An extract from The Virtual Currency Regulation Review, 3rd Edition

Introduction to the legal and regulatory framework

The Indian population has shown significant interest in virtual currencies. According to the most recent statistics available, there were estimated to be around 5 million traders in India in 24 exchanges, with trading volumes in the range of 1,500 Bitcoins a day.2

As the law currently stands, there is no clear definition of virtual currencies, cryptoassets or cryptocurrencies in India. On 4 March 2020, the Supreme Court of India set aside, on constitutional grounds, a circular (the VC Circular) issued by India's central bank, the Reserve Bank of India (RBI), which restricted the use of regulated banking and payment channels for the sale and purchase of virtual currencies (the IAMAI case).3 This affirmed virtual currency exchanges' fundamental right to trade and do business, guaranteed under the Constitution of India.

In the past, the RBI and the Ministry of Finance had issued warning statements about the risks associated with virtual currencies, including money laundering, consumer protection, market integrity, cybersecurity and volatility. However, various government committee reports have also lauded certain advantages of virtual currencies, such as efficiency and cost-savings.

In July 2019, an Inter-Ministerial Committee established by the Ministry of Finance released a report on a proposed regulatory approach towards distributed ledger technology and virtual currencies (the IMC Report). The Committee recommended an outright prohibition, along with criminal penalties, on dealing with virtual currencies.4 It also recommended the promotion of distributed ledger technology without the use of virtual currencies, and the exploration of a sovereign digital currency. The Committee's recommendation is non-binding and appears to be under consideration by the government.

Currently, despite the IAMAI case, which throws some light on the legal characteristics of virtual currencies, there is no law that expressly classifies virtual currencies as goods or commodities, services, securities, derivatives or currencies. The categorisation of virtual currencies into one or more of these stated classes is important, as the existing law would apply differently based on the categorisation.

At the time of writing, there are over 5,000 virtual currencies in existence,5 all with differing properties, and their categorisation depends on their nature.6 For instance, some are intended to be electronic cash (e.g., Bitcoin) and some are intended to be 'gas' for computer processing operations (e.g., Ether).

As there is no specific legislation regulating virtual currency, the laws referred to in this chapter are all of general application and we have interpreted them in the context of virtual currency.

Securities and investment laws

i Virtual currencies as securities

As the law currently stands, virtual currencies in the nature of Bitcoin and Ether are unlikely to attract regulations relating to securities. The Securities Contracts (Regulation) Act 1956 (SCRA) provides a non-exhaustive definition of securities, and there is currently no regulatory guidance on its application in the virtual currency context. Virtual currencies do not fall within the enumerated items of the definition. Further, the items under the definition derive their value from an underlying asset. However, virtual currencies like Bitcoin and Ether do not have underlying assets. Rather, the value is determined purely based on demand and supply. Further, virtual currencies such as Bitcoin often do not have an identifiable issuer, unlike the items in the definition of security under Indian law.

Even when considering the ordinary meaning of the word 'security', the word is defined in Black's Law Dictionary 7 to include an instrument evidencing a holder's ownership rights in a firm or a holder's creditor relationship with a firm (or government). It also states that a security indicates an interest based on investment in a common enterprise. Virtual currencies, including Bitcoin and Ether, do not have such ownership rights, credit relationships or investment in a common enterprise. Therefore, such virtual currencies are unlikely to fall within the definition of securities.

However, some tokens (although not all) issued through initial coin offerings (ICOs) may fall within the ambit of the SCRA if they are issued by an Indian entity and meet the above tests. This is likely to be the case if they are issued by an identifiable issuer and are backed by the underlying assets of the issuer. Such tokens should be subject to regulation under the Companies Act 2013 (the Companies Act) (in respect of requirements surrounding the issuance and transfer of securities) and the SCRA (in respect of securities only being allowed to be listed on licensed stock exchanges).

Some issuances of virtual currency tokens may also amount to collective investment schemes, which are regulated under the Securities and Exchange Board of India Act 1992.8

ii Deposits

Since many token sales involve the acceptance of money or other tokens, it is relevant to analyse what regulations other than securities regulations (e.g., for tokens that do not qualify as securities) apply in such sales.

The regulations under the Companies Act and the Companies (Acceptance of Deposits) Rules 2014 (Deposits Rules) specify when the receipt of money, by way of deposit or loan or in any other form, by a company would be termed a deposit, and also provides certain exemptions from its applicability. For example, any amount received in the course of business as an advance for the supply of goods or services would not be a deposit if the advance is appropriated against the supply of such goods or services within 365 days. If a company is deemed to be accepting deposits, a variety of compliance steps under the Companies Act and its rules, along with RBI regulations, would be triggered. Only the receipt of money, and not virtual currency, would trigger these steps.

Further, after the issuance of the Banning of Unregulated Deposit Schemes Act 2019, virtual currency token issuers will need to ensure, to be outside the purview of the Act, that any money received should not be liable to be returned.9

iii Regulation as commodities

In the IAMAI case, the Supreme Court expressed some doubt over whether a virtual currency could be classified only as a good or commodity. Ultimately, it held that a virtual currency is an intangible property which acts under certain circumstances as money.

India is a country with capital controls, where the inflow of foreign exchange into and outside the country is regulated under the Foreign Exchange Management Act 1999 (FEMA). If virtual currencies are classified as commodities, the activity of operating an exchange for trading virtual currencies may be regulated as a commodities exchange, which can have implications under India's regulation on inward foreign direct investment (FDI), that is, the Foreign Exchange Management (Non-debt Instruments) Rules 2019 (the NDI Rules).

Within the commodity space, there are two relevant concepts: a commodities spot exchange, which deals with ready delivery, and a commodities derivative exchange, which deals with derivative contracts. The NDI Rules restrict the amount of foreign investment into commodity spot exchanges to up to 49 per cent of the share capital, without government approval. The SCRA requires that any exchange facilitating commodity derivatives needs to be a recognised stock exchange (i.e., a licensed entity).

As the law stands, virtual currencies may not be regulated as commodities within the meaning of the NDI Rules. According to a Securities and Exchange Board of India (SEBI) Circular10 read with a central government notification11 under the SCRA, the central government has notified certain goods for the purpose of the term commodity derivative under the SCRA and does not include any virtual currency. While this notification is only applicable to commodity derivatives and not ready delivery contracts, it provides the closest guidance on the point of what may be considered a commodity exchange at the moment.

However, the central government may at any time choose to notify virtual currencies (in general, or any class of them) as commodities under the above notification. This would bring derivatives contracts in virtual currencies within the SCRA (and hence, SEBI's jurisdiction). For spot trading, FDI would then be restricted to 49 per cent of the capital. There is currently no separate licensing regime for commodities spot exchanges.

Other implications of a virtual currency amounting to a good or commodity (under foreign exchange control laws) are discussed in Section X.

iv FDI in Indian virtual currency-based businesses

The IAMAI case held that the RBI had jurisdiction over issues relating to virtual currencies, as virtual currencies act as money under certain circumstances. This poses the question of whether virtual currency businesses will be restricted because they are 'other financial services' (OFS) under the NDI Rules. FDI in OFS is permitted without government approval in up to 100 per cent of the Indian entity's equity except where: the financial services activity is not regulated by any financial sector regulator (RBI); only part of the financial services activity is regulated; or there is doubt regarding the regulatory oversight. It can be argued that since the IAMAI case clearly lays down that the RBI has jurisdiction over the virtual currency space, there is no doubt regarding the regulatory oversight and, hence, FDI is permitted without government approval.

Additionally, it can be argued that most business models facilitating the buying and selling of virtual currencies can be characterised as e-commerce marketplaces, in which foreign equity investment is permitted up to 100 per cent of the entity's capital, without government approval. The term e-commerce has been defined by the NDI Rules to mean 'buying and selling of goods and services including digital products over digital and electronic networks'. As discussed in Section X, virtual currencies such as Bitcoin and Ether can be characterised as goods or digital products.

Banking and money transmission

i No prohibition on dealing in virtual currencies

The VC Circular prohibited regulated financial institutions (including banks and payment processors) from dealing with virtual currencies or providing services for facilitating any person or entity in dealing with or settling virtual currencies.12 In the IAMAI case, this restriction was set aside by the Supreme Court and is therefore no longer valid in law. Further, the RBI responded to a citizen's Right to Information request stating that there was no prohibition on banks from dealing with virtual currency businesses.13

ii Payment and Settlement Systems Act 2007

As many virtual currencies are used as a means of value exchange, questions arise as to whether any authorisation or compliance is required under the Payment and Settlement Systems Act 2007 (the PSS Act). Under Section 2(1)(i) of the PSS Act, a payment system is defined as 'a system that enables payment to be effected between a payer and a beneficiary'. If virtual currency-based systems do form payment systems, any person commencing or operating them will require the authorisation of the RBI under Section 4(1) of the PSS Act.

There is nothing in the PSS Act to exclude virtual currency, since only the term payment is referred to, as opposed to currency, legal tender or money. Therefore, it needs to be judged whether a particular cryptocurrency-based system enables payment to be effected between a payer and a beneficiary, or a person to commence or operate such system.

Arguably, many virtual currencies are not part of a system that enables payment to be effected between a payer and a beneficiary. A user may, for example, merely buy virtual currency using fiat currency for investment purposes and never choose to make any payment with it, and then dispose of it in return for fiat currency. There would be no payment, payer or beneficiary in this connection, and it would resemble the sale and purchase of an asset such as gold. Further, the fact that the value underlying the virtual currency is not backed or guaranteed by the issuing entity or any other party (i.e., holders of virtual currencies cannot redeem them for value to the issuer (other than as a sale through ordinary market channels)) supports the view that a virtual currency is likely not to be considered a payment system.

Under this view, virtual currencies can be characterised as goods or digital products that people are trading just as they would any other digital products, such as music files or e-books.

Furthermore, owing to the decentralised nature of many virtual currencies, including Bitcoin, the issuers who do commence systems as a matter of practicality cannot be identified. This would mean even if decentralised virtual currencies amount to payment systems, regulators may be unable to pursue the issuers, as they are anonymous. In addition, as is the case with decentralised virtual currencies, entities without power, influence or control over a system are unlikely to be liable for operating it, as the ledger functions independently of any operator.

Even if there is a centralised issuer, that issuer may merely create and release tokens, which are then listed on virtual currency exchanges: the issuer may not play a payment, clearing or settlement role. In this case, a virtual currency can be seen as a licence to use the particular virtual currency ledger and the licence is freely tradable in the open market.

However, a counterargument to the above analysis can be made that a virtual currency blockchain does create a technology to enable the transfer of value from person to person, and hence enables payment to be effected between parties. According to this argument, many virtual currency blockchains may amount to payment systems, requiring the entities commencing or operating them to obtain authorisation under the PSS Act.

According to the RBI's submissions in the IAMAI case, virtual currencies do not amount to payment systems under the PSS Act.