The basics of digital gold

Timothy Lopes | Manager

Vinod Kothari Consultants Pvt. Ltd.

The precious metal, gold, has for the longest time been seen as a form of investment that provides adequate returns, diversification and also possess hedging properties. Especially in a country like India, which is one of the largest markets for gold according to the World Gold Council^[1], the yellow metal plays an important role. A report by ICRA forecasts that gold jewellery demand would grow by 11% YoY in FY 2023^[2].

In the era of digitisation, nearly every form of investment, traditional or otherwise, is available at our fingertips. Electronic media has brought with it ease of access, speed, convenience, as well as, new avenues for innovation.

Out of the digitisation era, the concept of digital gold has emerged as an avenue for investors and consumers alike to purchase gold through digital means. Although an innovative concept, there seems to be a gap in the regulatory framework surrounding digital gold, which is still evolving.

This article aims to highlight the concept of digital gold and the regulatory regime (or lack thereof) surrounding it.

What is Digital Gold?

At present there are several apps through which one can purchase the so-called ‘digital gold’. But what does that exactly mean? By purchasing digital gold, is one purchasing a security backed by gold or the commodity itself?

The idea behind digital gold is that it is a means to purchase physical gold through electronic or digital means. Essentially, making a purchase of digital gold is akin to buying physical gold and paying for it through digital modes. The difference, however, is that once the purchase is made digitally by the buyer through an app, an amount of gold equivalent to the amount of purchase is stored in a vault and insured by the seller on behalf of the buyer. This can be subsequently sold through the app or physical delivery of the digital gold may be taken by the buyer.

Further, the buyer may purchase gold for amounts as low as Rs. 1. This gives flexibility with respect to how much gold a buyer wishes to purchase.

How does it work?

Think of an ordinary platform where one can make payments, essentially payment apps. Such a payment platform partners with a gold refinery to provide an avenue for customers to purchase gold via digital means.

The customer can choose to purchase gold even at low ticket sizes and hold the same as an investment. It is said once a purchase is made, an equivalent amount of gold would be stored in a vault by the seller on behalf of the customer. The customer is free to sell the gold at the prevailing price using the payment app itself or take delivery of the amount of gold purchased.

It is not clear as to how gold of small ticket sizes of say Rs. 10 would be delivered to the customer, however, certain payment apps provide the options of 1, 2, 5 and 10 grams worth of gold to be delivered. So it seems that delivery cannot be taken for those amounts of gold that are not within the aforementioned options.

If it is possible to purchase gold for a notional amount of even Rs. 1, but delivery of the same is not possible because of the lack of delivery options, then how does one confirm whether the gold is actually being stored separately? Is it practically possible to set aside 0.1 mg of gold for a multitude of different customers who for the purpose of this example, make a purchase of just Rs. 1 worth of digital gold?

Had this been a purchase of physical gold, this would not have been possible. Physical gold is usually sold in units of at least 1 gram which would cost approximately Rs. 5000. Certainly, by enabling purchase of gold at as low as Rs. 1, the digital gold sellers are enabling purchase of a fraction of gold units. Which means, several buyers buying such a fraction would result in purchase of a single unit.

Think of transferability now. In case a customer intends to sell his/her part of the ownership in the gold, the ownership of that fraction of the gold unit is transferred. For movable properties, transfer of possession is the most commonly accepted manner of transfer. However, one cannot deliver possession in case of fractional ownership. How does one ensure transfer of rights then?

Of course there has to be a document, say a receipt indicating transfer of such rights. However, most payment apps do not offer the facility to transfer digital gold to a third party of the customers choice. Some platforms offer the facility to ‘gift’ the digital gold to another party. However, in most cases the digital gold may be sold/redeemed to the entity it was purchased from.

Particulars	Physical Gold	Digital Gold
Meaning	Purchase of physical gold including taking delivery of the same.	Purchase of physical gold through digital means without immediate delivery.
Purchase	Normally purchased from jewellers.	Payment apps or other digital platforms.
Quantity	Usually purchased in fixed quantities of 1, 2, 5, 10 grams, etc.	Can be purchased for amounts as low as Rs. 1.
Transferability	Can be transferred.	Can be gifted. Option to transfer is usually not available on most platforms.
Possession	After purchase, possession is normally with the customer.	After purchase, possession is with another entity who stores the gold on behalf of the customer.
Liquidity	Liquid but sale usually takes some time.	Can be instantly sold, making it highly liquid.
Acceptability as collateral	Can be used as collateral for borrowing purposes.	Option to be used as collateral not widely available, however, the option seems to be available on some platforms. In any case, it can be used as collateral after taking delivery.

Digital Gold as collateral

An interesting question that arises is whether digital gold can be used as collateral for availing a loan?

It seems like most platforms that sell digital gold do not offer the option to place the digital gold as collateral for availing a loan. The author has come across one platform where it is possible to obtain digital gold as well as, gold loans. However, it is still unclear whether the gold loan is being offered with digital gold as collateral.

Digital Gold – is it a security?

One of the common features of a security is transferability. As discussed above, digital gold does not seem to be transferable as there is no option as such given by the payment apps at present. Further, digital gold does not seem to fall under the definition of ‘security’ as per the Securities Contract (Regulation) Act, 1956^[3] (SCRA).

This would make it seem like digital gold purchased through an app is not a security but just a mode of purchasing the underlying physical gold through digital means and having the seller store the physical gold on the buyer’s behalf.

However, just by saying that the buyer is merely purchasing underlying physical gold through digital means without taking delivery of the same but benefiting simultaneously from the underlying price movements does not reflect the economic nature of the transaction in full.

The whole transaction seems akin to creating a synthetic derivative security wherein the buyer has an option to take delivery of the underlying or settle for a cash settlement while simultaneously being impacted by price movements of the underlying.

Is there a regulatory framework governing digital gold?

What seemed to be a seemingly innovative product and an alternative avenue for revenue for stock brokers across the country, turned out to be an eye opener for the securities market regulator. As it turns out, digital gold does not come with a regulatory framework. The question that arises then, is whether digital gold is at all legal in the absence of a regulatory body?

The argument in favour of the legality of digital gold is that it is perfectly legal to buy or sell gold by making payment for it using digital channels. If one could undertake the same set of transactions physically and legally (including purchase, sale and delivery of the yellow metal), then merely because the transaction is undertaken using digital means does not invalidate the legality of the transaction.

The aforementioned contention is strengthened by the statement that buying digital gold is nothing different from buying physical gold and making a payment for it using digital modes.

On the flip side, the uncertainty relating to whether digital gold is a ‘security’ or not still exists.

However, uncertainty still looms in the market for digital gold, since there is no regulatory body looking over the system of buying, selling and taking delivery of the digital gold. The author, in their findings, did not come across any law/ regulation dealing with digital gold specifically.

Stock exchange ban on stock brokers offering digital gold –

The argument against the legality of digital gold can be shown by the actions taken by the Securities and Exchange Board of India (SEBI), the securities market regulator in India against digital gold.

Earlier, digital gold as a product was offered on digital payment apps, as well as, by stock brokers registered with SEBI. However, according to Rule 8 (3) (f) of the Securities Contracts (Regulation) Rules, 1957^[4] (SCRR), members of the stock exchange cannot engage in any business other than that of securities or commodity derivatives, except as a broker or agent, not involving any personal financial liability.

SEBI noticed that certain stock brokers were providing a platform to their clients for buying and selling digital gold (which is not a ‘security’ as per SCRA) and informed the stock exchanges (vide a letter dated August 03, 2021) that such an activity is in violation of Rule 8 (3) (f) of SCRR and that members should refrain from undertaking any such activities.

Accordingly, the NSE released a circular dated August 10, 2021^[5] directing its members to not to carry out the said activity and comply with the regulatory requirements at all times. Members who were at that time carrying out such activities were given one month’s time to cease the buying and selling of digital gold on their platform.

The gold exchange framework –

The idea of a gold exchange was first announced in the budget speech of 2018-19. However, it was in the budget speech of 2021-22^[6] where it was announced that SEBI would be notified as the regulator and Warehousing Development and Regulatory Authority would be strengthened to set up a commodity market eco system arrangement including vaulting, assaying, logistics etc in addition to warehousing.

SEBI has now paved the way for the gold exchange by notifying ‘Electronic Gold Receipts’ (EGRs) as ‘securities’ under SCRA and putting in place the Securities and Exchange Board of India (Vault Managers) Regulations, 2021^[7], as well as, several subsequent circulars relating to EGRs and the gold exchange framework in 2022.

While SEBI is the regulator of the gold exchange framework, the focus here, however, is on digital gold, which is not the same as EGRs.

How is digital gold different from SEBI’s gold exchange?

SEBIs gold exchange framework is an entirely different concept from digital gold. The main source of difference is that firstly, unlike EGRs, digital gold is not notified as a security under SCRA. So, stock brokers still would not be able to deal in digital gold. However, they would be able to offer the gold exchange facility to its customers.

Secondly, digital gold is still running outside of the gold exchange framework. Payment apps have not stopped offering this product to customers. So it would seem that digital gold still goes unregulated till date.

Conclusion

It is clear that there are risks associated with a product like digital gold, in the absence of backing under any regulatory framework. However, if regulators are currently aware of the lack of regulation, then in order to protect consumer interests, there should ideally be some action by the appropriate regulatory body to put in place a framework for digital gold as well.

Merely coming up with an alternative to digital gold, such as the gold exchange framework, does not make digital gold go away. There are also concerns associated with how the payment apps offer purchase of gold for nominal amounts without providing an option for delivery. The digital gold product makes a claim that once a purchase is made, physical gold of an equivalent amount is stored separately in a vault on behalf of the customer. But how can that be verified? For instance if a customer makes a purchase of Rs. 1 digital gold (which is possible), is it reasonable and practical to assume that an equivalent amount of gold is separately stored in a vault somewhere on behalf of only this customer?

In the authors’ view, consumers are till date exposed to the risks associated with the lack of regulation when it comes to digital gold, which should ideally be addressed and dealt with to plug the gap.

^[1] https://www.gold.org/about-gold/gold-demand/india

^[2] https://www.icraresearch.in/research/ViewResearchReport/4347

^[3] https://www.sebi.gov.in/legal/acts/apr-2021/securities-contracts-regulation-act-1956-as-amended-by-the-finance-act-2021-13-of-2021-w-e-f-april-1-2021-_49750.html

^[4] https://www.sebi.gov.in/legal/rules/feb-1957/securities-contracts-regulation-rules-1957-last-amended-on-july-30-2021-_34671.html

^[5] https://archives.nseindia.com/content/circulars/COMP49251.pdf

^[6] https://www.indiabudget.gov.in/budget2021-22/doc/Budget_Speech.pdf

^[7] https://www.sebi.gov.in/legal/regulations/dec-2021/securities-and-exchange-board-of-india-vault-managers-regulations-2021_55153.html