Bitcoin and its functioning
Bitcoin is a cryptocurrency that allows users to transact directly without involving any central authority or a financial institution. It was first introduced in 2009 by a person (or group of persons) called Satoshi Nakamoto through a whitepaper explaining its functioning. It has been defined as “a purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution”. While traditional fiat currency is backed by a central government, Bitcoin is a decentralised currency, the value of which is based solely on its demand and supply. Bitcoin transactions are stored on a distributed public ledger called the Blockchain.
A blockchain is a sequence of blocks, with each block linked to the previous one, creating a chronologically ordered chain. A single block consists of a set of verified transactions and a reference to the block immediately preceding it. It also contains the answer to a mathematical puzzle, called ‘proof-of-work’, which is unique to the block. This puzzle is extremely hard to solve but once solved, easy to verify. The process of competing to find a solution to the puzzle and thereby adding new transactions to the network is called ‘mining’. In order to add a block to the blockchain, a majority of the network (51% or more) has to agree on its validity, thus ensuring that fraudulent transactions cannot be introduced into the blockchain by any individual or group.
When a ‘miner’ successfully adds a block to the network, he receives a fee from each transaction recorded in the block as well as a fixed amount of newly generated bitcoins. This acts as an incentive for the miner to carry out the heavy process of mining and thus maintaining the Bitcoin network. The number of new bitcoins generated per block starts at 50 and is halved every 2,10,000 blocks (currently 12.5 BTC per block). Since this is the only way to create new coins, there can be only 21 million bitcoins ever.
The blockchain represents the key innovation of Bitcoin. Since it is distributed and public, once a block has been added to the chain, it cannot be tampered with. It also eliminates the problem of double spending which all forms of digital money are susceptible to. The timeline of Bitcoin, from 2009 to how we got here, can be accessed here.
A single transaction
Each participant in a Bitcoin transaction is uniquely identified by a pair of keys: public and private. The public key is known to the entire network, while the private key is kept secret. The unique property of these keys is that they are complementary. If a transaction is signed using one of the keys, the other one can be used to verify it. So, if A wants to transfer some bitcoins to B, he has to specify the recipient (B’s public key) and the number of bitcoins to be transferred and add his signature to it (using A’s private key). This is then broadcasted to nodes in the Bitcoin network. A’s identity is verified from his signature using his public key. As part of the mining process, two additional things get verified: A has the coins to spend, and he’s not already spent those coins. Once the transaction is validated, it is placed in a block on the blockchain and A and B receive its address, thus completing the transaction and transferring the coins from A to B.
Bitcoins in India
Reserve Bank of India (“RBI”) via press release 2013-2014/1261 dated December 24, 2013 (access here) cautioned the users of virtual currencies stating that they are prone to hacking and their value completely depends upon demand and supply. RBI showed concern for anti-money laundering and financing of terrorism.
RBI via press release 2016-17/2054 dated February 1, 2017 (access here) clarified that it has not given any licence or authorisation to any entity to deal in virtual currency and investment, if any, would be done at the investor’s risk only.
Further, RBI via press release 2017-2018/1530 dated December 5, 2017 (access here) reiterated its earlier press releases.
Thereafter, Arun Jaitely in the annual budget speech declared that crypto-currencies are not a legal tender; however, blockchain technology may be explored for ushering in digital economy.
However, RBI took a leap and via a notification RBI/2017-18/154 dated April 6, 2018 (“April 6 notification”), banned the banking relationship of all the entities regulated by it with all virtual currency platforms and all the investors. It is pertinent to note that virtual currencies are not banned in India but only banking relationships with them. This would essentially mean that direct payment cannot be made through banks, or rather banks cannot provide a platform to transfer money for these purposes.
The April 6 notification was challenged in the Supreme Court by Internet and Mobile Association of India. Considering various pending petitions in various courts with respect to legality of virtual currencies, they were all clubbed together into one petition before Supreme Court. The challenge to the April 6 notification was primarily on two grounds, one being breach on Article 14, which prohibits discrimination and mandates equality unless there is a reasonable classification and the other being breach of Article 19(1)(g) which provides right to freedom to carry any trade, occupation and business.
For interim relief, a stay on the ban was sought, however the same was denied by the Supreme Court on July 3 and the matter is now to be heard on September 14.
Step-siding the notification
In an attempt to side-step the notification, the exchange platforms and the e-wallet entities are providing P2P services, wherein these entities would keep the bitcoins in escrow and would release it to the buyer only on double confirmation of payment from both the parties.
Plausible reasons for prohibition by RBI
The primary concern of RBI is money laundering and financing of terrorism. Other than that, the plausible reasons for prohibition, are the following:
To avoid repetition of Silk Road type fraud cases: Silk Road was a website that was launched in the year 2011, for selling all kind of legal and illegal products like illegal drugs, fake documents, pornography and cigarettes. The only mode of payment was bitcoins. Bitcoins, along with TOR technology, made the payments completely anonymous and could not be traced back to the identity of individuals. However, in 2013, the Federal Bureau of Investigation shut down the website and arrested the person behind it.
Data Privacy Concerns: All transactions are permanently recorded on the blockchain which makes in impossible to tamper with it. However, the transactions can be viewed by anyone. The transactions recorded are pseudonymised and are not completely anonymous. The difference being that, with reasonable effort, it is possible to trace the details of the transaction. Some transactions are confidential and cannot be disclosed for the sake of companies, in those case, financial transparency can be one of the biggest disadvantages of bitcoins.
Jurisdiction: While everything on the internet has jurisdictional issues, nobody has taken responsibility for trading in bitcoins. The central bank has in fact made it clear that individuals may trade in bitcoins at their own peril. With no regulatory authority taking responsibility, there seems to be lack of legal recourse in case of a dispute.
Classification of cryptocurrency globally
While it was originally meant to be a legal tender, it has been now accepted as a legal mode of payment by many entities including PricewaterhouseCooper. However, some countries seem to believe that it is a commodity or a security because of its nature. Below is a classification of bitcoins worldwide:CountryClassificationAustraliaLegal TenderUnited StatesCommodity/ CurrencyJapanLegal TenderUKAsset or Private MoneySouth KoreaAssetSwitzerlandLegal Tender
Laws in the US
Uniform Regulation of Virtual Currency Business Act (URVCBA): This, ready for adoption Act, is a result of a committee formed of eminent lawyers and judges, which regulates only the virtual currency business and not virtual currencies as such.
Anti Money Laundering Regime: Makes Banking Secrecy Act applicable except on the miners. Under the Banking Secrecy Act, all the exchange platforms have to register themselves for trading. This Act only applies when there is an actual transaction between different people. It would not apply where there is no transaction between two people, for instance miners. When they mine bitcoins, it is only for their use and involves no transfer of money.
Investment Regime: Commodity Future Trading Commission, in the year 2015, declared bitcoins to be a commodity. However, judiciary at different times has taken different approach depending upon facts of each case.
Laws in Japan
Japan has declared bitcoins to be legal mode of payment. In order to regulate virtual currencies, Japan has enacted Virtual Currencies Act, 2017. The Act defines it as a “property of value” that is usable for payments to unspecified persons. The Know Your Customer guidelines were later revised to include prevention of transfer of criminal proceeds.
They have strong regulatory requirements for the exchange platforms like
They must hold minimum liquid capital of 10 million Yen;
They must be equipped with sufficient IT system, with measures in place to prevent leakage and damage of funds and personal information;
They must disclose to the customer, detailed information.
Effect on Economy: Japanese financial holdings company Nomura estimates that post the introduction of Virtual Currency Act, gains from bitcoin trading by Japanese investors could see consumer spending rise by 0.2 to 0.4 billion Yen for every jump in asset value wealth of 10 billion Yen. This is attributed to an economic effect called the “wealth effect” which is an increase in consumer spending resulting from a rise in asset values. With Japan sitting on an estimated 5.1 trillion Yen in Bitcoins, it can drive 96 billion yen in personal consumption as per the analysis. In other words, it could lead to a 0.3% increase in the country’s GDP which is about 20% of the projected 1.5% GDP increase of Japan.
Regulating and Legalising in India
While it may be difficult to regulate all the investors and every single transaction, a possible solution seems to be to regulate the exchange platforms instead. Like URVCBA in the US, India could regulate just the exchange platforms and the entities which accept bitcoins as a legal mode of payment. In the absence of such regulation, security of customers’ property is at peril. Bitcoins have added advantages like no payment of taxes because it is a currency with no central authority and relaxation in repatriation process because of its digital nature and no processing fee for the same. Prohibiting them would only be a step back for India.
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