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Go For Smart Regulation

Banning cryptos totally will be counterproductive. Allow room for asset trading & tech innovation

Ashima Goyal

Cryptocurrencies, on which a bill will be tabled in Parliament’s winter session, are booming in value and as a topic of debate. The decentralised technology underlying them is impressive and has many applications. They grew partly as a reaction to the excess liquidity central banks created after the global financial crisis – much like people hold more gold when they expect inflation. It was also an expression of private freedom from possible government manipulation or errors.

But unfortunately all past experiments with free banking have never ended well. Cryptocurrencies are not backed by any sovereign. There is no one making a promise to pay as found on sovereign notes. No one is responsible for stabilisation of value, which can fluctuate wildly. The original Bitcoin was limited in supply but innovation has created a variety of cryptocurrencies with different attributes and functions. For example, stable coins are linked to dollars but their backing is non-transparent and falls short in governance standards.

They may be called currencies, but are not suited to perform any of the three functions of money. Their volatility makes them unsuitable as a medium of exchange. What you have to pay in cryptos for a cup of coffee can change drastically as you finish your coffee. This makes them erratic as a unit of account and unreliable as a store of value.

They are a kind of asset with no fundamental value or source of dividends. The only return comes from other peoples’ willingness to hold them that raises their value. This can fall as fast as it rises, as happened in the tulip and other manias of the past. The glamour of technology can trap investors into thinking ‘this time it is different’, but that is highly unlikely. In a digital world products like non-fungible tokens may prove durable, but they are not currency.

Governments and central banks do not have to worry as long as it is a niche play among a small set of informed investors. But ill-informed investors, attracted by the possibility of quick money riding intra-day volatility, or future appreciation, have to be protected not only for themselves, but also because of wider financial stability repercussions. Sharp fluctuations in value can create spillovers for the financial system. Domestic money may lose some value due to inflation but a cryptocurrency can crash, wiping out wealth.

Moreover, a broad exit from the domestic currency reduces the monetary base and the effectiveness of monetary policy. Seigniorage revenue falls for the government. A decentralised and dispersed money supply would not respond to the needs of the domestic cycle. Since the benefits of issuing it would go to private players, they would not be used to create public goods.

Cryptocurrency can easily be transferred abroad side-stepping capital controls. It can be used for illicit financing. The exchange rate can be affected. Since digitisation is the future and offers many advantages in lower transaction costs, including ease of cross-border transactions, central bank digital currencies need to offer these facilities, pre-empting possible lock-in of users into payment services of large global players such as Facebook.

India has had many government- and regulator-led innovations in the payment space and its depth of engineering talent will make further innovation easier here. Cheap payments are driving many innovations already.

Cryptocurrencies need intelligent light-touch regulation. Bans do not work and hurt the exuberant innovation that can throw up valuable products and services. Decentralised finance is difficult to police. The irony is that a ban can drive cryptos into the dark net, increasing their use in criminal activities.

But the digital tracks cryptos leave make them more transparent under regulation. Legal players are often keen to help track down those who are misusing and breaking laws. There is also international cooperation and exchange of information.

A possible approach for India is to ban crypto as a medium of exchange, while regulating it as an asset. Techbased regulation can build on the India stack that makes KYC relatively easy. It can provide investor protection, while taxing capital gains as well as transactions. Macro-prudential regulation could reduce volatility.

Exchanges must meet standards of governance, transparency and audit. Advertising must be responsible, highlighting the risks, providing investor education and raising awareness. Otherwise past returns are used to attract the gullible at the peak leaving them open to a large loss of wealth.

Cross-border transactions can be tracked and capped in line with the capital control regime in place. Regulators in other countries are willing to share experience and expertise. Any law passed today must leave room for increasing future learning, sophistication and institution-building in regulation.

Then cryptos should no longer have the attraction of the wild west, while giving freedom as well as some protection to those who want to take risks, to experiment and to innovate. That they continue as potential competition to the domestic currency will encourage innovation and more stability in the latter. Inflation targeting should itself give comfort. It makes a persistent rise in inflation unlikely, since central banks have to react to such inflation.

The writer is emeritus Professor IGIDR, Mumbai, and a Member of the RBI Monetary Policy Committee


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