Dealing with Disruptions: A Proposal for a Cryptocurrency Sandbox in India
The author is Kanishka Bhukya, third year student at National Law School of India University, Bangalore.
Technology has transformed the way individuals make transactions, manage investments, borrow money, and sign agreements in a constantly evolving multiverse of digital assets, technology, and infrastructure, which are collectively reinventing the workings of today's financial system. However, such technological advancements do not concurrently and proportionally improve the state's capability to oversee the tremendous expansion of private liability and risk-creation in the financial ecosystem. Therefore, the quicker, larger, algo-driven, and technology-dominated financial sector creates a structural regulatory difficulty in that regulatory agencies are increasingly confronted with complicated technological and distributional considerations in a fast-moving environment. And, more often than not, they lack the necessary legal and regulatory means to address these challenges comprehensively.
In the past decade, India has established itself as a hotspot of fin-tech innovation and entrepreneurship. Since 2013, around 2000 fin-tech firms have opened businesses in India, with the nation ranked 2nd internationally in fin-tech adoption. However, in the field of finance, such disruptions have frequently happened in a regulatory vacuum wherein rules and regulations were not sufficiently established. Against this backdrop, the RBI has issued a slew of regulations in order to stay up with the rapidly evolving technological landscape. The scope of this article, however, will be restricted to one such regulation, namely the RBI's regulatory sandbox. Therefore, this article will look at how the regulatory sandbox enables fin-tech firms and regulators to work together to minimize possible risks and build evidence-based policies for emerging technologies. To that end, it will specifically examine how the RBI's negative view of cryptocurrencies, and consequent exclusion of cryptocurrencies from the regulatory sandbox framework, prevents the RBI from assisting in the formulation of policies and regulations, as well as inhibiting innovation and competition in the fin-tech sector, which essentially ends up having an adverse impact on the economy.
II. REGULATING TO ESCAPE REGULATION: SANDBOX FOR FIN-TECH COMPANIES
A sandbox is a secure place wherein parents allow their kids to play without having to worry about them getting injured. Similarly, a regulatory fin-tech sandbox is set up so that banking institutions and fin-tech companies can test their breakthrough and innovative financial products, services and technologies for a set period of time and within secure limits. It was created primarily to foster innovation in the fin-tech space. In a sandbox, the features of the live environment are emulated in real-time, eliciting reactions from all the platforms with which such products or applications might interact. This would help businesses and regulators to identify any risks and would also have adequate security measures in place, allowing them to contain or lessen the damages in the event of a failure. In essence, a sandbox is established to support and facilitate a positive dialogue among the regulators and the regulated.
Taking notice of the benefits, the RBI issued the "Enabling Framework for Regulatory Sandbox" in 2019, in which fin-tech companies, start-ups, banking and finance institutions, among others could participate. Predictably, however, cryptocurrencies have been excluded from the framework. Although it is clearly an extension of the administration's stated position on cryptocurrencies, it could be an opportunity wasted, considering that a Sandbox might be the ideal method to engage with cryptocurrencies.
III.A CRYPTOCURRENCY SANDBOX: THE NEED OF THE HOUR
A. Costs of Non-Regulation
Cryptocurrencies are virtual currencies that are protected by cryptography, making them virtually impossible to fabricate or double spend. They are decentralised systems based on blockchain technology, and one distinguishing aspect is that they are not usually issued by any centralised authority, thereby making them impervious to state interventions or manipulations. Therefore, as a result of the decentralised, anonymous, and encrypted nature of cryptocurrencies, the need for regulation is even greater.
The Covid-19 crisis has led to a rise in cryptocurrency trading both nationally and internationally. For instance, an Indian crypto-exchange stated that during the lockdown phase, signups increased by 30% and transaction volume increased by 270%. This development, unfortunately, is taking place in a regulatory void, and the RBI's immediate reaction to this problem could be to include cryptocurrencies in the fin-tech sandbox.
The policy to not regulate the cryptocurrency market and leave it to the void would not only stall the cryptocurrency industry, but it may also drag the ecosystem undercover, bringing to fruition each of the government's fears about cryptocurrencies. Non-regulation may culminate in the emergence of an altogether new kind of a shadow economy that fosters tax avoidance, misappropriation, and aids in the commission of financial crimes such as money laundering, among other things. Instead, by regulating the market, cryptocurrencies could be used to generate public funds and stimulate economic activities in the economy. Therefore, rather than imposing any kind of restrictions, the government should endeavour to grasp the tremendous potential offered by the use of cryptocurrencies and adopt measures to govern the crypto marketplace.
B. The Benefits of a Cryptocurrency Sandbox for Regulators
A traditional regulatory framework for fin-tech activities includes licencing procedures, periodic tax filings, information reporting, inspections, compliance with rules and standards, and a robust and sophisticated dispute settlement mechanism. However, because cryptocurrencies are decentralised and encrypted, they pose significant and distinct challenges to traditional finance.
Therefore, a regulatory sandbox is the most ideal approach to deal with this scenario since it enables product/service experimentation and assessment in a more controlled environment, and more crucially, in a regulatory limbo. A regulatory sandbox's primary aim is to assist regulators in the regulation-making process for such disruptive technology. For instance, if cryptocurrency firms are given the opportunity to operate in the sandbox, the RBI will be able to identify new risks, and accordingly introduce new regulations swiftly.
Moreover, a sandbox clarifies the scope of the regulatory framework, as well as the deployment of suitable technologies to monitor and analyse operations, and gives the mechanism for enforcing the regulations. A regulatory sandbox would also enable the RBI to develop a model which will anticipate the impact of cryptocurrency growth on macro-economic stability, anti-money laundering, and capital account convertibility. In conclusion, it would allow the RBI to select the best suitable intervention from the various regulatory tools.
C. The Benefits of a Cryptocurrency Sandbox for Cryptocurrency Businesses
Allowing sandboxing for cryptocurrency entities would not only spur innovation instead of enforcing creativity-stifling pre-emptive regulatory oversight, but it would also provide a protected marketplace for consumers to expose oneself to the cutting-edge cryptocurrency technology and decide whether it is beneficial for them and if it presents a significant risk to them. Working closely with regulatory agencies such as the RBI and SEBI would also lend credibility to cryptocurrencies, alleviating fears and mistrust about the technology and potentially attracting more investors and consumers.
The sandbox also creates a welcoming atmosphere for such inventions and breakthroughs in the cryptocurrency space, allowing firms to experiment in a less rigorous setting. This would help firms in exploring their potential while being overseen by a regulating agency. Moreover, it would provide cryptocurrency firms and their managements with an opportunity to avoid glaring business model problems obscured by their insider viewpoint. They will be able to identify the potent weaknesses in their products/services that way and make the necessary adjustments when they institute their product in the broader financial market. Also, since the entities would have already functioned under the regulating agency, in this case the RBI, albeit under a less stringent environment, the transition to the actual regulations would be much simpler and smoother for the firm.
We previously discussed how, due to various reservations about the volatility and safety of cryptocurrencies, developing countries such as India have imposed severe limitations on cryptocurrency companies, thereby rendering them unprofitable. We've also seen how many cryptocurrency firms have migrated to more crypto-friendly jurisdictions as these limitations disincentivise and deter them from operating in regions like India. In light of such events, I propose the adoption of cryptocurrency sandboxes, which can assist regulators in testing the perceived risk that is associated with cryptocurrencies and unleash its investment potential. Not only would cryptocurrencies increase inbound investments, but would also boost economic growth by encouraging greater market innovation. This massive pool of assets may be channelled into the mainstream economy by establishing a proper legislative framework. The goal ought to be to use fin-tech to help India's economy flourish and foster an increased access to financial services, enhance competitiveness, and, as a result, expedite the growth of local financial institutions.
This unwillingness to adopt cryptocurrencies appears to stem from fears that cryptocurrencies may subject markets to unforeseen financial, regulatory, logistical, and user-related risks. And, these fears are justified since there is no central authority that issues currencies, the coded nature makes it impossible to monitor the transfer of crypto-assets, and valuing such assets is extremely difficult. However, it is argued that the very objective of sandboxing is to monitor and limit such concerns, guaranteeing that when cryptocurrency entities eventually join the market, the environment stays secured and risk free. However, there is a caveat: a regulatory sandbox is not a panacea or a standalone solution for this issue. They are not an effective substitute for permanent directives or regulatory frameworks. These are enablers that must be utilised as a stopgap solution to attain the objectives of a larger strategy. In a highly volatile and risk-laden businesses like cryptocurrencies, sandboxes offer regulators with a strategic approach and while it isn't a one-stop destination, it is a stop worth pursuing.