CBDC will operate as cash.
Why should DLT be used in financial systems?
- Intermediation: Usually, in payment systems, there are layers of intermediation that add to cost of transaction. Through DLT, the transaction will be executed directly between the nodes with no intermediary which would then reduce the transaction costs. Further, in cross-border transactions through intermediaries, authorisations require a lot of time and result in slow down of transaction. This can also be done away through DLT.
- KYC: Keeping KYC records and maintaining the same requires huge amounts of data to be stored and updated regularly. Various entities undergoing the same KYC processes, collecting the same proofs of identity from the same person for different transactions result in duplication of work. Through a blockchain based KYC record, the same record can be made available to various entities at once, while also ensuring privacy of data as no centralised entity will be involved. Loan appraisal: A blockchain technology can largely reduce the burden of due-diligence of loan applicant as the data of customers’ earlier loan transactions is readily available and their credit standing can be determined through that.
- Trading: In trading, blockchain based systems can result in real-time settlement of transactions rather than T+2 settlement system as prevailing under the existing stock exchange mechanism. Since all the transactions are properly recorded, it provides an easier way of post-trade regulatory reporting.
- Land registries and property titles: A robust land registry system can be established through use of blockchain mechanism which will have the complete history of ownership records and other rights relating to the property which would facilitate transfer of property as well as rights related to it.
- E-stamping: A blockchain based system would ease out the process of updation of records across various authorities involved and would eliminate the need of having a central agency for keeping records of transaction.
- Financial service providers: They can be benefited by the concept of ‘localisation of data’ due to which their data is protected from cyber-attacks and theft. Our article studies implementation of blockchain technology in financial sector.
What will be the challenges?
- For implementation of DLT: Though a wide range of benefits can be reaped out of implementation of DLT in various aspects of financial systems, it has still not been implemented because there are a few hindrances that remain and are expected to continue even further. Some of the challenges that are slowing the pace of transition towards this technology are as follows:
- Lack of technological equipment to handle volumes of transactions on blockchains and to ensure data security at the same time.
- Absence of centralised infrastructure or central entity to regulate implementation of DLT in the financial system. Also, the existing regulators lack the expertise to oversee proper implementation.
- First, a comprehensive regulatory framework needs to be in place that ensures governance in implementation. The framework will need to address concerns like jurisdiction in case of cross border ledgers, point of finality of transactions etc.
- For common digital currency: Decisions regarding validation function, settlement, transfer, value-addition etc. are of crucial importance and would require extensive study. Factors that might be hampering issue of such currency are as follows:
- Having in place a safe and secure blockchain network and robust technology to handle the same will require significant investments.
- High volumes of transactions may not be supported and might result in delays in processing.
- In case an interest bearing CBDC is issued, it would pose great threat over the commercial banking system as the investors will be more inclined towards investing in CBDCs instead of bank deposits.
- This is also likely to increase competition in the market and lower the profitability of commercial banks. Commercial banks may rely on overseas wholesale funding which might result in downturn of such banks in overseas market.
- For banning of private cryptocurrencies: A circular issued by the RBI has already banned its regulated entities from dealing in VCs. Many other countries have also banned dealing in VCs. Despite such restrictions, entities continue to deal in VCs because their speculative motives drive the dealing in VCs to a great extent.
The recommendations of the Committee intend to ensure safety of financial systems and simultaneously urge the growth of the system through innovation and technological advances. Rising above the glorious scenes of these recommendations, one realises that achieving this is a far-fetched reality. One needs to accept the fact that India still lacks in technology and systems sufficient to support innovations like blockchain. Various reports have already shown that operation of blockchains consumes huge volumes of energy, which can be the biggest issue for the energy-scarce India. India needs to work in order to strengthen its core before flapping its wings towards such sophisticated innovation.