Despite the lack of an investigation into the implication of VCs for the Indian economy, RBI had stated several reasons in the notifications issued by it, which are analyzed below individually:
a) Prone to Security-related Risks
RBI’s concern– The notifications stated that VCs are prone to hacking, loss of password, compromise of access credentials, malware attacks, etc.
Analysis– In this respect, it is stated that all authorized payment systems that work through the internet are also susceptible to security risks mentioned by RBI. Recently, in May 2018, hundreds of millions were stolen from Mexican Banks by hacking their payment system.[1] In 2016, approx. $171 million were siphoned from Union Bank of India and transferred overseas to other banks.[2] Various other major incidents have been cited by RBI itself from time to time.[3] Moreover, there is no clarity on how the risk was determined by RBI as it was clearly stated in its RTI response. It can be said that this reason does not hold ground because electronic services provided by banks and e-wallets like PayTM are prone to security risks just as much as the bitcoins and other VCs.
The solution to the concern- To ensure adequate cybersecurity preparedness of the VC exchange systems, in light of the recent hacking incidents and their impact on the currency, it is imperative to regulate these exchanges to enhance their resilience towards such unfortunate events. (i) In order to permit VC exchanges to provide services to its customers, RBI should promulgate certain guidelines with certain technical specifications and make it mandatory for exchanges to adopt them; and (ii) VC exchanges should be required to put in place a policy on cybersecurity expounding their strategy and principles to combat such security-related threats, which for the purpose of approval may be submitted to RBI.
b) Recourse to Customer Disputes
RBI’s concern- RBI showed the concern that these transactions are peer to peer-based, and there is no established framework for recourse to the consumer in case of disputes and problems.
Analysis– It is stated in this respect that it is the duty of the government to ensure the protection of its citizens’ interests and enacts legislation to ensure efficient dispute resolutions. In Japan, virtual currency exchange service providers are required by legislation to seek resolution through a financial alternative dispute resolution mechanism that aims to resolve disputes through a Designated Dispute Resolution Organization (Shitei funso- kaiketsu kikan). Moreover, a self-regulatory organization called Japan Blockchain Association has been in place since April 15, 2016 which intends to obtain the status of Certified Association for Payment Service Providers in the near future as set forth in their Payment Services Act (articles 87ff) in order to, inter alia, provide guidance and recommendations to its members, establish rules that are necessary for the appropriate management of the business, investigate the status of compliance, and address user complaints.
Solution- While the technology on which VCs operate, i.e. Blockchain, is secure, VC exchanges that play an intermediary role crucial for increasing the amount of trade, are prone to hacking. In light of the recent increase in hacks such as the Coincheck hack, the largest hack after Mt. Gox which was the world’s largest bitcoin trading exchange before its collapse, it is imperative to ensure efficient customer recourse. (i) Appropriate systems and procedures should be in place by such exchanges to ensure that customers feel safe about transacting in bitcoins, which may include robust and dynamic fraud detection, measures to mitigate risks, repeatedly advising customers on how to protect themselves from such frauds, etc.(ii) Since the VC transactions are irreversible, it should be ensured that customers’ liability is clearly determined in the cases where the deficiency is on the part of the exchange, or where there is a third-party breach and where the loss is due to negligence on the part of the customer. (iii) Ensure that there is a designated dispute resolution mechanism in place by every exchange to ensure faster resolution of disputes. (iv) There should be a suitable reporting mechanism in place in every exchange and a committee shall be formulated therein to address any concerns that the customers might have.
c) Extreme Volatility
RBI’s concern– RBI expressed concern over the huge volatility in the value of VCs arising out of speculative trading without the backing of any asset.
Analysis– With regards to the lack of asset backing, it can be observed that both fiat and virtual currencies have no intrinsic value. While a fiat currency derives its value from the trust people place in the government that backs it, the value of a VC arises purely out of market forces. Both fiat and virtual currencies are subject to volatility in the exchange market. However, in the case of a fiat currency, the central bank can take steps to influence its value based on certain macroeconomic targets, thereby keeping the volatility at the desired rate. While this keeps the value of a currency from fluctuating too wildly, it also exposes a currency to shocks due to actions of other central banks. For example, in January 2015, the Swiss National Bank (SNB) abandoned its cap on the Franc’s value against the Euro, causing the Euro to drop to its lowest level against the US Dollar since November 2003.[4] In terms of the Volatility Index (with respect to USD), a standard deviation based measure, Bitcoin started in 2018 at around 8% and has fallen to around 3% now.[5] While this is still high in comparison to gold, which generally has about 1.2%, or major currencies that lie in the range of 0.5% to 1.0%, the trend of decreasing volatility is an indicator of the improving stability of Bitcoins and VCs in general. A research paper[6] published in May 2017 analyzes the viability of Bitcoin as an alternative to fiat currencies. Identifying price volatility as its biggest challenge to functioning as a method of payment, the paper offers an empirical analysis of Bitcoin’s volatility using a GARCH model and concludes that if the trend of decreasing volatility holds, it could be a functional alternative to fiat currencies in two to three years. Though the trend was interrupted by a massive price rise and subsequent market correction, the current volatility level of about 3% is similar to the level exhibited by data analyzed in the paper (August 18, 2010, to March 17, 2017). It can thus be concluded that in the next two to three years, ceteris paribus, the volatility index of Bitcoins will be within the range of most popular currency pairs enabling mass adoption of Bitcoin as a stable method of payment. The higher volatility of VCs as compared to fiat currencies can be attributed to the following reasons:
A vast majority of coins are held by the early adopters and investors. “About 40 percent of bitcoin is held by perhaps 1000 users”, says Aaron Brown, former managing director and head of financial markets research at AQR Capital Management. Liquidating even a small portion of any individual’s holdings can exert negative pressure on the exchange rate of VCs.
The market cap of VCs is much smaller than major fiat currencies and is an aggregate of even smaller exchanges spread across the world. This makes them more vulnerable to fluctuations in demand and supply that could arise out of factors such as regulatory action or market sentiment. Currently, the value of all the VCs put together is about 300 billion USD[7] while there is approximately 1.67 trillion USD in circulation.[8]
A classic rule in economics states that higher the liquidity, lower is the volatility. Liquidity is a measure of demand and supply in the market. Thus, if the demand and supply increase, fluctuations in prices decrease. The validity of the rule can be observed in exotic currency pairs that exhibit the most volatility in the forex market. For example, the Turkish Lira currently has a volatility index of 6.56% (against USD)[9] which is almost double that of Bitcoin. The major reason for the low liquidity of VCs is their limited acceptance arising out of uncertainty about their nature among regulatory authorities.
Solution– Since VCs are designed to operate entirely on market forces which favor equilibrium in the long run, extreme volatility can be controlled by regulatory authorities by clarifying the nature and legal status of VCs within their jurisdiction and preventing market manipulation. VCs are vulnerable to a variety of manipulation techniques due to loopholes in the algorithms governing them, including but not limited to, trading with oneself (“wash trades”), placing a large order to influence market sentiment and canceling as the price approaches that level (“spoofing”), exchange operators using prior knowledge of orders to make trades before customers (“front-running”) and insider trading on their own exchange. It is suggested that RBI notify VCs as currencies and recognize them as foreign currencies in order to bring them under the ambit of the Foreign Exchange Management Act, 1999 (FEMA). Further, INR-VCs trading pairs are to be permitted and VC exchanges to be recognized as “authorized persons” as defined under Section 1(c) of the Act, giving RBI regulatory oversight of VC exchanges and allowing it to minimize fraudulent trades and market manipulation.
d) Money Laundering and Financing Terrorism
RBI’s concern– One of the major concerns shown by RBI is that it could be used for illicit activities and the anonymity of transactions could lead to breaches of anti-money laundering guidelines and financing of terrorism.
Analysis– The conclusion reached by RBI is solely based on “media reports” as, admittedly, RBI has not done its own research before concluding in this regard. Further, these “media reports” on which RBI has relied to reach this conclusion have not been disclosed. RBI seems to have not taken into cognizance that the established exchanges in India are strictly following Know Your Customer (“KYC”) and Aadhar linking. Money laundering is a common phenomenon even with fiat currency. It is controlled by placing proper regulations in place for curbing such practices by strictly following KYC norms. The United Nations Office on Drugs and Crime (UNODC) estimates that around 2 – 5% of global GDP, or $800 billion to $2 trillion, is laundered annually[10]. In contrast, data collected by CipherTrace indicates that about $1.5 billion[11] of funds stolen from VC exchanges will be laundered by the end of the year, which is a minuscule fraction of the global amount. Japan, a VC revolutionary, had only 669 reported incidences of money laundering out of a total of approx. 4,00,000 reported cases of money laundering, which means VCs amounted to only about 0.2% of all suspected money laundering cases[12]. Such a small percentage seems to undermine the argument that VCs are a tool for criminals to wash their money. As opposed to the popular belief that VCs are a gateway for money laundering, it must be noted that the blockchain is extremely transparent and therefore money laundering activities can, in fact, be tracked, thereby reducing the thriving black economy. As mentioned in the recent RBI report, prohibition of banking relationships has led to exchanges engaging in peer to peer transactions which involves increased usage of cash. A large amount of cash-based transactions is a gateway for money laundering and terrorism. Migration of exchanges to offshore locations has further raised concerns for taxation issues. It must be noted that regulating VCs would make the task of government easier and enable them to keep a close watch.
Solutions: There is a threat of VCs being used for illegal activities like money laundering and financing terrorism just as much as it exists for fiat currencies. In order to tackle the issue, following regulations are recommended: (i) It should be mandatory for all exchanges to have an anti-money laundering policy in place which should comply with existing Prevention of Money Laundering Act, 2002, Prevention of Money Laundering (Maintenance of Records) Rules, 2005 and existing Know Your Customer Directions dated February 26, 2016, bearing no. RBI/DBR/2015-16/18.[13] (ii) Exchanges must provide the authorities with customer information on a timely basis when such cases are suspected. (iii) Exchanges must be made to strictly observe such guidelines prescribed for money laundering by the government and RBI. (iv) RBI must be informed immediately of any suspicious activities and all the exchanges should also be alerted to trace such a transaction through an automated tagging system. By tagging stolen funds as tainted funds, it would be easier for exchanges to verify if the funds are withdrawn or deposited to a regulated exchange.
Conclusion
The internet has fundamentally changed the way society functions and improved human relations and commerce. VCs are an application of this decentralized technology to financial markets. It is imperative that governments and regulators all across the world gain an understanding of the impact of VCs on the economy and publicly disclose their findings and opinions. VCs have many advantages over fiat currencies such as, for instance, the transactions are entirely traceable as each one of them is publicly visible on the distributed ledger system. Further, VCs are becoming increasingly capable of fulfilling all the functions of fiat currency. Since the number of VC users is rising day by day, the best way to protect economic and financial order would be the acceptance of VCs by the government and regulating it to ensure best practices by users and exchanges. In the meantime, all exchanges should ensure there is some self-regulation in place. It must be ensured that such self-regulation do not go beyond the scope of general laws of the country where it is based. It is obvious that the client base would be spread across the world and therefore, verifying procedures must be put in place keeping in mind all such factors. In order to increase acceptance and reduce the risk associated with VCs, the following must be implemented:
Firstly, all exchanges must have a compliance program and laid down methods to prevent money laundering;
Secondly, ensuring that proper verification norms are in place is a must. However, one should not ask of information which may not be relevant from the KYC perspective.
It must be borne in mind that usage of VCs shares many similarities with banking activities; hence, some of those regulations may be made directly applicable to exchanges with a higher consideration for usage of technology. In conclusion, hasty action without being backed by research will only result in alienating the VC community in India. Exchanges will relocate to more favorable countries, leading to jurisdictional (no access to transaction data recorded on the blockchain), economic (lost opportunities for taxation) and social (brain drain of blockchain talent from India) losses.
[1] Thomsan Reuters, Mexico central bank to create cyber security unit after hack, May 16, 2018, Access at https://in.reuters.com/article/us-mexico-cyber/mexico-central-bank-to-create-cyber-security-unit-after-hack-idINKCN1IG3AB
[2] S. S. Mundra, Information Technology & Cyber Risk in Banking Sector – The Emerging Fault lines, October 2016, access at https://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/03SP70CD258133744A519C13600F06096418.PDF
[3] ibid
[6] Vavrinec Cermak, Can Bitcoin Become a Viable Alternative to Fiat Currencies? An Empirical Analysis of Bitcoin’s Volatility Based on a GARCH Model, (May 2, 2017) , access at
[8] Board of Governors of Federal Reserve System, Frequently Asked Questions, access at Questionshttps://www.federalreserve.gov/faqs/currency_12773.htm
[10] United Nations Office on Drugs and Crime, Money-Laundering and Globalization, access at https://www.unodc.org/unodc/en/money-laundering/globalization.html
[11] CipherTrace, Q2 Crypto AML Report Summary, access at https://ciphertrace.com/q2-crypto-aml-report/
[12]Japan Financial Intelligence Center (JAFIC), Annual Report (2017), access at https://www.npa.go.jp/sosikihanzai/jafic/en/nenzihokoku_e/data/jafic_2017e.pdf
[13]Reserve Bank of India, Master Direction – Know Your Customer (KYC) Direction, 2016 (February 25, 2016) access at
Comments