Cryptocurrencies have taken the world by storm. In the relatively short period since the creation of bitcoin in 2009, the value of all cryptocurrencies has risen rapidly, although with many ups and downs. Their total market value now stands at well over $2 trillion (₹150 lakh crore), a remarkable figure by any measure. Adding in the value of other crypto assets that have developed as part of this financial ecosystem makes this figure even larger.

The proliferation of these new currencies and related products has made governments and regulators increasingly concerned about the risks they pose to financial and monetary stability. As the number of investors and the amounts of investments in these markets grow, the highly volatile prices of cryptocurrencies pose risks to the traditional financial system and could wreak significant economic damage. There are also concerns that cryptocurrencies could be used to finance illicit activities within and across national borders, in addition to enabling tax evasion and various forms of fraud.

Currency Goes Cryptic

Regulators around the world are cracking down on the cryptocurrency industry. China initially banned initial coin offerings (the cryptocurrency equivalent of initial public offerings, or IPOs, of stock by companies). It then banned its financial institutions from enabling cryptocurrency transactions. This is similar to the RBI’s 2018 injunction on banks under its jurisdiction, which was subsequently overturned by the Supreme Court. China has now gone further, effectively banning its citizens and financial institutions from undertaking any cryptocurrency-related transactions. GoI is considering similar legislation that would cut the legs out from under the cryptocurrency industry.

Other countries have taken a less restrictive approach. In the US, the Internal Revenue Service (IRS) treats some cryptocurrencies as property. Capital gains have to be reported and are taxed, as in the case of other financial assets. The Securities and Exchanges Commission (SEC) is considering regulation for certain cryptocurrencies that, along with financial derivatives based on cryptocurrency prices, could be classified as securities.

However, such regulation is developing in a reactive and piecemeal fashion, generating concerns about fragmented regulatory responses that leave significant gaps in the regulatory edifice. This has led the US Congress to consider legislation that would, at least, tighten reporting and tax enforcement of cryptocurrency-related transactions, including those intermediated through cryptocurrency exchanges rather than banks.

The challenge that regulators around the world face is how to derive the ostensible benefits of cryptocurrencies and related technologies while mitigating the risks. After all, cheaper and faster digital payments within and across national borders benefit consumers and businesses alike. Unless, of course, those payments facilitate money laundering or illicit commerce.

In countries like China and India, the ready availability of low-cost digital payments reduces the user case for cryptocurrencies as mediums of exchange. The Unified Payments Interface (UPI) has enabled a wide swathe of India’s population to have easy access to such payments, benefiting businesses and consumers alike. Moreover, bitcoin has proven to be an ineffective medium of exchange. Its value is volatile and its network is not scalable to handle a large volume of transactions.

Blockchained to Success

Whatever bitcoin’s failings in its stated purpose as a medium of exchange, the blockchain technology underpinning the cryptocurrency is a marvel that is already beginning to find uses in other areas of finance. The technology will make it possible to conduct a broad range of transactions, even purchasing a house or car, without traditional intermediaries such as banks and lawyers. It is the foundation of decentralised finance, which involves financial intermediation through technology platforms rather than conventional financial institutions, and that could make a wide range of financial products and services easily accessible to the masses.

The emergence of cryptocurrencies has also prodded central banks into issuing digital versions of their own currencies. China, Japan and Sweden have already initiated trials of central bank digital currencies. The US Federal Reserve will soon be releasing a study on the prospects for, and potential technical design of, a digital dollar. And the RBI has indicated plans to commence trials of a digital version of the rupee in the coming months.

Regulators have legitimate concerns, but should also recognise the benefits that could accrue from such technological innovations catalysed by bitcoin and other cryptocurrencies. This is especially relevant for middle-income economies, including India, where rising financial inclusion has still not provided widespread access to products for savings, credit and insurance. This is not to minimise the risks, including that of naive retail investors who get swept up in speculative frenzies and fail to recognise the risks of investing in crypto assets that have no fundamental value.

This will call for more nimbleness on the part of regulators in staying ahead of rapid changes that could make financial markets more efficient, but also generate new and unknown risks. Retrofitting existing regulatory models is unlikely to prove a productive approach. The government, regulators and industry need to work together to develop a framework that is based on principles for overseeing new products and technologies, while keeping their risks under control.

As with the UPI and other elements of the India Stack that have caught the world’s attention, India could lead the world in finding ways to resolve this tension creatively and constructively.