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Every crypto-token or altcoin has one thing in common. They break down the geographical impediment of finding investors by holding the token offering at a global level: the advent of online transactions facilitating them. China and Turkey have outrightly banned any kind of sales related to cryptocurrency while Thailand has opted for a selective ban. Though crypto-tokens are now regulated in the US after getting recognized as a commodity, the situation pertaining to the sales aligned with ICOs, after getting an initial ban is now selectively regulated by the SEC. India, backed by its technological boom could not remain a stranger to cyber innovation and witnessed its first major crypto-exchange, Unocoin in 2014 which opened the proverbial Pandora’s Box. Since then, it has been nothing short of a turbulent journey for the Indian crypto-community.

An inter-ministerial commission was set up in the fall of 2017 to weigh the factors against the regulation of cryptocurrency and submitted the bill titled Crypto Tokens and Crypto Assets (Banning, Governing, Regulating) Act of 2018. A consensus was reached that banning might not produce the best results considering the government’s own experimentation with the blockchain technology. However, this was all set to change soon, when RBI decided to issue a notification dated 6th April 2018; through which it sought to immediately stop all banks from transacting with the crypto-exchanges. The Parliament’s own tryst with the complexities of the issue produced two bills: Banning of Cryptocurrency & Regulation of Official Digital Currency Bill, 2019 and the Cryptocurrency and Regulation of Official Digital Currency Bill, 2021; both of which have failed to get enacted. In the light of this, if it had not been for the IAMAI judgment, we would have been stranded cascading complexities of the crypto-sphere. Albeit the judgment took cognizance of budding investments in this paradigm and gave them a green signal; on second thought, it still could not address what is the true nature of the tokens and in what form are they to be regulated. Based on the above premise, we are aware that Kik v SEC [1] ruled SAFT agreements to be securities. Furthermore, the CFTC is the governing body in the paradigm of future tokens and views these tokens as commodity.

To be regulated like security?
Instead of viewing cryptocurrency as an alternative to fiat currency, a compelling approach would be to see it through the lens of security market. RBI would not be issuing any legal tender to cryptocurrency anytime in the near future; however so until any such arrangement is made it is prudent to see it as a security. The tokens take the value from the startup behind the project and give the holder a stake in that startup through ICOs. People buy these tokens solely with the idea that their value will increase in the future along with the underlying value of the cryptocurrencies. Thus they derive their value from the underlying asset just like a derivative does.

Howey Test
The Howey test finds it origins in the USA which was formulated by the US Supreme court in the case of Sec v Howey, to pinpoint whether a financial instrument would be in nature of an investment contract. As per this test, a transaction is an investment contract if it has three important features: first, it involves a money investment; second, the investor has an expectation of profit; and third, the profit is generated by the efforts of the issuer of the instrument. In Kik v SEC, the court was of the opinion that SAFT construed to be a security since it satisfied all three prongs. In addition to the start-ups issuing the token, we can also take into account the crypto-exchanges which facilitate trading in the secondary market and contribute to the influx of new investors.

The broadest prong of the Howey test surrounds the issue of actual investment of money. The ICO private sales invite accredited investors for a seed stage financing. The total market capitalization for Kin was around $75 million. One of the crypto-networks founded in India known as Polygon has a market capitalization of $13 billion[2]. In the secondary market, the usual method followed; by the crypto-exchanges involves the exchange of fiat currency of the buyer with the seller of the cryptocurrency. The takeaway is that the cryptocurrency they receive is in form of a stablecoin. The investor needs to exchange this stablecoin for other cryptocurrencies[3]. Since there is a prima facie initial investment of money, the first condition of the test stands satisfied.

In respect of the second test where the investor expects profit, it is important to review the dividend rights asserted through the ICO. Kin was sold on the promise of huge returns on completion of project which incentivized the investor. As discussed above, ICOs are way to raise fund for the projects and represent a stake in the network. Investors expect profit as the value of the organization increases just as they would when public shares of a company return profits. A relatively new ICO could average the return rate of 50% in the first 30 days[4].
Let’s also consider the other investors who only wish to trade in the secondary market. Even when we view it from their standpoint, it does not fall short of what an ordinary person would expect from a profit stock market. The investors who had bought the stablecoin would now invest in different crypto-tokens and expect profit in the event of a bullish market. The analogy not only goes a long way in establishing a connection between cryptocurrency trading and the ordinary stock market but also helps in identifying a nexus between cryptocurrency and securities.

To satisfy the third test, the profits drawn should have been a result of others’ efforts. The effort here can be construed to be managerial efforts of the crypto-network to contribute to the development of the network and in creating a demand of the tokens in general. Investors in the case of Kin held onto the SAFT as a promise to be delivered future tokens after the complete development of the network subsequent to the public offering. The tokens would have been issued only when the overall project would be successful which depended heavily on the managerial effort[5]. Hence the profit was drawn from the active effort of others.
In this context, the crypto-exchanges perhaps stand out the most because of the myriad of functions that they perform such as maintaining liquidity, compiling the aggregate information of buying and selling price and thereby depicting the token value accurately[5]. Further, investors will choose the crypto-exchange depending on the quality of their whitepaper, their business plans, the kind of interface they deploy, their ease of transaction.

SEBI can come within purview only when the transactions involve securities within the meaning of Section 2(h) of the Securities Contracts (Regulation) Act, 1956:
“(h) “securities” include—
(i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate;
[(ia) derivative;
(ib) units or any other instrument issued by any collective investment scheme to the investors in such schemes;]”

On a plain reading, it is clear that the definition of securities is befitting for cryptocurrency. Although SAFTs are not equivalent to a debenture but are in the nature of a future commodity, they could still come within the ambit of this definition by the virtue of being a unit issued by through a collective scheme. Furthermore, the price of crypto-tokens on the secondary market derives its value from the development of the crypto-network. Hence correspondingly SEBI can become the regulatory body for crypto-exchanges in lieu of RBI.

It was noted in Sudhir Shantilal Mehta vs. Centra Bureau of Investigation by the Supreme Court bench that: “The definition of `securities’ is an inclusive one. It is not exhaustive. It takes within its purview the matters specified therein and all other types of securities as commonly understood. The term `securities’, thus, should be given an expansive meaning.”[6]
In Naresh K. Aggarwala & Co. vs. Canbank Financial Services Limited[7], it was contended that only listed securities would come under the definition of the SCRA. While the apex court eventually held the definition of securities to be wide enough to include unlisted securities also; we need to reminisce that SAFTs are also in nature of unlisted security sold to private investors before a public offering of tokens is held.
Lastly, in Sahara India Real Estate Corporation Limited and Others vs. SEBI and another, the Supreme Court opinionated that,

“Section 2(h) of the SCR Act gives emphasis to the words “other marketable securities of a like nature”, which gives a clear indication of the marketability of the securities and gives an expansive meaning to the word securities. Any security which is capable of being freely transferrable is marketable. The definition clause in Section 2(h) of SCR Act is a wide definition, an inclusive one”[8].

Thus, in either nature of investments, we find that tokens qualify as security that would enable the Central authorities to regulate it. However, the major setback, in this case, would be that of failing to achieve the objective of decentralization. If we look at the eventual result, we are still tying up the value of tokens with fiat currency in the application of the first prong of the test which proves to be detrimental to the cause of decentralization as envisioned by the Government think tank, Niti Aayog[9].

Misplaced Concern
The IAMAI judgment although liberated the exchanges and gave them a right to trade by striking down the circular, it missed the crucial point of assessing the true nature of crypto-tokens. It viewed them from a mono-dimensional view of currencies only and considered the various definitions cited in different acts across the years[10].

Clause (33) of Section 65B of the Finance Act, 1994, inserted by way of Finance Act, 2012 defines ‘money’ to mean “legal tender, cheque, promissory note, bill of exchange, letter of credit, draft, pay order, traveler cheque, money order, postal or electronic remittance or any other similar instrument, but shall not include any currency that is held for its numismatic value”.

S.2(h) of FEMA defines currency as “includes all currency notes, postal notes, postal orders, money orders, cheques,drafts, travellers cheques, letters of credit, bills of exchange and promissory notes, credit cards or such other similar instruments, as may be notified by the Reserve Bank.”
And a final consideration of the The Central Goods and Services Tax Act, 2017 which defines ‘money’ under Section 2(75) to mean “the Indian legal tender or any foreign currency, cheque, promissory note, bill of exchange, letter of credit, draft, pay order, traveler cheque, money order, postal or electronic remittance or any other instrument recognised by RBI, when used as a consideration to settle an obligation or exchange with Indian legal tender of another denomination but shall not include any currency that is held for its numismatic value.”

On a perusal of the above definitions, the court was of the view that promissory notes, cheques, bills of exchange, etc. were not exactly currencies but operated as valid discharge (or the creation) of debt only between 2 persons or peer-to-peer. From this standpoint, it was short-sighted for the bench to accept the contention of the petitioners that VCs were just goods/commodities and can never be regarded as real money. Having established that the sales of tokens are backed by contractual protections (SAFT in cases of crypto-network), their utility is actually quite similar to a promissory note. They promise the delivery of tokens which represents a stake in the network.

Conclusion
Prohibitions are “economically inefficient means of regulation” because they may eliminate any potential benefit that could have stemmed from the banned technology and also dampen any subsequent future innovation[11]. Various countries however have already started regulating cryptocurrency under different approaches. Japan has made it a legal tender under the – Payment Services Act, 2005 while Canada has treaded cautiously by placing it under -Proceeds of Crime (Money Laundering) and Terrorist Financing Regulations, 2002: Section 1(2):
“Virtual currency means (a) a digital representation of value that can be used for payment or investment purposes that is not a fiat currency and that can be readily exchanged for funds or for another virtual currency that can be readily exchanged for funds; or
(b) a private key of a cryptographic system that enables a person or entity to have access to a digital representation of value referred to in paragraph (a).”

Singapore has gone for the dual approach of regulating virtual currencies both as securities and legal tender money. All the while USA and Indonesia have categorized it as a commodity. Under Section 1a(9) of the US Commodity Exchange Act, the Commodity Futures Trading Commission, USA defines “commodity” to include, among other things, “all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in.”[12]

United Kingdom has followed the footsteps of Canada by mandating all the crypto-exchanges to comply with the AML/CFT measures and the categorization of cryptocurrencies has been as under property. Lastly the European Union’s Directive 2018/843 of 30 May 2018 (5thAnti-Money Laundering Directive) Article 3(18) which defines cryptocurrency as:
“Virtual Currencies’ means a digital representation of value that is not issued or guaranteed by a central bank or a public authority, is not necessarily attached to a legally established currency and does not possess a legal status of currency or money, but is accepted by natural or legal persons as a means of exchange and which can be transferred, stored and traded electronically.”

Cryptocurrency through the advent of blockchain can avoid the traditional banking systems opted during international trading which in turn prevents any extra transaction fee and lowers down the cost of cross-border payments. From a broader perspective, the rise of cryptocurrencies is not only for easier trade but it is also a direct consequence of the sub-prime mortgage crisis of 2008 which saw the financial sector come crumbling down. The heavy dependence on the aficionados of the finance world: banks; cost the individuals a lot in respect of their livelihood and savings because of which the idea behind the decentralized system as propagated through cryptocurrency flourished. On similar lines, the virtual currency also came to be celebrated as it facilitated veiled transactions, safe from the scrutiny of the government.

 

Written by:

Shiladitya Mishra,

Intern at Prime Legal

 

Footnotes:

[1]Case No. 19-cv-5244

[2]https://www.businessinsider.in/cryptocurrency/news/cryptocurrency-polygon-founded-by-3-indians-has-touched-13-billion-in-market-cap/articleshow/82770196.cms

[3]WazirX, WRX Token whitepaper, https://download.wazirx.com/wrx/wrx-whitepaper.pdf, Coinbase whitepaper, https://www.sec.gov/Archives/edgar/data/1679788/000162828021003168/coinbaseglobalincs-1.htm

[4]Benedetti, Hugo E and Kostovetsky, Leonard, Digital Tulips? Returns to Investors in Initial Coin Offerings (May 20, 2018). Journal of Corporate Finance, Vol. 66, No. 101786, 2021, Available at SSRN: https://ssrn.com/abstract=3182169 or http://dx.doi.org/10.2139/ssrn.3182169

[5]Kristin N. Johnson, Regulating Cryptocurrency Secondary Market Trading Platforms, https://lawreviewblog.uchicago.edu/2020/01/07/298/

[6]CRIMINAL APPEAL NO. 905 OF 2005

[7]IVIL APPEAL NO.5173 OF 2004

[8]Para 111, CIVIL APPEAL NO. 9813 OF 2011

[9]Blockchain: The India Strategy, https://niti.gov.in/sites/default/files/2020-01/Blockchain_The_India_Strategy_Part_I.pdf

[10]Writ Petition (Civil) No.528 of 2018

[11]Kesan, J. P., & Shah, R. C. (0AD). Shaping Code. SSRN Electronic Journal. https://doi.org/10.2139/SSRN.328920

[12]See, e.g., Board of Trade of City of Chicago v. SEC, 677 F. 2d 1137, 1142 (7th Cir. 1982). Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.