Ripple started in 2009 when Satoshi Nakamoto (pseudonym) published his research paper titled ‘Bitcoin: A Peer-to-Peer Electronic Cash system’. Abstract explains ‘A peer-to-peer electronic cash system would allow online payments to be sent directly from one party to another without going through a financial institution’. We usually refer to this system as ‘Decentralized Finance’ or ‘DeFi’ in abbreviated form. For the uninitiated, a decentralized finance is a system where financial exchange takes place between two parties directly without involving a regulatory body or facilitator. In simplest terms it means two individuals doing transaction with each other without the ‘bank’ in between. We often follow a somewhat similar mode of transaction which takes place between two parties via mode of cash. A decentralized finance is more than that, it is ‘anonymous transaction’ ie it keeps identities of the people involved hidden. We shall have to go in to a bit of basics before we can weigh it against fiat currency.

Bitcoin is the first cryptocurrency, which was created by Nakamoto. It works with the help of blockchain. A blockchain is an open ledger system where all the parties involved record their transaction digitally. If a transaction is not in blockchain it is considered nonexistent. Everyone who is participating in this bitcoin transaction can download a copy of the blockchain hence verify it at personal level. Bitcoins are not exactly ‘coins’, the term is misleading and probably the root cause of controversy. It’s a reward in the form of digital point which ‘miner’ receives when he successfully creates a ‘block’ in blockchain. A block consists of a limited number of transactions (as the space is limited) followed by a private and exclusive code called ‘hash’. This ‘hash’ verifies the authenticity of the block. Hence ‘miners’ or persons solving puzzles compete to create a block and add it to the chain. They receive their payment in form of digital money called Bitcoin. First block in blockchain is called ‘genesis block’. First transaction in the blockchain is called ‘coinbase’. In Bitcoin’s case first Bitcoin was mined in by Nakamoto to start the blockchain. After initial transactions Nakamoto disappeared in 2011, he still holds 1 million bitcoins but they are lying idle. Nakamoto was and is still anonymous. It could be one person or a group of persons. No one knows who or where he is. In this way Nakamoto proved another significant point of his creation: Anonymity. Transactions in blockchain are strictly confidential. Now here’s the wonderful paradox: it’s a transparent system and confidential at the same time. It is transparent in the sense that participants can see all the transactions that have taken place. It’s confidential because system never reveals anyone’s real identity. Entire business of bitcoin takes place with encrypted keys. Every account holder possesses two keys: Private key and public key. Public key is used for credit in the account. Anyone can use this key to send a ‘X,Y,Z’ to a particular person. Private key is a secure key which is known only to the account holder and is used to debit one’s own account. In the world of cryptocurrencies, keys are our identity. Satoshi Nakamoto released a few bitcoins to start the chain, this was supposedly first transaction in the virtual world. In real world first recorded transaction with bitcoin took place in 2010 when Laszlo Hanyecz paid 10000 bitcoins for two pizzas to a restaurant called Papa John’s. There are only 21 million bitcoins that doesn’t mean that source is being depleted, it simply means that Nakamoto designed the programme in such a way that only 21 million bitcoins can be created until and unless someone changes the code which is available on open source. Also, Bitcoin is not the only digital coin, there are at least 10,000 more, it just so happens that bitcoin is the most famous one.

Cryptocurrency- Tax-mans Perspective

At the time of writing this paper approx. 100 million users were reported in India only. Going by the trends we can assume that fad is going to rise. Cryptophiles have their own logic to support it.

Decentralized: It is a system which has got no regulatory body overseeing it. Cash transfer is instantaneous. Since it is not regulated by bank no KYC is required. Devoid of all the paperwork it saves time and resources. Anyone can join and quit as per will.

Transparent: For cryptocurrency transparency means blockchain to which all participants have access. All transactions are invariably recorded in blockchain. If it isn’t in the blockchain, it is not valid. Blockchain is the backbone of entire digital currency world. To add a block to the chain requires solving a mathematical puzzle which in turn requires enormous resources. This process is called ‘mining’. Miners have to compete with each other in speed because whoever creates a block with specific hash first gets to insert it in to the chain. All the other blocks are discarded. Everyone can download a copy of blockchain and verify transactions. In this way it is fairly transparent.

No Double Spending: Counterfeiting is impossible with cryptocurrency. As transactions are added to the block they cannot be replicated. The system works with encoded keys. If someone tries to replicate the transaction, block and transaction keys will not match hence such transaction will be rejected by the system itself. Therefore, it is impossible to spend same digital coin twice.

Anonymous: Anonymity is the most controversial point in entire cryptocurrency system also it is the most loved feature too. Exchange of digital currency takes place with encrypted keys. Sender uses public key of the receiver to transfer money while receiver uses private key to transfer digicoin. It should be noted that here coin is being sold. Digicoins are still not very useful in physical world at least not in the legit way.

Scam proof: Digital currency is impossible to duplicate and transactions cant be imitated. This system uses template based digital signature system which means that if anyone tries to modify the template, signature would show a mismatch and vice versa. Hence, manipulation on technical level is impossible.

Now comes the analysis part. Number of people dealing in cryptocurrency in India is approx. 100 million. The rise in numbers has been stupendous and sudden. It is more about adventure of making quick money rather than anything else. Digital currency is not infallible and it’s not decentralized as it appears on the surface.

Mining: Mining means ‘solving the puzzle’. Of all the people involved in crypto business only 1 % are miners rest are just buying and selling. It means that miners are recording transactions and creating a block, later they have to add a specific code to the block, if this code fulfills the criteria of the software only then their block will be added to the chain. Miners receive a commission for every transaction they record and mining is an expensive thing. Thus, a handful of people are controlling the entries in the ledger as everybody hasn’t got that kind of resources and knowledge. This debunks the ‘decentralization’ theory.

Is it possible to forge a blockchain: It isn’t possible to forge a single transaction or a single block? To create one fake transaction a miner needs to make change in minimum 51% of blocks. Once the transaction gains majority it becomes valid and the minority chain will be abandoned by the miners. This is called ‘51 % attack’. Is it practically possible? Yes, but economically unviable. 51% attack makes sense if owing to high volatility price of currency zooms up to unexpected levels.

Privacy: As long as transactions are taking place in a digital world, they are private. We need to understand the basic psychology behind transactions. Most people buying and selling cryptocurrency are expecting a windfall counting on its unpredictable nature. Those who are treating digital currency as ‘quick money scheme’ they will sell it at some point of time for gains. Once the money lands in to account it is traceable. If there are large sums involved it’s very easy to identify the person. So, the surest way to maintain one’s privacy is to never encash ones’ coins. This is what Nakamoto did when he disappeared. He still holds bitcoins whose value right now is 73 billion US dollars but his account is inactive and he is not converting them into fiat currency that’s how he is maintaining his anonymity. Can normal people live like this? Besides, what’s the point of having money if one can’t spend it?

Crypto hacking: Quite contrary to the popular belief crytptos are not scam proof. There have been cases of crypto hacking and the amount goes in millions.

1. Bitfinex (exchange) was hacked in 2016, hackers stole BTC of the value $66000000.

2. Gatecoin (exchange) lost multi-currency valued at $2000000 from their hot wallet.

3. Bitstamp (exchange) lost 19000 BTC from their hot wallets supposed to be valued at $5100000 in 2015.

4. Another attack at Bitstamp made them lose 18866 BTC from their hot wallets supposed to be valued at $5263614 in 2016.

5. Cryptsy (exchange) multi-currency to the value of $6000000 to hackers in 2014.

All these hacking attempts have been made on exchanges and wallets.

How did it happen despite of all the talk about hash and private keys? Hackers have been unable to invade a blockchain through 51% attack till date but they have found other ways. One need to install various apps to deal with cryptocurrencies. There are apps galore who act as wallet and then there are exchanges where crypto transaction takes place. A basic rule is “anything that involves human intervention is prone to manipulation.” These apps are the weak link for hackers. One might not be able to decipher a private key but key to wallet can be decoded because wallets are maintained by us, ordinary human beings and we create passwords out of habit.

Rationale: The first thing we should ask ourselves: from where do cryptocurrency derives its value? It isn’t backed by anything. Crypto currency is not even a currency. It is a digital code which is the result of a puzzle. So why people are paying high price for it? No one knows, participants don’t know themselves except that the prices are insanely volatile and if it’s a lucky day they might make outlandish profits. Perhaps it would have been better if Creator has named it as ‘DigitalPoint’ instead of ‘Bitcoin’.

Current scenario: Digital currency is in ‘grey area’ in India as of now. In 2018 RBI banned cryptocurrencies, this ban was overturned by Supreme Court in 2020. Government since then hasn’t banned it but hasn’t accepted it yet. So, they are in grey area. Here comes the most interesting part:

Taxation: As long as it is not banned people can trade it but once they encash their cryptocoins and money reflects into account it is taxable. So, government is neither approving it nor it can ban it. But it can extract tax from the proceedings anyway.

No Remedy for Loss: A decentralized, unregulated system might appear attractive at the beginning but every system has it’s own discordant. What if a transaction goes wrong in any way? Whom are we going to complain? The first and foremost function of a regulatory body is that it invokes feeling of safety. In regular banking transactions there’s a customer care department for taking complains and banking ombudsman for public grievances. Being a free, decentralized system crypto market has got no such security. Once your coins are lost you cannot recover them and cannot expect any compensation either. Once again, your money is taxable but your troubles are not anyone’s concern right now. Why would anyone want that kind of deal?

It’s Raining Altcoins: Bitcoin is the first cryptocurrency, several other digital currencies were launched after Bitcoin, these are called Altcoins or Alternative cryptocurrencies. Ethereum, Dogecoin, Shibu, Tether, XRP, Stellar to name a few. Once Bitcoin became popular digital currencies started raining like cats and dogs. There are at least 10,000 cryptocurrencies in circulation though all of them are not as successful as Bitcoin and Ether. So, everyone is making his own currency and hoping to get lucky. This gives a feeling of Deja vu. Muhammad Bin Tuglaq in 1330 issued token currency made of brass and copper whose value was equal to that of gold and silver coins. Seeing the opportunity people started minting coins at home, Sultanat came on the verge of bankruptcy. Point is if everyone is creating their own digital coins then what’s the significance of currency? And what will be the value of such currency? Who is going to decide the value to begin with?

Crypto vs Fiat: Crypto supporters argue that crypto is not backed by anything just like fiat currency. Fiat money is not backed by gold like it used to be before, agreed, but there’s a basic flaw in this argument. Fiat currency is endorsed by the government. A sovereign, democratic, legitimate government. Who is endorsing virtual coins? No one. At least not in India.

Seamless International Transaction: Cryptocurrencies have been projected as ‘global currency’ because their transfer across the borders is easy. This is a half-baked fact. Exchange rates are an inherent part of international transfers as no two fiat currencies are equal in value. High volatility displayed by crypto in recent times will make it very difficult to fix an exchange rate. Moreover, since it is a decentralized system factors which influence its price are not in government’s control. Sudden, steep fluctuation in price could create havoc to national economy, especially the smaller ones.

It’s an interconnected world: We live in an interconnected world needless to say no country is independent even though we very much like to boast it. We are more dependent on each other than we ever were: commercially. Let us accept the fact that there is no such thing as ‘freedom’ or ‘independent decisions’ as a nation. Our decisions are guided by our requirements in which international relations play a crucial part. There are countries where Bitcoin trading is legal eg USA, Canada, Australia, EU, Denmark, France, Germany, Japan. And then there’s El Salvador which has accepted Bitcoin as its legal tender. Now the payment part. Merely trading or holding crypto is not enough. One must be able to make payments with it. Some of the global brands have started accepting payments in cryptocurrency: Subway, Burger King, KFC, Microsoft, Xbox, Coca Cola, Starbucks, BMW. The list is quite long actually, names have been selected on their ease of identification. More people visit Subway, Burger King, KFC then BMW showrooms. That reveals how digital currency has already seeped its way into our daily life. According to Triple.vA, a leading cryptocurrency payments company there are approx. 300 million crypto users in the world right now with India alone contributing 100 million. From 35 million in 2018 to 300 million in 2021, this is nothing short than an astronomical rise and going by the trends we all know that number is going to rise. The question is how long can others stay aloof? Or is it even possible? If money is involved then it can’t be just ‘virtual’ at some point of time digital and physical worlds are going to collide for sure. This situation is far too complex to be swept under the blanket ban.

To Ban or To Regulate: Current debate is whether government should ban these digital currencies completely or regulate them? Government has declared its intentions of banning private cryptocurrency in the past. In common parlance ‘private’ means anything which is not controlled by government. According to this definition all digital coins are private and susceptible to ban. People who are trading or holding crypto will need grace period to redeem their investment and close their accounts. If government really decides to put a blanket ban on all pvt digital currencies, panic selling will swing the price most certainly in favour of buyers and sellers will have to incur losses.

Acknowledging virtual currency will open a whole new pandora’s box for regulator. A currency whose origin is obscure and which cannot be controlled by the Central bank, allowing such currency to circulate freely in the system means giving rise to a parallel economy over which authority has no control. This idea itself is preposterous. RBI is apprehensive about macroeconomic stability which it very valid but banning it will not solve the problem it will encourage underground activity.

Another option is to regulate it with restrictions. Government may consider giving concession to select currencies which have widespread network. It could be classified as ‘digital asset’ under the asset class. Declaration of digital assets must be made mandatory irrespective of value of the holdings. Exchanges dealing in digital currency trade ought to be regulated. This will act as a deterrent for small ticket transactions and encourage high volume transactions which are comparatively easier to track and tax. Any type of international transaction must be reported. As far as the anonymity part is concerned, it cannot exist along with regulation. Identity verification should be made compulsory by exchanges and all data to be stored in the country with no data mirroring. Authentication and taxation will curb one major problem: it will act as a resistance to mass movements during highly unpredictable sessions.

If government is contemplating any type of approval to private cryptocurrencies then it must keep in mind the complexities created by VPNs. Virtual Private Networks are available for free on dark net also they are available for a fee too. Evaders often pick up a free VPN and use it to obfuscate real location of their device. This trick is so simple that Indian’s are watching Israeli shows on Netflix with no hiccups at all. VPNs and Tor are and will be used for sure against all rules. Good thing is even with hidden IP address traders will need an exchange and a wallet to buy/sell/hold their currencies. So by keeping a strict vigil on exchanges backdoor transactions could be traced.

In practice situation is a bit more complicated. Here we are talking about equating fiat currency with digital currency about which we know nothing. There could be a separate exchange rate for converting digital coins into fiat currency keeping the later one on higher pedestal. Crypto transactions hasn’t happened in physical world so far in India because no shopkeeper or organization is accepting them. If digital coins get government approval businesses might begin accepting them as a mode of payment. In such a situation unfair valuation (higher value of fiat currency) will help in striking the balance. The purpose of putting all these checks points is to ward off insincere, penny-wise traders. High volume traders will be easy to monitor and track if necessary. If we ban it we shall have to deal with outlaws/vpn; if we regulate it we can garner revenue from it and we still had to deal with outlaws but this time we shall be having a framework on how to deal with it. Only recently it was proposed that crypto dealers were to fined 20 crores though the bill has been postponed and we don’t know yet for sure how much is the fine and punishment going to be. But if government really thinks people are making that kind of money (in justification of 20 crore fine) it has all the more reason to bring it under tax ambit.

In India cryptocurrency is neither goods nor service but exchanges have to pay 18% GST on the service they provide. Crypto exchanges have expressed their displeasure and some of them are planning to shift base to countries where tax rates are lower. Considering the type of business model they follow it is easy for them. Once again there’s the question of revenue. Why gift our revenue to someone else? Instead of making them shift base, would it not be better to legitimize their service by forming appropriate rules?

Crypto traders can convert their digital coins in to dollars or pound, later on they can transfer their foreign currency into India through foreign exchange market. That could create additional problems. In a nutshell ban on cryptocurrencies will open countless new channels for crpytophiles.

With various rules in place cryptocurrency will retain its ‘DeFi’ status but it will lose it’s privacy which is a practical bargain between legitimacy and illegitimacy. Naysayers will say lots of things against digital currency, their prime fear is that it will encourage money laundering. Not if we can keep a tab on exchanges and fix their accountability. Same type of negative prophesies were made during the advent of internet. Internet is very much here and we have learned to deal with it’s menaces. As long as there’s ‘money’ there will be laundering, be it physical cash or virtual money. If government decides to bring ‘crypto’ in assets class we shall sure learn to deal with it too.

Absolute freedom is as flawed an idea as absolute control. Trick is to know where and when to draw a line.

References:

1. Bitcoin: A Peer to Peer Electronic Cash System; Nakamoto Satoshi (2009).

2. The Basics of Bitcoins and Blockchains: An Introduction to Cryptocurrencies and the Technology that Powers Them; Lewis Antony (2018).

3. Views expressed are personal.

*******

Dr. Shweta Bhadauria | State Tax Officer | Department of Commercial Tax | Indore (MP)

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