Imagine not paying transaction fee for an online purchase. Or transfering money across thousands of kilometers in no time, and for no charge. A currency free of government. Virtual currencies offer all this – and much more. In America and Europe, currencies such as Bitcoin are gaining users; Japan and the Scandinavian countries are emerging havens of this new legal tender, as also in other countries with widespread broadband connectivity. From college fee to e-commerce, transactions are done in bitcoins. Entrepreneurs, especially venture capitalists, are excited about the idea.

Central banks and financial regulators are never comfortable with a system they do not understand and have no way to influence, let alone control. Regulators in the industrialised countries are taking cautious steps towards dealing with this new financial ecosystem. In the US, New York state’s department of financial services plans to propose a set of rules for virtual currency firms by mid-2014. The department announced last year it is accepting applications to operate exchanges for digital currencies.

Unlike the paper or the centrally regulated money, virtual currency (also referred to as crypto-currency and digital currency) are generated by a bank of computers and server farms. These use complex mathematical algorithms, which get progressively difficult to execute and solve. When the network solves the algorithm, a block of 25 bitcoins is generated.

In their own ways, regulators across the world acknowledge that technological innovation is speeding ahead of them. Indian financial regulators have adopted the cautious route, advising users that virtual currency exchanges are unauthorised. Its users have no recourse to the law in cases of fraud and malpractice. In February, RBI governor Raghuram Rajan expressed concerns over who decided the value of the currency. “Can we have confidence in unseen, unknown centres which maintain the value of the currency, or an algorithm that will maintain the value of the currency—we need more credibility there,” said Rajan, while speaking at the Nasscom leadership summit.

The fluctuations in the value of virtual currency have made it a favourite for speculators, says an enforcement directorate official of the Mumbai zone. Extreme fluctuations in the value of bitcoin act as an incentive for speculators. The value of virtual currency was $13 in 2011. Between May 2013 and December 2013, its value sky rocketed from less than $200 to $1,100. At present a unit of bitcoin is equivalent to $495.

Two leading digital evangelists, who have invested in bitcoins, currently see the virtual currency as a high-risk high-return investment option. The two top industry leaders who Governance Now spoke to include a Mumbai-based senior executive of a diversified business group and head of a Bangalore-based media group. Both see bitcoins as an investment that has good potential to appreciate. The two also hope that at some point of time it will acquire the status of a full-fledged global currency.  

The Indian regulator’s dilemma pertaining to virtual currency is not completely baseless. The anonymity associated with the digital currency has gained it notoriety and is often equated with Hawala, the informal money transfer system. It is being used to fund a variety of illegal transactions — buying drugs, counterfeit currency and arms and credit card details.

Anonymity, the biggest challenge

The concerns related to security and anonymity are currently major obstacles in bringing in cryptocurrencies within the existing monetary regulatory framework.

The transaction history of all bitcoin addresses (read bank account) is available in public domain on ‘blockchain.info’, an online public ledger. The information, however, about the owner of the bitcoin address is not known to anyone. “There is no way to identify the owner of a wallet. Proving anything in a court of law will be a major challenge for the government agencies,” said an enforcement directorate (ED) official working in the Delhi Zone.

Speaking to Governance Now, hackers and bitcoin users say that owing to anonymity, virtual currencies are preferred for illegal transactions. Consider the case of Liberty Reserve (LR), the Cost Rica-based digital currency and payment network. Since it was set up in 2006, LR gained notoriety for its massive use for purposes of money laundering. Media reports described it as the ‘largest payment processor for illicit and criminal transactions’.

In 2013, when the US law enforcement agencies clamped down on the LR, it had processed more than 55 million transactions worth over US$6 billion. It had more than a million users. Bitcoins, several experts say, is headed the same way.

The exchanges too are reckless towards standard KYC norms. “They just ask for scanned copy of the PAN card through an email from the investors,” says another ED official working in the Mumbai zone. In December 2013, the ED raided two Ahmedabad-based exchanges: buysellbitco.in and rbitco.in. The exchanges were running a trading platform for investors without proper verification of their credentials. The exchanges required requisite permission and authorisation from the RBI as it involved transfer of money within and the outside the country.

Cryptocurrencies are also vulnerable to cyber theft. The Mount Gox (a Tokyo-based Bitcoin exchange set up in July 2010) episode underlines security concerns.  By 2013 the exchange was handling 70 percent of all Bitcoin transactions. Early this year it reported that unknown hackers stole about 850,000 bitcoins, worth $450 million. The exchange filed for bankruptcy protection. On April 16, a Tokyo court dismissed its application. Now the exchange faces liquidation; the company’s assets may be sold to repay its debts.

Not all is lost

Regulators and law enforcement agencies are in a bind. Is virtual currency legal? Is it a currency or a commodity? Insiders believe RBI, sooner or later, will have to design a legal framework to accommodate the parallel currency system, preventing its abuse.

“How do you tame the beast?” asked Abheek Baruah, chief economist at HDFC Bank. No doubt, virtual currency has made e-commerce cheaper and will increase its popularity. The ecosystem of virtual currency, Baruah said, is outside the monetary authorities’ ambit. The central banks risks losing a great deal of control over the financial system and money supply.

“But you can’t suppress technology innovation. We need to work on developing regulatory and controlling parameters to address the challenges,” said Baruah. He is of the opinion that the parallel currency system should be brought into the legal framework as ‘complete democratisation of money might lead to macro-economic issues’.

According to the ED official of Mumbai zone, the digital currency can be brought into the current legal framework itself by tightening rules and regulations defining the exchange operations.

A section of venture capitalists and free market proponents pitch strongly for cryptocurrencies. Keertan Patel, who works with the Indian subsidiary of US-based exchange, BitQuick, said that in rural areas, lacking banking facility,  cryptocurrencies offer people an opportunity to get networked with real-time transactions. “This can create jobs for people who don’t have an easy way to receive payment for services,” said Patel.

The RBI itself hasn’t debunked bitcoin. “I don’t want to say that there is no future for these virtual currencies, I think it’s a process of evolution, but for now all we’ve done is express the kinds of concerns we have about it, without determining in any which way what we intend to do,” Rajan said at the Nasscom event. For all its lack of official recognition, the value of all bitcoins in circulation currently exceeded $2 billion. Virtual currencies are here to stay and sooner the policy gurus come to grips with it, the better it is for everybody.

THE 5-MINUTE CAPSULE

How does it work?

To use Bitcoin one needs to have a wallet, which is as easy as opening an email account. Once a wallet is installed in a computer or smart phone, the application generates a bitcoin address (say the account number which could run in over 30 characters including numbers and alphabets) and a key (understand this as a password—required for every transaction—running in 64 characters with alphabets and characters).

According to bitcoin.org, payments are made from a wallet application, either on your computer or smartphone, by entering the recipient’s address, the payment amount, and pressing send. The transactions are maintained in the online ledger, blockchain.info. All confirmed transactions are included in the block chain.

One can get a bitcoin either through purchase or ‘mining’ (say minting). Unlike paper money which is printed, bitcoins are generated through computers that solve complex algorithms. The process performed by computers is called mining. The algorithms are complex and requires great computing power. Miners have been running hundred and thousands of servers on 24x7 basis to process these algorithms. Several miners collaborate and form a common pool of computing resources. The network of miners is required to approve transactions. Each miner is provided proportionate number of Bitcoins based on contribution.

The policy conundrum

RBI’s position: In a statement issued in December 2013, RBI has said that creation, trading or usage of virtual currencies including Bitcoin, as a medium for payment are not authorised by any central bank or monetary authority. The apex bank has also pointed out that no regulatory approvals, registration or authorisation has been obtained by the entities concerned for carrying on such activities.

Enforcement directorate’s perspective: Taking cue from the RBI advisory against buying and selling of Bitcoins, Enforcement Directorate (ED) in India conducted few raids in companies that are believed to provide bitcoin trading platform. As of now, ED officials believe Bitcoin is not a currency but a commodity. However, the agency too is yet come up with clear guidelines or policy framework on virtual currency.