Money is not coin and banknotes. Money is anything that people are willing to use in order to represent systematically the value of other things for the purpose of exchanging goods and services.
-Yuval Noah Harari, Sapiens (2011)
Brief Overview
The history of usage of money dates back thousands of years to ancient civilizations. It evolved from bartering to the use of commodities like shells, salt, and precious metals. As societies grew, standardized forms of currency issued by the State Sovereigns, such as coins and paper money, emerged to facilitate trade and overcome the limitations of bartering. In modern times, digital currencies and cryptocurrencies have emerged, adding new dimensions to the concept of money, resulting in challenges to the traditional systems of value exchange. Cryptocurrencies, like Bitcoin, Ethereum and Tether (to name a few) have disrupted and had a significant impact on the traditional domains of sovereign entities in the realm of finance and monetary policy.
What is Cryptocurrency?
A cryptocurrency is a form of virtual asset based on a network that is scattered across a huge number of computers and cryptography (encryption technique) which is used to verify transactions instead of relying on banks. Transactions relating to cryptocurrency are decentralized that allows it to exist outside the control of the government or authorities.
At their core, cryptocurrencies are built around the principle of a universal, inviolable ledger, one that is made fully public and is constantly being verified by high-powered computers, each essentially acting independently of the others.
Various governments across the globe either explicitly or impliedly recognize Cryptocurrencies, or Virtual Currencies (‘VCs’) as a digital representation of value and that they are capable of functioning as (i) a medium of exchange and/or (ii) a unit of account and/or (iii) a store of value.
The IMF, the FATF, the European Central Bank, the Financial Conduct Authority of the United Kingdom, Internal Revenue Service which is the Bureau of the Department of Treasury, United States, and the Canadian Revenue Authority treat virtual currencies as digital representations of value. The European Central Bank went a step further by describing a virtual currency as a type of unregulated digital money. The Internal Revenue Service of the United States has recognized that a virtual currency can function in the same manner as a country’s traditional currency. The Securities and Exchange Commission, USA also recognizes that virtual currencies are intended to perform many of the same functions as long-established currencies such as US Dollar, Euro, or Japanese Yen. Yet another wing of the United States Department of Treasury namely Financial Crimes Enforcement Network calls virtual currency as a medium of exchange that operates like a currency in some environments, though it may not have all the attributes of a real currency.
At this juncture, it is essential to understand how the cryptocurrency work and are exchanged, with the example of Bitcoin which is widely considered to be the first cryptocurrency. Bitcoin was introduced in a whitepaper titled “Bitcoin: A Peer-to-Peer Electronic Cash System” published by an individual or group using the pseudonym Satoshi Nakamoto in October 2008. In January 2009, the Bitcoin network was launched, marking the birth of Bitcoin.
Rather than relying on a central bank or company to issue and keep track of the money, this system was set up so that every Bitcoin transaction, and the holdings of every user, would be tracked and recorded by the computers of all the people using the digital money, on a communally maintained database that would come to be known as the Blockchain.
The process by which this all happened had many layers, and it would take even experts months to understand how they all worked together. But the basic elements of the system can be sketched out in rough terms and were in Satoshi’s paper.
According to the Satoshi’s paper, each user of the system could have one or more public Bitcoin addresses – sort of like bank account numbers – and a private key for each address. The coins attached to a given address could be spent only by a person with the private key corresponding to the address. The private key was slightly different from a traditional password, which must be kept by some central authority to check that the user is entering the correct password. In Bitcoin, Satoshi harnessed the wonders of public-key cryptography to make it possible for a user to sign off on a transaction, and prove he has the private key, without anyone else ever needing to see or know his private key.
Once the user signed off on a transaction with his private key, he would broadcast it out to all the other computers on the Bitcoin network. Those computers would check that the user had the coins he was trying to spend. They could do this by consulting the public record of all Bitcoin transactions, which computers on the network kept a copy of. Once the computers confirmed that user’s address did indeed have the money he was trying to spend, the information about user’s transaction was recorded in a list of all recent transactions, referred to as a block, on the blockchain.
The result of this complicated process was deceptively simple but never previously possible: a financial network that could create and move money without a central authority. No bank, no credit card company, no regulators. The system is designed so that no one other than the holder of a private key could spend or take the money associated with a particular Bitcoin address. What’s more, each user of the system could be confident that, at every moment in time, there would be only one public, unalterable record of what everyone in the system owned.
To believe in this, the users didn’t have to trust a central authority like the users of the traditional currencies had to trust the Reserve Banks, they only had to trust their own computers running the code which was open source and therefore available for everyone to review and change. People who joined the Bitcoin network were, quite literally, both customers and owners of both the bank and the mint.”
Bitcoin (as well as other cryptocurrencies) can be stored in wallets[1], both online such as websites and apps as well as hardware wallets such as hard disk drives and cold wallets which are not connected to the internet.
Cryptocurrency and Cross Border Transactions
In India, foreign trade, foreign investment, and all forms of cross-border transactions are governed by the Foreign Exchange Management Act, 1999 (‘FEMA’). The applicability of FEMA and related rules on cross-border cryptocurrency transactions is still ambiguous. FEMA under Section 2(h) provides for an exhaustive definition of “Currency” however a residuary power has been given to the Reserve Bank of India (‘RBI’) to declare any instrument similar to the ones listed in definition as currency. It may be noted that the RBI has not notified Cryptocurrency/ VC as ‘currency’, hence as of now cryptocurrency cannot be classified as “currency”.
It is pertinent to mention that such notification by RBI will require complex framework and would be counterproductive for users of cryptocurrency as one of the salient features of cryptocurrency is it being delinked from the sovereign guarantee.
Furthermore, Section 2(m) of FEMA defines “foreign currency” as any other foreign currency except Indian Currency. Since Cryptocurrency/ Virtual Currency doesn’t fall under the ambit of Section 2(h), it cannot be termed as foreign currency. Further, as per Section 2(n) of FEMA, “foreign exchange” includes foreign currency and various instruments payable in foreign currency. Therefore, since it has been established that cryptocurrency is not “foreign currency”, by extension, cryptocurrency is also not “foreign exchange”.
The problem that now arises is that there exists neither a specific classification for cryptocurrencies nor regulations pertaining to import and export of cryptocurrency under FEMA. Moreover, as per Section 3 of FEMA, only authorised persons or persons who have been permitted in this regard by RBI can deal in foreign exchange or cross-border transactions outside India.
The RBI issued certain statement[2] and circular[3] directing the entities regulated by it to not to deal with or provide services to any individual or business entities dealing with or settling virtual currencies, and to exit the relationship, if they already have one, with such individuals/ business entities, dealing with or settling virtual currencies. The said statement and circular was challenged before the Supreme Court of India by Internet and Mobile Association of India. The Supreme Court of India in its judgment dated 04.03.2020[4] held that statement and circular issued by the RBI were unenforceable and illegal due to lack of proportionality without declaring that cryptocurrencies were legal or illegal. In the said judgment it was also observed that the Cryptocurrencies are not regulated in India because there is no law on this issue. Till date there is no law regulating Cryptocurrencies in India.
It is pertinent to mention that the Legislature had already drawn up a bill namely “Crypto Token and Crypto Asset (Banning, Control and Regulation) Bill, 2018”, but the same was not enacted. The Government’s second draft for crypto legislation, “The Banning of Cryptocurrencies and Regulation of Official Digital Currency Bill, 2019” which sought blanket ban on cryptocurrencies also remained on paper. Thereafter, “The Cryptocurrency and Regulation of Official Digital Currency Bill” seeking to prohibit all private cryptocurrencies in India and create favourable framework for the creation of digital currency issued by the Reserve Bank of India was scheduled to be introduced in the Winter Session in 2021, however, it also hasn’t seen light till now.
As explained above, neither there is any legislation to regulate cryptocurrencies nor the definition of currency under FEMA is wide enough for cryptocurrency to be classified under it. However, they can be bought and sold, transmitted, transferred, delivered, stored, and possessed and these peculiar features along with demand for these cryptocurrencies for these purposes indicates their utility. It could be argued that the nature of cryptocurrencies could be associated to that of goods under FEMA, however, the legislature is yet to make any observation on these lines.
Such theoretical classification will imply and that if a person resident in India enters into transaction with a person resident outside India, it will be considered as export and import and accordingly, the provisions of FEMA will apply to such transactions.
Cryptocurrency and Money Laundering
As per Section 3 of Prevention of Money Laundering Act (‘PMLA’), 2002, any person who directly or indirectly attempts to indulge or knowingly assists or knowingly is a party or is involved in any process or activity connected with the proceeds of crime including its concealment, possession, acquisition or use and projecting or claiming it as untainted property shall be guilty of offence of money-laundering.
The Indian Government imposed Anti-Money Laundering (‘AML’) provisions on Virtual Digital Assets (‘VDA’) vide Ministry of Finance notification dated 07.03.2023. VDA has been assigned the same meaning as defined under Section 2 (47A) of Income Tax Act, 1961[5].
Impacts of the abovementioned notification:
- VDA service providers (including exchanges, custodians, wallet providers) have now become ‘Reporting Entities’ under PMLA Act and will have to follow reporting standards and Know Your Customer (‘KYC’) norms as the other regulated entities like banks, securities intermediaries, payment system operators do. VDA service providers now will also have to comply with obligations which are applicable to “Reporting Entities” inter alia being, maintaining record of transactions and/or reporting and furnishing the details of suspicious transactions. On non-compliance with the said rules, there is provision of monetary penalty on reporting entity of an amount not less than Rs. 10,000 which may extend to Rs. 1,00,000 for each failure.
I.The following transactions were brought under the ambit of PMLA:
a. Conversion of VDA to Currencies and vice versa
b. Conversion of one VDA to another VDA (E.g., Bitcoin to Ethereum)
c. Transfer (sale and purchase) of VDAs
c.Sale of VDAs
e.Safekeeping, storage, and administration of VDAs or instruments enabling control over VDAs.
II. Moreover, Enforcement Directorate (‘ED’) now has power to search and seize while investigating any VDA Service Provider under PMLA as well as VDA Service Providers could now be subjected to penal provisions of the act.
Stages at which Money Laundering is possible
A. Exchanges
Exchanges on which the users are not identified as per the recognised AML practices and fail to perform strict and thorough checks allow cryptocurrencies to be traded across various markets, deposited into unregulated accounts and traded for different altcoins.
B. Cryptocurrency Smurfing Scheme
In this method a smurf or a mule is used to launder the money. A money mule is a person that transfers on behalf of the person seeking to launder money. Money launderers usually utilize numerous money mules as front men, then break up and divide large funds between them to avoid easy detection.
C. Prepaid Cryptocurrency Cards
Prepaid debit cards can be loaded with cryptocurrency. Once the prepaid debit card is loaded, the funds can then be utilised for different types of illegal activities. They can be traded for other currencies or handed off to third parties.
D. Online Gambling
There are numerous online gambling and gaming websites that accept cryptocurrencies. Cryptocurrency can be used to buy credit or virtual chips. Usually, the money launderers would play for a few rounds and then cash out again after just a few small transactions. By doing so, the money launderer has an explanation for the origin of the funds right away. He can simply claim that the funds are the proceeds from winning in online games.
E. Cryptocurrency Peer-to-Peer Networks
The peer-to-peer architecture of blockchain allows all cryptocurrencies to be transferred worldwide, without the need of any middle-man or intermediaries or central server. Many criminals turn to these decentralized peer-to-peer networks to lower crypto money laundering risk, which is frequently international. Here, they can often use unsuspecting third parties to send funds on their way to the next destination. Most cryptocurrency money laundering schemes end with the clean coin funnelled into exchanges in countries with little or no AML regulations. It’s here that they can finally convert it into local fiat and use it.
F. Cryptocurrency Mixing Services (Tumblers)
A cryptocurrency tumbler or cryptocurrency mixing service is a service that mixes potentially identifiable or “tainted” cryptocurrency funds with others, so as to obscure the trail back to the fund’s original source for a percentage transaction fee. Tumblers can be used to split up the dirty cryptocurrency effectively. Tumblers send it through various addresses and then recombine it—the reassembly results in a new, rather clean, and hardly traceable amount of cryptocurrencies. In most laundering cases that involve tumblers, the cryptocurrency starts in a legitimate wallet and is then transferred to a wallet in the dark web making multiple hops before landing in a second dark web wallet. At this point, the currency is clean enough to bring it back up to the whitenet and trade it on a legitimate cryptocurrency exchange or even sell it for fiat currency.
Conclusion
The current status of legality pertaining to cryptocurrency in India is ambiguous, as it is not officially recognized as a currency or legal tender. The ED operating under FEMA, frequently conducts raids on cryptocurrency exchanges in India due to suspected violations of foreign exchange laws. Therefore, it can be concluded that an Indian resident engaging in cryptocurrency transactions with a non-resident without proper documents and KYC are likely to be seen as violating India’s foreign exchange regulations. It is important to note that regulations specifically addressing cryptocurrency are still in the process of being formulated in India, with the aim of facilitating and regulating both domestic and international cryptocurrency transactions. Although this article does not delve into the applicability of Information Technology Act, 2000 to such transactions, but the nature of such transactions would inevitably attract the provisions of the said act in conjunction with the FEMA and PMLA.
Further, with the inclusion of requirement of VDA service providers to report transactions, it is expected that there will be a surge in ED investigations and consequent attachment of money which is already a staggeringly high figure[6]. The question confronting the ED is whether it can balance the competing interests of the uninformed public who may have invested in cryptocurrency, while simultaneously leveraging its own capabilities to explore the crypto market and uncover its intricacies.
Author: (Left to right) Apoorva Mishra, Gaurav Bhalla, Nishant Rewalia
Footnotes
[1] Wallets are used for storing and managing digital assets. Broadly there are two types of wallets, namely hot wallets and cold wallets. The main difference between the two lies in their connection to the internet and their level of security.
- Cold Wallet: A cold wallet, also known as an offline wallet, is a cryptocurrency wallet that is not connected to the internet. It is typically stored on a physical device, such as a hardware wallet or a paper wallet. They offer a high level of security because they are not connected to the internet, making it difficult for hackers to access the private keys and are typically used for long-term storage of cryptocurrencies or for holding large amounts of digital assets.
- Hot Wallet: A hot wallet, on the other hand, is a cryptocurrency wallet that is connected to the internet and readily accessible for transactions. It can be a software wallet installed on a computer or mobile device, or it can be a web-based wallet provided by a cryptocurrency exchange. They are suitable for holding smaller amounts of cryptocurrencies that user needs for regular transactions or trading. However, due to their online connectivity, they carry a higher risk of potential security breaches.
[2] Statement on Developmental and Regulatory Policies dated 05.04.2018.
[3] Prohibition on Dealing in Virtual Currencies (VCs) dated 06.04.2018
[4] Writ Petition No. 528 0f 2018 titled as Internet and Mobile Association of India Vs. Reserve Bank of India 2020 SCC Online 275
[5] Section 2 (47-A) “virtual digital asset” means—
(a) any information or code or number or token (not being Indian currency or foreign currency), generated through cryptographic means or otherwise, by whatever name called, providing a digital representation of value exchanged with or without consideration, with the promise or representation of having inherent value, or functions as a store of value or a unit of account including its use in any financial transaction or investment, but not limited to investment scheme; and can be transferred, stored or traded electronically;
(b) a non-fungible token or any other token of similar nature, by whatever name called;
(c) any other digital asset, as the Central Government may, by notification in the Official Gazette specify:
Provided that the Central Government may, by notification in the Official Gazette, exclude any digital asset from the definition of virtual digital asset subject to such conditions as may be specified therein.
Explanation.—For the purposes of this clause,—
- “non-fungible token” means such digital asset as the Central Government may, by notification in the Official Gazette, specify;
(b) the expressions “currency”, “foreign currency” and “Indian currency” shall have the same meanings as respectively assigned to them in clauses (h), (m) and (q) of section 2 of the Foreign Exchange Management Act, 1999 (42 of 1999).]
[6] The data released by the Enforcement Directorate as on 31-3-2022 shows – INR 1,04,702 crores which has been attached by the ED, cases recorded for investigation–5422, making it an average of ~20 crores per investigation.