Virtual currency trade sees challenges with FDI

By Arjun Rajgopal and Akshaya Iyer, L&L Partners
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On 4 March 2020, the Supreme Court (court) quashed the Reserve Bank of India’s (RBI) circular of 6 April 2018 prohibiting entities regulated by the RBI from dealing in virtual currencies (VC) or providing services that facilitate dealing with or settling VCs. The SC held that the circular violated article 19(1)(g) of the constitution, which allows the right to carry on occupations, trades or businesses, because it “almost wiped the VC exchanges out of the industrial map of the country” and failed the test of proportionality.

VC
Arjun Rajgopal
Partner
L&L Partners

The RBI argued that it has not prohibited VCs and the 2018 circular sought only to restrict the access of traders and VC exchanges to banking channels. The court’s judgment pointed out that trading in VCs and using VCs for payments towards goods and services to willing recipients was not restricted by the circular.

The judgment has, in theory, given a new lease of life to VC exchanges and has restored traders’ ability to trade in and settle VCs, and to exchange VCs with fiat currency. However, there remain practical difficulties, not least the draft Banning of Cryptocurrency and Regulation of Official Digital Currency Bill, 2019, and global sentiment towards the regulation of VCs and VC platforms.

VC
Akshaya Iyer
Managing associate
L&L Partners

VC exchanges in India are primarily online platforms facilitating trade in VCs, involving their storage in digital wallets and converting VCs into fiat currency and vice versa. Exponential growth of VC exchanges prior to the circular provided lucrative opportunities for investors. However, foreign direct investment (FDI) in the sector is almost unregulated. Although the court stated that the exact nature of VCs “eludes precision”, and that “there may be no difficulty in accepting the divergence of views, if those views are not driven by fear of regulation”, it rejected the argument that VCs are online goods or services and therefore outside RBI regulation. It held that the RBI may exercise statutory power over the use and trading of VCs despite their absence from credit or payment systems.

VC exchanges do not provide conventional payment systems or other financial services recognized by the RBI, nor are they considered to be stock exchanges or other infrastructure companies in the securities market subject to Securities and Exchange Board of India (SEBI) regulations. While the judgment of the court could allow VCs to be categorized as commodities, the categorization of VC exchanges as commodities, spot or derivative exchanges is unrealistic and has no legal basis. VCs are not recognized as commodities or goods under securities laws and VC trading transactions do not qualify as ready delivery contracts. Given the lack of regulation in the sector, the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (FDI rules), do not permit the classification of VC exchanges as being engaged in the other financial services sector or as infrastructure companies in the securities market, leaving VC exchanges outside the current FDI sectoral regime. VC exchanges could possibly be categorized either as e-commerce marketplaces or as being engaged in the services sector.

VC exchanges seemingly fit criteria for e-commerce marketplaces under the FDI rules, but only if VCs can be categorized as goods or digital products, a position which may not be possible following the judgment. Under this position, FDI in e-commerce faces challenges such as the FDI rules requiring the disclosure of the details of sellers on the website. This would impact the anonymity of the user and of the transaction, a key feature of VC trading. Other concerns include the price determination of VCs, the ability of VC exchanges to be paid facilitation fees in VC, which could be construed as ownership over inventory, and the requirement that payments for sales on the platform conform with guidelines issued by the RBI. The alternative argument is that, in the absence of any specific prohibition or regulation of FDI in VC exchanges under the FDI rules, VC exchanges provide services. In such cases FDI is permitted under the automatic route up to 100%, without conditions.

While the judgment is a step forward in the modernization of economic policies, the RBI may have lost the battle but won the war. The judgment permits the RBI to frame regulations for the use of and trade in VCs under existing powers in the RBI act, 1934. Combined with the reluctance of the government to permit the use and trading of VCs within a regulatory framework, there are challenges to the sector making the regulatory situation for VCs and VC exchanges, including FDI, uncertain and volatile for investment purposes.

Arjun Rajgopal is a partner and Akshaya Iyer is a managing associate at L&L Partners.

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