Good crypto and bad: Defining, regulating and taxing this world

At long last, the government and regulatory authorities appear to be getting together with stakeholders to consider a legislative and regulatory framework for cryptocurrencies. These virtual assets have been around for over a decade — the pioneer bitcoin started trading in 2010. There are literally thousands of cryptos. Some have given truly extraordinary returns. Investors see these instruments as potential hedges against currency volatility and inflation.

Traders who pay in rupees generate over Rs 50 crore in daily cryptocurrency volumes and, as we’ll explain, Indians actually invest a great deal more in forex-denominated trades. There’s a substantial, active Indian crypto-investment community which multiple sources estimate hold over $15 billion worth of crypto assets. Moreover, the related non-fungible token, or NFT, market is booming and there’s been an advertising blitz tempting Indians to invest in cryptos.

Regulating these instruments is not easy. Japan, Korea, Finland, Estonia, Australia, El Salvador, etc, have regulatory frameworks. It’s easier to do this if the local currency is fully convertible, as will become obvious.

But enforcing any ban on them is impossible. It’s legally okay for a resident Indian to open an overseas broking account (which offers cryptocurrency trading) and to remit equivalent of $250,000 abroad every fiscal, for a wide variety of purposes, including investing in overseas assets. Shutting down that route would make life impossible for importers, exporters, Indians studying abroad, and so on.

The first thing regulatory authorities must do is define a tax treatment, outlining incidence of long-term and short-term capital gains for investors. It’s rumoured an approved list of cryptos will be announced — the framework must go beyond that to define “good” cryptocurrency versus “bad” ones.

There are over 7,000 recognised cryptocurrencies in existence as of November 2021. The list would grow; any smart coder can create a new crypto. Some cryptos are created by fraudsters seeking to fleece the gullible; others are well laid out with carefully defined structures and peer-to-peer verification systems.

A good cryptocurrency includes a secure peer-to-peer verification system, an assurance of some anonymity, a method of mining that allows for predictable growth in money supply, which cannot be manipulated, and so on. The regulatory framework should include a definition of what makes a good crypto. It must include some reference to the most common use cases for cryptos. One is remittances. A remittance of, say, dirhams to rupees, involves bank charges and delays while the Reserve Bank of India (RBI) processes payments. Instead, you can buy cryptocurrency with dirhams and hand over the relevant codes to somebody who sells the crypto in rupees. There are no bank charges, and much faster processing, if the counter-parties are comfortable with price volatility.

CRYPTO QUICK FACTS

• Over 7,000 cryptocurrencies listed in investopedia
• Over $15 bn held in cryptocurrencies by Indians. Over Rs 50 cr traded daily in rupees
• Bitcoin first traded at $0.08 in July 2010 — that is 12.5 coins to a dollar. It’s trading at $61,000 / coin today. Ethereum, Ripple, Doge Coin also have extraordinary returns. A bitcoin can be split into 100 million Satoshis, which allows for it to be used to buy small, relatively cheap items. Ethereum, etc. can be similarly split into smaller units

This is illegal but unstoppable. There’s anecdotal evidence that non-resident Indians, or NRIs, are adopting this route, especially for small remittances. It will show up in annual official remittance data as lower remittances. This is why Indian interest in cryptocurrency is likely underreported since a lot of trading happens in forex.

Another use-case is currency swaps. A swap is a deal where two entities exchange two currencies, say USD and INR, at an agreed rate, and commit to the reverse exchange of exactly the same amounts of USD and INR after an agreed time, regardless of how much the exchange rate may have changed in the interim. The RBI itself has done swaps, most notably during the global financial crisis. Corporate entities often find such transactions convenient and again, it is easier to do this by using cryptocurrency trades rather than via banks.

Yet another use case regulators must note is the straightforward use of crypto to purchase assets, or services. If a massage parlour, coffee house or automobile company wants to accept payments in cryptos, there must be clear accounting processes laid out for reflecting such transactions. El Salvador has, for example, adopted bitcoin as an alternative currency and while this experiment has revealed many pitfalls, it’s worth studying for these reasons.

A third use case, which could prove quite useful in the Indian context, is the “trustless” contract enabled by blockchain. In such a contract, money is put into an escrow account with an instruction inscribed in blockchain that if certain conditions are fulfilled, the money is to be transferred automatically to a given account. This is much cheaper and less cumbersome than conventional bank escrow.

For example, a municipality hands out a garbage disposal contract. It may create a blockchain where the residents sign off that the garbage is being disposed of to their satisfaction. Such contracts cut down on corruption and accelerate government payment processes. The UNHCR uses trustless contracts to pay for goods supplied to Syrian refugees.

Regulators also have to take note of climate change. Bitcoin and many other cryptocurrencies have very energy-intensive verification systems. More energy efficient cryptos are desirable. There could be tax structured inducements to design more energy efficient verification systems.