The threat of cryptos: Unregulated, new asset class can disrupt economy

The income tax department is making a serious effort to unearth the dimensions of cryptocurrency trading in India and tax evasion that may be associated with it. This appears to be part of a concerted effort by the authorities to establish some regulatory control. After a series of surveys of nine major Indian cryptocurrency exchanges, the tax department has established that around $3.5 billion has been traded on these exchanges in the past 17 months. It has sent out notices to hundreds of thousands of individuals who may have been involved in these trades. Although the Reserve Bank of India has issued advisories warning against trading cryptocurrencies, and the finance ministry has described them as “Ponzi schemes”, the regulatory position on these instruments is still unclear. Not all cryptocurrencies are Ponzi schemes or frauds. The Securities and Exchange Board of India (Sebi) is reluctant to play a supervisory role, and the exchanges remain unregulated and unsupervised.

Indeed, the tax department may be hampered in the assessment of tax implications because it is not clear how to classify cryptocurrencies and, thus, to judge what rate of capital gains tax should apply to profits made from such trades. Indian regulators are not the only ones in a bind. Cryptocurrencies have gained so much traction in the past year that many governments have been forced to review these instruments. This asset class and its impact on the global financial economy are likely to be on the agenda for discussion at the next G-20 meeting in March. For instance, Japan has already bitten the bullet and recognised “cryptos” as currencies, if certain definitions are met. The Japanese authorities have laid down know-your-customer (KYC) and net-worth norms for exchanges dealing in cryptos. Australia is in the process of drafting similar regulation. South Korea has outlined a structure for cross-border transfers. China has taken the opposite approach and banned such trading. However, such an outright ban is hard to enforce, even in China.

In practical terms, it is nearly impossible to prevent trading of these instruments. It is possible to make such trades with little or no trace left in the formal banking system. The issues are even more serious for nations such as India and China, which do not have open capital accounts. It is possible to exchange rupees for dollars and bypass currency controls by using bitcoin or some other cryptocurrency as a via media. Trades can also be layered in such a fashion that anonymity is maintained. Hence, tax officials and regulators face a tough task in attempting to enforce any kind of control. The tax department has taken a positive step by gathering information on trades and sending out notices. But this must be backed up by concerted action from other regulators in order to be meaningful. This class of assets needs to be reviewed at the highest levels with inputs from multiple regulators. Decisions need to be taken in laying down definitions of what qualifies as a cryptocurrency, the applicable tax rates to trading profits, regulation of exchanges, and usage in commercial transactions, including cross-border transactions. If this asset class continues to be ignored or if its regulation is mishandled, it has the potential to seriously disrupt the financial economy.