Virtual Digital Assets (VDAs): Challenges in Regulation – Explained, pointwise

Introduction

The first meeting of G20’s Finance Track was held recently in Bengaluru. Regulation of Virtual Digital Assets (VDAs) emerged as a top priority agenda in the meeting. VDAs are a new evolving technology and are at the intersection of finance, economy and technology. The concerns associated with the exploitation of VDAs as a medium of money laundering and terror financing has necessitated their regulation. The Government of India has been leading efforts at the global level to counter terrorism and its financing. In the recent ‘No Money for Terror’ Conference hosted by India, 93 participating countries agreed to end all financing of terror, including through the use of emerging technologies such as VDAs. The Government has pushed regulation of VDAs as an agenda of G20 in the year of its Presidency. There are several challenges in regulation of VDAs that requires a coordinated international effort.

What are Virtual Digital Assets (VDAs)?

The Financial Action Task Force (FATF) defines a virtual asset as “A digital representation of value that can be digitally traded, transferred and used for payment or investment purposes“. This definition is included in the FATF’s global recommendations on Combating Money Laundering and the Financing of Terrorism and Proliferation.

According to the US Department of the Treasury, a virtual currency is a “digital representation of value that functions as a: (a) Medium of exchange; (b) Unit of account; and/or (c) Store of value; and is neither issued nor guaranteed by any jurisdiction”. This description fits neatly into the FATF definition of a virtual asset and the idea of a digital representation of value.

The Finance Act, 2022 introduced a new taxation regime for income arising from transfer of Virtual Digital Asset (VDA) under Income-tax Act, 1961 (the Act). The term Virtual Digital Asset (VDA) has been defined under Section 2(47A) of the Income Tax Act to include the following: (a) Any information or code or number or token (not being Indian currency or foreign currency) generated through cryptographic means or otherwise, by whatever name called, which  meets certain conditions; (b) Non-fungible token (NFT) or any other token of similar nature, by whatever name called. Further NFT is defined to mean such digital asset as the Central Government may, by notification in the Official Gazette, specify; (c) Any other digital asset, as the Government may specify by notification.

The Government may exclude any asset from the definition of Virtual Digital Asset by notification.

A Non-Fungible Token (NFT) is a digital asset that exists on a blockchain, allowing anyone to verify its authenticity and who owns it. Digital art, images, videos, text, music and even virtual real estate and in-game items can be bought and sold as NFTs.

While VDA includes cryptocurrencies, the definition can cover a wide variety of digital assets which is implied by the wording ‘or otherwise’ in the phrase “generated through cryptographic means or otherwise”. The definition is also made exhaustive with the words ‘information’, ‘code’, ‘number’.

Because of the broad definition, VDAs can potentially include vouchers, reward points issued by shopping sites or credit card companies, airline miles etc. Experts have sought clarifications from the Government. They fear the scope of VDA may impact digital assets created by companies.

The Central Board of Direct Taxes (CBDT) in Notification 74 has excluded certain items from the definition of VDAs. These include gift cards, vouchers (discounts), mileage/reward/loyalty points (promotional programmes) etc.

What steps have been taken to regulate Virtual Digital Assets (VDAs)?

First, The Financial Action Task Force has issued the Guidelines on Virtual Asset Transactions (FATF Guidelines) related to VDAs. The Guidelines have been adopted by various jurisdictions, including the EU, Japan and Singapore.

Second, The Finance Bill 2022 has promulgated a new taxation regime for the class of VDAs including cryptocurrencies and non-fungible tokens (NFTs). The gains arising from the transfer of VDAs are proposed to be taxed at the rate of 30%. However, the Act did not have any provision related to legalizing/banning the cryptocurrencies or any other Digital Asset.

Third, Under the presidency of India, G20 Finance Track discussion has put the regulation of VDAs to curb their use in money laundering and terror financing as a top priority.

What are the challenges in regulating Virtual Digital Assets (VDAs)?

First, the technologies behind blockchain and cryptocurrencies are complex. It is difficult to determine their governing structure.

Second, the blockchain technologies are decentralized by design. They transcend national jurisdictions in a digital domain. Hence it is difficult for Governments to regulate them.

Third, Digital Technologies including blockchain are evolving rapidly. It is difficult to regulate such technologies without fully comprehending their benefits and drawbacks. It is challenging to come up with a singular and concrete structure to apply to every known and unknown technological development and change in the financial sector.

Fourth, Lack of reliable data on VDA transactions allows bad actors to engage in unchecked transactions and defraud investors as happened in the case of FTX bankruptcy, which was the second largest Virtual Digital Asset (VDA) trading platform before its collapse.

What should be done going ahead?

First, A viable approach for India is in taking the industry and the investor into confidence by allowing anti-money laundering (AML) authorities visibility over VDA transactions, and the power to impose controls upon them and prosecute in the event of any misuse.

Second, The concerns around the misuse of VDAs for illicit activities require careful legislative responses and forward-looking regulatory mechanisms. The present concerns related to VDAs stem from lack of reporting and transparency norms, and an absence of international consensus on regulatory design. G20 provides a suitable platform to develop an understanding and consensus regarding regulation of VDAs. The Government has taken a positive approach by pushing this matter as a priority for G20 Finance track.

Third, The financial institutions, fintech, regulators, consumers, and government need to join forces to have a fair and comprehensive regulation benefitting every stakeholder.

Fourth, Development of adequate financial and technology literacy programs (e.g., through initiatives at different education levels, tailored communication, and outreach programs) should be considered.

Conclusion

The technology surrounding the financial sector (blockchains, cryptocurrencies, VDAs) has been evolving rapidly. While these technologies have several benefits, their misuse (money laundering, terror financing, financial frauds) pose a big threat. Complexity and ever evolving nature of technology makes their regulation a major challenge to the regulatory authorities. A coordinated effort at the global level is necessary for this purpose. India currently has two crypto unicorns operating domestically, and is home to major VDA players and a thriving community with 25+ million people, making it all more important to regulate the sector. In addition to the domestic efforts, the Government of India should take a lead in guiding the discourse on the global regulation of VDAs.

Syllabus: GS III, Indian Economy

Source: Indian Express, The Hindu BusinessLine, Financial Express, Mondaq, FATF