Photo: Reuters

Madan Sabnavis

It’s a concept that holds undeniable appeal but poses a variety of threats that cannot be overlooked

Gold has no intrinsic value, but its scarcity and acceptability have created a pricing mechanism for it. Theoretically, any stone of any colour found only in select regions that can be used as an ornament will gather value from scarcity and acceptability. The same is true of cryptocurrency. There are willing buyers and sellers of something that has come from out of the blue. The idea has gained strength with the government of El Salvador announcing that it holds Bitcoin. The corollary is that if a government believes in it, no one can be left out and its use may become a habit.

Bitcoin, created by Satoshi Nakamoto, who has not yet been identified, is the most popular cryptocurrency. Despite its cryptic origin, Bitcoin is widely traded and a force to reckon with in financial markets. Other currencies have emerged with fancy names such as Ethereum, Litecoin and Dogecoin. While we may have to accept this wave, the broader question is whether they should be allowed to circulate.

The main purpose of a currency is to serve as a medium of exchange for transactions. Logically, the reins of such an instrument must be with a country’s central bank as we cannot have multiple currencies operating within a jurisdiction. In India, we must surrender foreign exchange beyond a limit to the Reserve Bank of India and cannot buy goods and services domestically with dollars or euros. This is the edifice of a currency system, which provides the basis for monetary policy. But today, interestingly, one can pay for hotels in Thailand or insurance in Switzerland with Bitcoin. Cryptocurrency is being used as a medium of exchange. This is bad news for central banks. If everyone uses cryptos for transactions, monetary policy would become superfluous.

The genesis of such currencies lay in the perception that central banks and governments had mismanaged economies by printing too much currency, which was what the US Federal Reserve did through quantitative easing, later followed by other central banks. The roll-back of all this easy money is now a problem, as it can generate turbulence in financial markets.

The concept of cryptocurrency seeks to overcome such a problem by generating a finite—yet infinite—stream of coins through blockchain technology. It’s finite because there is typically a cap on final currency units, but it’s infinite as the new coins generated would be at a proportion of the remaining balance, and this never changes. But their anonymity of use creates a conundrum, as the antecedents of a payment-maker can’t be known. Because identity gets concealed, such currencies serve as useful conduits for drug money. Therefore, it would be injudicious for governments to legitimize cryptocurrency as a medium of exchange.

An interesting implication of this was that there was nothing sacrosanct about Bitcoin, and so came a plethora of other cryptocurrencies. There are around 6,000 of them presently, although probably not more than 10 are actively being followed and traded.

How about crypto as an investment? If one can invest in stocks, race-horses and gaming, then why not in such currencies? Many things hold value that aren’t backed by anything but market perception. This is not too different from betting on sports or elections, in which there are no fundamentals driving the price. The argument here can be that if we permit these currencies as investment avenues, then all activities of this nature should be made legitimate (and taxed). Even betting on Indian Premier League matches can be seen as an investment. What’s important is that tax authorities should be aware of such transactions, lest they become ‘hawala’ deals where the gains escape taxation. There is already a lot of scepticism over participatory notes floated by foreign portfolio investors on concerns that Indians could be rerouting foreign exchange through them.

There is a strong case for banning cryptocurrencies, though tracking their activity could be a challenge. Or, if we allow them as investment avenues, investors should make full disclosures so that all transactions are taxed—under GST as well as capital gains.

There are two major threats for governments and central banks. First, while such transactions operate outside the financial system, all these currencies are denoted in dollars. This means that investors are using formal channels to gather dollars to pay for these cryptocurrencies. Therefore, any shock in the Bitcoin market can seriously disrupt the formal financial system.

The second is even more serious. If cryptos are legitimized, there is nothing to stop entities from starting a parallel crypto-banking system, where they accept deposits from holders and pay an interest rate which is higher than what one gets from a bank and use the same as a peer-to-peer lending platform. This can go on without authorities noticing.

The government of India has been relentlessly going after black money with measures like demonetization, which proved unsuccessful despite its boldness. Allowing cryptos would only encourage black money to be generated and stashed away from the regulatory system’s reach. Good reasons exist to ban them until we can put in place an appropriate regulatory framework.

Madan Sabnavis is chief economist, Care Ratings and author of ‘Hits & Misses: The Indian Banking Story’