Editorial Notes

[Editorial Notes] Regulation of Cryptocurrency Exchanges

Crypto currencies have begun to alter the existing means of electronic payments, money transfers, policies and regulations. However, there are several concerns which demand their regulation and supervision
By IASToppers
June 04, 2020

Contents

  • Introduction
  • Crypto currency
  • Timeline of crypto currency
  • Crypto exchanges
  • Concerns
  • Regulatory Approach
  • Conclusion

Regulation of Cryptocurrency Exchanges

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Introduction:

The Supreme Court in its March 2020 verdict has lifted the ban by the Reserve Bank of India on banks and financial institutions from dealing with virtual currency holders and exchanges. But the judgment has also revived the question of regulating crypto exchanges. As of now there exist no clear legal and regulatory framework governing cryptocurrencies in India.

Crypto currency:

  • Virtual currency is the umbrella term for all forms of non-fiat currency being traded online.
  • It is a method of exchange of value, with no globally accepted definition.
  • Virtual currencies are mostly created, distributed and accepted in local virtual networks.
  • Cryptocurrencies have an extra layer of security, in the form of encryption algorithms.
  • Most cryptocurrencies operate on the block-chain or distributed ledger technology, which allows everyone on the network to keep track of the transactions occurring globally.
  • There would be no central regulator for virtual currencies as they would be placed in a globally visible ledger, accessible to all the users of the technology.

Timeline of Crypto currency:

  • In a circular in 2018, the RBI had banned banks from dealing with virtual currency exchanges and individual holders.
  • The ban was on the grounds that these currencies had no underlying fiat, had excessive volatility in their value, and anonymous nature which goes against global money-laundering rules.
  • The SC in its March 2020 verdict held that the RBI directive came up short on the five-prong test to check proportionality — direct and immediate impact upon fundamental rights; the larger public interest sought to be ensured; necessity to restrict citizens’ freedom; its capacity or tendency of Act to be harmful to the general public; the possibility of achieving the same object by imposing a less drastic restraint.
  • The test of proportionality of any action by the government, must pass the test of Article 19(1)(g), which states that all citizens of the country will have the right to practise any profession, or carry on any occupation or trade and business.

Crypto exchanges:

  • A cryptocurrency exchange or a digital currency exchange is a marketplace or online platform that allows customers to trade cryptocurrencies or digital currencies for other assets, such as conventional fiat money or other digital currencies.
  • By also enabling trade or exchange of cryptocurrencies for fiat money, they connect the crypto and traditional financial systems.
  • Regulators also look to exchanges for information on users and transactions, although this may depend on their organisational structure and functions.
  • Crypto exchanges have also assumed importance due to their role in initial exchange offerings.
  • Crypto exchanges have emerged as a key market infrastructure within the crypto-ecosystem.

Concerns:

  • There are key risks associated with crypto exchanges which include the safety and security of cryptocurrencies; lack of investor/consumer protection in the form of recourse, and quick and orderly access to their own funds/assets.
  • Crypto exchanges perform additional functions like custody of assets or funds, clearing and settlement. They are also known to co-mingle client and proprietary funds or assets sometimes.
  • Such practices, without adequate internal checks and controls, lead to conflicts of interest, micro-prudential and consumer protection risks.
  • A particular concern is the un-intermediated access given to retail investors of complex products without adequate disclosures or advice regarding their suitability.
  • The borderless nature of cryptocurrencies and service providers (like wallets and payment processing) weaken the ability to enforce investors’ rights and recover their assets.
  • Crypto exchanges are also known to enable circumvention of capital controls and commission of financial crime including money laundering and terrorism financing.

Regulatory Approach:

1. Define cryptocurrencies as securities:

  • In jurisdictions that categorise cryptocurrencies as securities or other financial instruments, licensed crypto exchanges have emerged as a point of regulation, including for the implementation of anti-money laundering (AML) and terrorism financing (CFT) laws.
  • A legal and regulatory framework must first define cryptocurrencies as securities or other financial instruments under the relevant national laws and identify the regulatory authority in charge.
  • Regulation must then define who can carry out crypto exchange and intermediary functions, who can trade and what can be traded.

2. Issuance of Regulatory licenses:

  • Operation of crypto exchanges or intermediaries like brokers or custodians can be subject to receiving regulatory licenses.
  • Licenses may be issued based on compliance with eligibility requirements and a detailed scrutiny of operational policies and procedures on internal governance, risk management and financial resources.
  • Trading can be restricted to approved cryptocurrencies as in the case of Japan.
  • Exchanges can be required to screen undesirable cryptocurrencies that don’t permit tracing or are vulnerable to cyberattacks.

3. KYC checks:

  • Regulations can also require the performance of stringent KYC checks and independent verification by exchanges before onboarding investors.
  • Access to retail or unsophisticated investors can be prohibited or intermediated through professional advisors.

4. Transparency measures:

  • Thereafter, regulation must provide for ongoing supervision on matters concerning safety and security of assets and funds, transparency of operations including trading and price discovery, comprehensive and timely disclosures on the cryptocurrencies traded including risks and suitability for retail investors, and compliance with AML/CFT requirements.
  • Record keeping, inspections, independent audits, investor grievance redressal and dispute resolution may also be considered to address concerns around transparency, information availability and consumer protection.
  • The regulations must enable investor protection through quick and orderly access to their funds or assets.

Conclusion:

In the changing world dynamics, the concept of money has also to be evolved with time. Cryptocurrencies are borderless and often beyond the regulatory classifications of a single country. The regulatory mechanism needs establishing robust information sharing and coordination mechanisms between regulators and enforcement agencies within the country, and with relevant foreign agencies around the globe.

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