A lawyer and her client walk into a room full of accountants. The client looks at the room and says, “I hereby pay my lawyer, X units.” All the accountants note this transaction in their ledgers. [note] Credits for this illustration go to NPR’s fantastic podcast – Planet Money, Episode: Bitcoin Losers [/note]

This is the first post in a two-part series about about the legal nature of cryptocurrencies in India. The second part is available here.

This sounds like a roundabout way of carrying out a transaction – something that could have been accomplished simply by the client giving the lawyer a cheque instead. When the client pays the lawyer through a cheque, only their respective accounts would reflect this transaction. When the client pays the lawyer by the earlier method, all ledgers reflect this transaction. This transaction is harder to dispute and much harder to reverse, reducing the overall chances of either party being defrauded. This is a decentralized ledger – the way in which cryptocurrencies (like Bitcoin) work. The “X amount” in this example above is the number of units of a particular cryptocurrency – say, 1 Bitcoin or a 100 Ether.

This understanding of a decentralized ledger is pivotal to our post in which we try to legally classify cryptocurrency to understand how it ought to be regulated. We will show that the word cryptocurrency is, in fact, a misnomer and that cryptocurrency is not a currency of any form, and therefore should not be regulated as such. In fact, we argue that cryptocurrencies are merely assets whose value is rooted in speculation, similar to stocks. Therefore it should not be given specialised treatment.

This is the first post in a two-part series that will be looking into cryptocurrency regulation. In this post, we elaborate on what cryptocurrency is, how it works and lay down the foundations of regulation. The second post will explore the implications of public law on cryptocurrency in depth while looking at regulation in India and other jurisdictions based on the diverse applications of cryptocurrency.

Going back to the earlier illustration, how would the client have obtained the cryptocurrency in the first place?

There are three ways to obtain any cryptocurrency – mining new ones; buying on a cryptocurrency exchange, and accepting them for goods and services. While the word “mining” mimes the creation of a legal tender, “mining” in the context of cryptocurrencies is more similar to a newspaper’s crossword puzzle contest. Here’s how:

Cryptocurrencies are “mined” via an algorithm. This algorithm is always on the lookout for transactions on the internet that involve an exchange of cryptocurrency. Once it gathers a specific number of such transactions, it puts them in a “block” and turns that into a “puzzle”. It then invites “miners” (basically, programmers) to solve this puzzle. The answer to this puzzle is a unique key. Miners often use other algorithms to crack this key. The first miner to find the key announces it to other miners on the network. The other miners then check whether the sender of the funds has the right to spend the money and whether the solution to the puzzle is correct. These other miners are the accountants from our earlier illustration.

Once a majority of these other miners verify this, the entire block of transactions is added to the ledger containing the previous chain of all transactions (hence the term “blockchain”). The miners now move on to the next set of transactions. The miner who found the solution gets 25 bitcoins as a reward, but only after another 99 blocks have been added to the ledger. Imagine that the accountants in our example were paid on the condition that they accurately record all transactions that take place in the room and cross-verify the ledgers maintained by the other accountants. This gives miners an incentive to participate in the system and validate transactions. This also means that cryptocurrencies are an essential subset of blockchains, and any effect on one will have repercussions on the other.

This basic understanding of the technology is at the core of its relationship with any regulation. Failure to understand these basics may lead to two extremes – it could either lead to an overarching legislation that might threaten to halt further useful research based on this technology. On the other hand, there is the danger of succumbing to the claims that because of the unique nature of this technology, no laws apply and it should be left as is resulting in a parallel platform ripe for fostering illicit transactions. However, if we take a look at the way this technology functions, we may just realize that existing regulation is perfectly capable (maybe, with a few modifications) to contain this epidemic.

Why regulate cryptocurrency?

The debate around cryptocurrency regulation has swirled up again in the past few months because of the sudden rise (and subsequent fall) in the prices of these cryptocurrencies. The value of cryptocurrency is determined by speculation of adoption. That is, if the pool of investors believes that there will be more adoption (demand) for this cryptocurrency in the future, the price rises. While cryptocurrency by itself may not be fully accepted as legal tender, it is an asset in which investments are made and it is increasingly becoming an accepted form of tender.

At one time in December 2017, bitcoin had been trending at $19,783. One of the many reasons behind this was the increased speculation as people started investing in “futures” contracts with bitcoin. This meant that they could speculate about the price of bitcoin without ever owning one. Simply put, futures are an agreement to buy or sell an asset on a specific future date at a specific price. Once the futures contract has been entered, both parties have to buy and sell at the agreed-upon price, irrespective of what the actual market price is at the contract execution date. This caused the price of cryptocurrencies (especially bitcoin) to rise exponentially.

This sudden increase in prices lead to concerns amongst regulators for two main reasons. Given the opaque and anonymous nature of cryptocurrency transactions, they are susceptible to be used to finance illicit activities. This came to the light in 2013, when the FBI cracked down on the online black market – Silk Road, which was being used as a marketplace for illegal drugs. The underlying method of payment for these drugs was through bitcoin. Secondly, regulators are also worried that the hype around cryptocurrencies poses an inherent credit risk in the market as an increasing amount of investors jumping on the bandwagon use credit cards to purchase cryptocurrency. If investors are unable to pay off this credit card debt, this could potentially affect other commodities in the market.

South Korea was the first to announce possible legislation that would ban trading on cryptocurrency exchanges. Bitcoin prices fell about 12% to around $12,801 following this news. Then in February 2018, the Indian government started talking tough about cryptocurrency. While the RBI had previously cautioned against investment in cryptocurrency, during the financial budget, Finance Minister Arun Jaitley announced that the country does not recognize Bitcoin as legal tender and steps would be taken to penalize crypto payments. He however maintained that research on the underlying blockchain technology would continue.

Shortly after the minister’s statement, the price of Bitcoin fell to a two-month low of less than $7,000. At least 2 cryptocurrency exchanges have now halted trading in India, whereas most Banks have notified their customers that their credit and debit cards will not be allowed for cryptocurrency transactions. These private players have interpreted the government’s actions negatively and are erring on the extremely cautious side of any impending regulation.

While the government has made it clear that any potential regulation would not affect blockchains but merely cryptocurrency, given the rarity of blockchains without an accompanying cryptocurrency, makes one wonder if such regulation may have a cascading effect on blockchain research as well. As investors, regulators, and the markets in general struggle to answer this question of what constitutes adequate regulation, the first question they would need to ask is cryptocurrencies are in fact a currency or just another asset.

(i) Is cryptocurrency a currency?

The basic definition of legal tender is that it must be a medium of exchange that is recognized by a legal system to be valid for meeting a financial obligation. Finance Minister Jaitley emphatically stated in his address that India did not recognize bitcoin (and any other cryptocurrency, by extension) as legal tender. This is true – Entries 36 and 46 of List I of the Seventh Schedule of the Constitution gives the unrestricted power to legislate in respect of currency, coinage, legal tender, foreign exchange, and other like instruments. Further, the Reserve Bank of India (RBI) has the power to regulate the issuance of bank notes under Section 22 of the RBI Act. The definition of currency is found in Section 2(h) of the Foreign Exchange Management Act, 1999 and includes currency notes, postal notes, postal orders, money orders, cheques, drafts, travelers cheques, letters of credit, bills of exchange and promissory notes, credit cards or such other similar instruments, as may be notified by the Reserve Bank. In the absence of any such notification by the RBI, it is but natural that cryptocurrencies are not considered legal tender. In fact, the RBI has explicitly cautioned against the use of virtual currency. This approach however is consistent with other jurisdictions in the world (with the possible exception of Japan) who do not consider cryptocurrency as a form of currency.

Cryptocurrency as we understand it is simply a medium of exchange. It cannot be classified or treated as an alternative or a parallel form of currency because it is simply not recognized by the law as legal tender.

(ii) If not, are cryptocurrencies just a speculative asset class?

This raises the question of what these “virtual currencies” should be classified as. In our earlier example, would the transaction still be legal if the client agrees to pay the lawyer in the form of a painting.

The argument is that, cryptocurrencies are simply just another form of assets. They are highly speculative in nature, yes, however, they are simply another type of asset class. Some countries have gone as far as to defend the right to invest in these under the constitutional right to property. If individuals are not prohibited from making speculative investments in assets like art, antiques, and even real estate, why should investment in cryptocurrencies be any different? While cryptocurrencies have been at the center of scandals used to finance illicit activities like the Silk Road case, this is just as true of other assets.

One of the recent judgments of the New York Federal Court succinctly captures this understanding. In CFTC v. Patrick K. McDonnell, the Commodities Futures Trading Commission (“CFTC”), a federal body which regulates the futures and options market in the US, sued the defendants, alleging that they “operated a deceptive and fraudulent virtual currency scheme” and “simply misappropriated customer funds.” CFTC sought a preliminary injunction, damages and restitution. The first question framed by the Court was whether cryptocurrencies are commodities bringing them under the jurisdiction of the CFTC. Judge Weinstein of the Eastern District of New York concluded that virtual currencies were commodities simply because, “Virtual currencies are “goods” exchanged in a market for a uniform quality and value.”

We believe that this is one of the most valuable takeaways for the Indian legal system currently. The current legal framework may very well be sufficient, if we were to understand how cryptocurrencies function. In such a scenario, given that they behave as commodities, securities, sometimes as derivatives, and facilitate payments, they may simultaneously be governed by SEBI, RBI, payment systems regulations, as well as the agencies in charge of anti-money laundering. We will look into this aspect of cryptocurrency regulation in a follow-up post.

Prachi Srikant Tadsare is a legal consultant at the World Bank and Namratha Murugeshan is 3rd year student of NALSAR University of Law.

Disclaimer: The views expressed by the authors are in their personal capacity and do not necessarily reflect the views of the institution the authors are affiliated to.