The cryptocurrency industry has been abuzz in the last few months, primarily on account of the recent clamp down by the Financial Intelligence Unit of India (FIU) on cryptocurrency exchanges and crypto wallet providers.
With the rise of cryptocurrency or crypto, which has been given the name virtual digital asset (VDA or Digital Asset) in India, Governments and regulators around the across geographies, have struggled to keep pace with the evolving crypto industry and formulate a framework to regulate such VDAs and VDA providers.
In the Indian context, the cryptocurrency saga began as early as 2013 and continues even today. From a prohibitive regime which contemplated an absolute ban or prohibition on crypto, India seems to have progressed to more of a regulatory regime. The Finance Minister of India, Ms. Nirmala Sitharaman, also propagated and furthered this stance at the G20 summit last year, by calling for a concerted effort by global economies to frame a regulation which has the consensus of the cryptocurrency industry.
Be that as it may, there have been pertinent developments over the course of the years which have impacted all industry stakeholders. In this article, we attempt to provide a broad overview of the evolution of those developments and their implications on the sector.
Overview of the Evolution of Cryptocurrency Regulation in India
The Reserve Bank of India (RBI), which is not only the central bank but also the regulator of financial services, was the first to caution users about cryptocurrency in India, with issuance of public notices and press releases in 2013 and 2017 that expressed concerns around the potential risks associated with virtual currencies.
With the crypto industry picking-up pace, the RBI, in the month of April 2018, issued a directive that mandated regulated entities (such as banks and payment system operators) to not deal in virtual currencies or provide services that facilitate dealing in virtual currencies (Directive). One of the direct consequences of the Directive was that in India, one could not use fiat currency to purchase or sell cryptocurrencies and other virtual digital assets. This action resulted in a prohibition for dealing in VDAs through banking channels.
As one would have expected the Directive was challenged before the Supreme Court of India (Supreme Court).and wasstruck down as unconstitutional. The Supreme Court held that the Directive was violative of the fundamental right of the cryptocurrency businesses to undertake their business in India. Also, it was held by the Supreme Court that the issuance of the Directive was "disproportionate" as the RBI did not find any adverse impact on the way the regulated entities (such as banks) function, on account of the activities of exchanges of the Digital Assets and that the RBI has taken the stand that it has not banned cryptocurrency in India.
While there were subsequent attempts by the Government of India to introduce a standalone legislation to specifically regulate cryptocurrencies India, no bill was eventually tabled before the Parliament.
Later in the year 2022, the tax regime of India was modified to impose tax on cryptocurrency transactions, including transfer of cryptocurrencies. In fact, the direct tax law also saw introduction of the term 'virtual digital assets', which includes cryptocurrencies and non-fungible tokens.
More recently, in March 2023, the Government of India introduced an important legislative change to the anti-money laundering law of India, which is contained under the Prevention of Money Laundering Act, 2002 and the Prevention of Money-Laundering (Maintenance of Records) Rules, 2005 (collectively, the PML Law).
Dealing with Crypto through the Anti Money Laundering Way
The implementation of robust regulations on know-your-customer (KYC) and anti-money laundering (AML) has been observed to be one of the ways through which the regulatory authorities have approached regulation of cryptocurrencies. India has followed suit and through a similar method, adopted significant changes to the PML Law to regulate Digital Assets.
The Government of India has brought the following within the realm of the PML Law by categorising these as 'reporting entities': (a) service providers which enable exchange between Digital Assets and fiat currencies; (b) service providers which enable exchange between different forms of Digital Assets; (c) service providers which facilitate transfer of Digital Assets; (d) entities that provider safekeeping or administration services for Digital Assets or associated instruments which enable control over Digital Assets; and (e) service providers which enable participation in an issuer's offer or sale of Digital Assets or provision of related financial services (collectively, Entities). The business activities included under the ambit of the PML Law is extremely wide, as a result of which, any business undertaken by Entities that are associated with cryptocurrency, like an exchange that enables the trading of cryptocurrency, is likely to fall within the ambit of the PML Laws.
One of the main consequences of such a categorisation, is that such Entities need to register themselves as a 'reporting entity' with FIU and also designate a principal officer and a director for overall compliance with the PML Laws. With the notification of the registration requirement, there have been instances of the FIU reaching out to various cryptocurrency exchanges to require such exchanges to register as a 'reporting entity'.
Upon their registration under the PML Laws as a 'reporting entity', the Entities will need to undertake identity verification for customers and their beneficial owners, in the form of due diligence and KYC checks, to establish an account-based relationship as well as the customers carrying-out certain type of transactions such as those involving international money transfers.
The Entities also have certain record keeping and reporting obligations in respect of the customer identification and transactions.
Additional Guidelines by FIU
With the objective of identifying and curbing money laundering, terrorist financing or proliferation financial activities, the FIU issued AML & CFT Guidelines (FIU Guidelines) for compliance by the Entities.
The FIU Guidelines mandate that an Entity will need to undertake counterparty due diligence of the other Entity to whom its customers transfer their Digital Assets.
Pursuant to the FIU Guidelines, Entities will need to implement adequate employee-screening and undertake employee-trainings for areas such as customer on boarding, KYC, sanctions screening and record keeping etc.
On the customer-screening front, the FIU Guidelines require Entities to apply directives pertaining to suppression and combatting of terrorism, terrorist financing and proliferation of weapons of mass destruction and its financing.The screening must also factor in resolutions of the United Nations Security Council, besides the other requirements under the local laws.
Amongst the record keeping obligations, the Entities need to maintain accurate originator and beneficiary information, about transactions of transfer and exchange of Digital Assets. In this context, one may argue that the transfer of Digital Assets and wire transfer may not be like-for-like comparison, hence, the nature of information that Entities are required to obtain, and hold may pose practical challenges for the Entities involved in such transfer.
While on the one hand, Entities are required to disclose suspicious transaction to FIU, on the other hand, the Entities are also under a prohibition to disclose or give tip-offs to customers about such suspicious transaction.
Enforceability Scheme – Amendment to PML Laws and FIU Guidelines
In addition to the regulatory measures, the country has also witnessed certain enforcement steps. The FIU under the Ministry of Finance, has sent show cause notices to certain offshore virtual digital asset service providers who are operating in India and has an Indian user base, but are not complying with the PML Laws that provide for anti-money laundering laws and counter financing of terrorism framework.
Further, the FIU had also written to the Ministry of Electronics and Information Technology to block the URLs of such offshore entities for the abovementioned non-compliance. The FIU in its press release of December 28, 2023, clarified that the obligations under the PML Law are activity-based and not contingent on whether a VDA service provider has a physical presence in India.
What Lies Ahead for the Crypto Industry
It is abundantly clear now that the Government of India is becoming more proactive in taking steps in the direction of regulating cryptocurrency transactions.
While the compliance and administrative burden of VDA providers may substantially increase, one may say that treating cryptocurrency exchanges at par with the reporting entities under the PML Laws and mandating the implementation of KYC and customer due diligence measures is a step in the right direction.
However, the mechanism of ensuring implementation of such measure for transactions with offshore exchanges remains uncertain and the steps that FIU takes for such enforcement will be interesting to see.
Originally published in Legal Era, 24 March 2024
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