Why Dynamic Regulations For Indian Crypto-Asset Investors May Be Need Of The Hour

Currently, India only regulates crypto asset space from an Anti-Money Laundering and Counter-terror financing perspective, which does not provide enough protective measures or any grievance redressal.

Approaching courts in the event of a crypto fraud may be the first reaction of victims, but it is not a straightforward one. (Photo source: Freepik)

Crypto assets have again become the talk of the town, not only because of off-the-chart returns, but also because of a recent hack in one of the crypto asset exchanges operating in India. Such an incident highlights the vulnerabilities in the Indian crypto industry. It also brings to light the absence of a robust regulatory oversight over the crypto asset exchanges, to ensure protection of the interests of the Indian crypto-asset investors. Any security breach of a crypto asset exchange leading to the loss of funds of the individual investors leaves the retail investors high and dry and at the mercy of any possible measures that the crypto asset exchange decides to pursue.

In the event of fraud, the first solution contemplated by every individual is approaching the court for interim relief of ring-fencing assets and protecting their interest. However, this potential solution may not be a straightforward one, as every crypto asset exchange has a user agreement binding its user to an arbitration clause, thus making the Indian courts unapproachable for any grievance redressal. Generally, every user agreement (usually a clickwrap agreement) has an arbitration clause which sets forth the seat and venue of the arbitration along with a prescribed mechanism for appointment of the arbitrator(s) as per the Arbitration and Conciliation Act, 1996 and over which the user has very little control. It is difficult for retail investors to move forward with this option, considering the costs and the long drawn legal process associated with the same.

Even the Insolvency and Bankruptcy Code, 2016, has its limitations in terms of reliefs for the crypto asset users, as it only provides the creditors with a recourse to recover their funds from the insolvent entity. Crypto assets parked by users with an exchange could fall into a legal grey area, as such assets cannot be considered as assets of the exchange itself, thus, keeping such assets out of the purview of the insolvency proceedings and keeping the users out of the definition of creditors.

Furthermore, the distribution of assets under the Insolvency Act is undertaken based on the priority mechanism referred to as the ‘Waterfall Mechanism’ under Section 53 of the Insolvency Act. According to the Waterfall Mechanism, any unsecured debt, (debt without creation of charge over any security)—which is the case with the crypto asset users entering into a click wrap agreement with the exchange—would be given a very low priority, that is, crypto-investors will be paid at the very bottom of the Waterfall Mechanism.

Alternatively, an option for the user in distress could be to approach the consumer forum under the Consumer Protection Act, 1986. However, the courts in India have ousted the ambit of CPA by observing that matters involving fraud, forgery and cheating in relation to financial transactions are challenging to resolve through the summary proceedings of the CPA and are more suitable for adjudication in a civil court, thus ruling out this alternative for seeking redressal.

Crypto assets have again become the talk of the town, not only because of off-the-chart returns, but also because of a recent hack in one of the crypto asset exchanges operating in India. Such an incident highlights the vulnerabilities in the Indian crypto industry. It also brings to light the absence of a robust regulatory oversight over the crypto asset exchanges, to ensure protection of the interests of the Indian crypto-asset investors. Any security breach of a crypto asset exchange leading to the loss of funds of the individual investors leaves the retail investors high and dry and at the mercy of any possible measures that the crypto asset exchange decides to pursue.

In the event of fraud, the first solution contemplated by every individual is approaching the court for interim relief of ring-fencing assets and protecting their interest. However, this potential solution may not be a straightforward one, as every crypto asset exchange has a user agreement binding its user to an arbitration clause, thus making the Indian courts unapproachable for any grievance redressal. Generally, every user agreement (usually a clickwrap agreement) has an arbitration clause which sets forth the seat and venue of the arbitration along with a prescribed mechanism for appointment of the arbitrator(s) as per the Arbitration and Conciliation Act, 1996 and over which the user has very little control. It is difficult for retail investors to move forward with this option, considering the costs and the long drawn legal process associated with the same.

Even the Insolvency and Bankruptcy Code, 2016, has its limitations in terms of reliefs for the crypto asset users, as it only provides the creditors with a recourse to recover their funds from the insolvent entity. Crypto assets parked by users with an exchange could fall into a legal grey area, as such assets cannot be considered as assets of the exchange itself, thus, keeping such assets out of the purview of the insolvency proceedings and keeping the users out of the definition of creditors.

Furthermore, the distribution of assets under the Insolvency Act is undertaken based on the priority mechanism referred to as the ‘Waterfall Mechanism’ under Section 53 of the Insolvency Act. According to the Waterfall Mechanism, any unsecured debt, (debt without creation of charge over any security)—which is the case with the crypto asset users entering into a click wrap agreement with the exchange—would be given a very low priority, that is, crypto-investors will be paid at the very bottom of the Waterfall Mechanism.

Alternatively, an option for the user in distress could be to approach the consumer forum under the Consumer Protection Act, 1986. However, the courts in India have ousted the ambit of CPA by observing that matters involving fraud, forgery and cheating in relation to financial transactions are challenging to resolve through the summary proceedings of the CPA and are more suitable for adjudication in a civil court, thus ruling out this alternative for seeking redressal.

Also Read: ED, CBI Arrest CAs, Crypto Trader In Rs 640-Crore Cyber Fraud

Some users may also opt to initiate criminal action against the founders/ directors of the crypto asset exchanges in the hope of securing the funds still available with the exchange and getting them to justice. However, a criminal action against the exchange and the founders/directors may result in prosecution by the state, however, the same shall not be a viable option for retrieving the user’s crypto assets as the criminal action, at best, secures punishment to the offender and that, too, by way of long drawn criminal proceedings. Such actions may also be rendered otiose if the founders are based outside India.

Currently, India only regulates crypto asset space from an Anti-Money Laundering and Counter-terror financing perspective, which does not provide enough protective measures or any grievance redressal mechanisms for the users on the crypto-asset exchanges. Some of the concerns of such authorities with respect to the crypto space, around decentralised peer to peer activities, in the crypto-asset space, which completely relies on voluntary compliance and potential tax evasion may be justified. Having said that, it cannot be deemed that, the crypto-asset exchanges have not only brought form, but also structure in the scattered crypto space and all exchanges are not only open but are keen for legitimate and reasonable regulations.

Considering the complex nature of this space, the Indian government may include stakeholder recommendations in forming the guardrails to not only consider the AML/CFT perspective, but also focus on investor protection, a step towards creating a safer environment. India may take inspiration from other jurisdictions and mandate investor safeguarding measures on crypto asset exchanges, such as executing transactions through escrow mechanisms, transparent regulation of the initial coin offering, mandatory disclosure of material information about any listed crypto assets and its issuer, comprehensive cold wallet security measures, etc. Such measures may make this space not only more accessible to Indian users but also safe for first time and uninitiated users.

Also Read: Trump May Be Good For Crypto — But Bad For Bitcoin

Pallavi Singh Rao is partner at Cyril Amarchand Mangaldas.

Shrish Gautam is associate at Cyril Amarchand Mangaldas.

Disclaimer: The views expressed here are those of the author, and do not necessarily represent the views of NDTV Profit or its editorial team.

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Pallavi Singh Rao
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Shrish Gautam
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