Bancor Comes of Age: A Case for an Indian Bitcoin Reserve

Introduction

The emergence and popularity of cryptocurrencies signify a major shift in the way we perceive money as an institution. Robust debate on cryptocurrency in the international realm is scarce since (a) the evolution of cryptocurrency is just a decade old and is still an emerging technology whose impacts are yet to be assessed, (b) cryptocurrencies present a possibility of devolving economic sovereignty to the individual, undermining state monopolies as mediums-of-exchange and (c) economic and financial systems, especially fiat-based legacy banking, are entrenched in the economic consciousness of most states and in day-to-day life, which creates inertia in the discussion of fundamental shifts.

This article focuses on the intersection between Indian monetary and foreign policies and places cryptocurrencies, specifically Bitcoin, in this context. It will examine the role of international reserve currency status, the emergence of Bitcoin, and Indian foreign policy priorities. This paper will also introduce a model for the governance of crypto-assets by the Indian state and how it can be used in its international relations.

Economic Sovereignty and the State

The act of exerting sovereignty in the economic sphere poses many challenges because of its conceptual ambiguity. At best, states exercise economic sovereignty by controlling their integration with the global economy through capital controls, licensing and regulation of trade matters within its territorial reach. States cannot thrive in isolation from the global economy which is why states trade absolute sovereignty for access to global markets, resources, technology and goods. Notions of economic sovereignty have also remained largely unchanged even as the concept of state has evolved. Partly, this is explained by the fact that the traditional rules of international commerce have remained unchanged over centuries without innovation in structural fundamentals like a common medium of exchange.

When we compare power dynamics in international relations, a state enjoys strategic advantages when it incubates advancements in technology. Significant technological improvements act as catalysts for the concentration of power especially when technology has commercial applications and is highly prized for its economic and strategic value. In such a scenario, other states attempt balancing out this power disparity by developing their own technology either by copying and/or improvement to reap the economic benefits that come with it (Acemoglu & Akcigit, 2012, p. 40).

Political Economy of Reserve Currencies and Power Dynamics

There are several constituents of economic power, but its greatest expression is seen when states leverage their economic power to affect global economic decision-making and the norms associated with international economics. In the contemporary era, the outsized influence that the United States has over international economic governance amply demonstrates this dynamic through the ‘virtual veto’ in quota systems, king-making tendencies in the leadership of the international economic organisations, and the indiscriminate peddling of neoliberal reforms as the global standard for economies all around the world despite its unsuitability in several countries all around the world (Felder, 2009; Schwartz, 2019; Vermeiren, 2013).

Yet, the biggest expression of economic power lies in the way a country is able to leverage its currency as the world’s reserve currency. As a concept, a reserve currency signifies (a) the scale and openness of an economy where global commerce simply adopts the currency as the most convenient measure of value due to the sheer frequency of global commercial intercourse and (b) an expression of faith in the dominant status of the power that creates the reserve currency and predicts continued stability of the issuer for a significant time to come without fear of major counterparty risk. The reserve currency demonstrates a continuation in hegemony when it is a preferred medium of exchange even when the issuing state is not party to any commercial transaction. As D’Arista (2009) maintains, the country that issues the global medium of exchange would experience larger credit inflows and a larger availability of credit to the advantage of its residents.

In such a case, the central bank issuing the reserve currency becomes a very powerful institution in international economic governance through its regulation of currency supply which also decides the fate of international trade and commerce. As a primarily national endeavour, there is no incentive for the central bank to act independently in the interests of global governance and on the contrary, acts to secure maximum power for its national interests (Pape, 2021, p. 14).

History shows us that reserve status for any currency is not permanent and exists only as long as other states continue to confer this status on the dominant state. The Dutch Guilder is considered to be one of the first reserve currencies in the world because of the dominant status that Holland enjoyed at the time with a more educated population, higher adoption of technology and an extensive mercantile network (Quinn & Roberds, 2014). Eventually, conflicts with other European powers diverted resources from its economic development and precipitated Holland’s decline as an empire.

Like the Dutch Guilder, the British Pound became the reserve currency of its time, fueled by the extensive British presence around the world through colonialism and extensive trading networks. The strains of maintaining a large empire eventually became the undoing of British power and its weaknesses compounded in the course of the two World Wars. Some scholars argue that the US Dollar was already eclipsing the Pound Sterling in the 1920s, which makes it one of the natural successors to global reserve currency status (Eichengreen, 2011, p. 32).

A big question after the end of the war was what international economic governance would look like with extensive damage to virtually every realm of economy and society across the world and the magnitude of resources required to begin reconstruction. The Bretton Woods Conference and its institutions (World Bank and International Monetary Fund [IMF]) convened after the war was an attempt to answer these pressing questions of economic reconstruction.

One of the core themes that the Bretton Woods agreements sought to answer concerned the standards and practices to secure the stability of national currencies. At its core, currencies are promissory notes to the holder of the currency that the issuing authority will pay an equivalent of the amount specified on the note when it is presented. Theoretically, states must issue currency notes against the assets they own such as gold or foreign currency, but states routinely issue currency notes exceeding their assets to ensure liquidity for everyday life and economic growth. The Bretton Woods consensus established that states would try to ensure that the circulation of currency does not overly exceed the assets held by them, to ensure that Central banks lived up to their fiduciary duties to the public and for the healthy functioning of the economy (Knafo, 2006).

The proliferation of the US Dollar accelerated through generous aid programmes issued in dollars to America’s new allies in Europe and Asia that were rebuilding after the war (Eichengreen, 2011, p. 48). America’s military dominance, its generous aid programmes and its hegemonic influence on the Bretton Woods institutions created the perfect conditions for the wide acceptance of the US dollar as the reserve currency.

While the Cold War unfolded, the American dollar was still considered the world’s reserve currency despite competition with the Soviets in the strategic realm. By the 1970s, it became clear that America issued currency far in excess of the underlying assets that backed the US dollar. As it became clear that America no longer held assets to repay claims made on the currency notes issued, President Nixon took America off the gold standard in 1971 which meant that the US dollar would be backed by its dominant status rather than tangible assets (Gowa, 1984). In effect, America was monetising its power projection to maintain its hegemony and uphold its standard of living. With no challengers to American hegemony, this controversial move went largely uncontested and America did not face major consequences of going off the gold standard.

This lack of challenge also meant that America could simply pay off its debts to other countries by printing more currency since its reserve currency status rendered it both an asset and a currency. It is argued that since the reserve currency was backed by the ability of the United States to project power, it incentivised the US to undertake much higher military expenditure to maintain its dominance (Wheatley, 2013, p. 19). America was also expected to undertake the costs of providing security goods around the world to secure the liberal international order, which became a source of tension in the international system (Wheatley, 2013, pp. 25–27)

Despite the widespread use of the dollar outside the United States, other states do not have a say in decisions about its supply, rendering international commerce heavily reliant on the decisions of the US Federal Reserve. As of 2021, IMF estimates that 59% of the world’s foreign exchange reserves is denominated in the US Dollar (International Monetary Fund, 2021). America also holds disproportionate power through its large investments in corporate interests around the world. As Starrs (2013) argues, Americans own much more of the world than the rest of the world owns the United States, and this asymmetric interdependence leads to asymmetric power.

Worse still, the Federal Reserve controls the accessibility of the dollar to a large extent through sanctions where countries, entities or even individuals are denied access to banking services and capital to coerce them into a change of position. Farrell and Newman (2019) while elaborating on ‘weaponised interdependence’ narrate how the Belgium-based SWIFT network in 2018 decided to revoke access to Iranian banks fearing sanctions by the US Treasury Department. Depending on the severity of sanctions, it can severely curtail the ability of states to access credit in an internationally accepted medium of exchange. In a more severe iteration of sanctions, other states may decide to comply with US sanctions on a sanctioned state so as to not become the target for sanctions themselves. A history of sanctions shows us that the US frequently uses sanctions as a tool to coerce states into changing their positions in line with US national interests (Yang et al., 2004, p. 24).

So we see that the globally accepted medium of exchange for trade and commerce around the world is highly centralised; undemocratic in its governance even though the majority of its users are outside the United States (U.S. Currency Education Program, 2021); whose supply is often manipulated to undermine the sovereignty of states and most importantly, is not backed by actual assets but a perception of dominance which incentivises mass military spending and perpetuation of a security dilemma. The network effect created by globalisation only reinforces this dependency and forces a higher degree of vulnerability on the international system.

The search for alternatives within existing monetary and currency systems has been unsuccessful for several reasons. For one, many states are big holders of debt in dollars through the purchase of US Treasury bonds and a policy of criticism would undermine a state’s own economic decision-making (refer to Table A1). Calling upon a discussion about a change of the status quo could irk the United States leading to unpleasant outcomes for commerce, especially since the US is one of the biggest sources of much-needed investments (Jackson, 2017). Second, over the past few decades, globalisation has helped several states improve economic prospects without major liquidity hurdles. Third, despite the emergence of new powers, the world remains largely unipolar with the US being the provider of security goods all around the world, reinforcing its dominant status and by extension, the faith in the US dollar.

When we consider long-term debt cycles, we see that even with a dominant position, countries who are over-leveraged and are unable to pay off their debts will face prospects of displacement and a revocation of the privilege of holding the world’s reserve currency. Such a displacement is usually glacial in pace and is usually triggered by large-scale security challenges or conflict as history shows us about Holland and Britain in their time.

Since the creation of reserve currency is a power multiplier, the issuing state will resist any attempts at finding a complementary mechanism or to replace the reserve currency with another one, despite its resilience-enhancing effects. The replacement of the Dollar as the reserve currency is currently not on the agenda of most multilateral economic bodies. Other replacement solutions to the US Dollar are rather piecemeal and mostly limited to bilateral arrangements such as currency swaps, but the scale is nowhere close to an extent where states can operate independently of the US Dollar. The concept of Special Drawing Rights (SDR) of the IMF is also an unsuitable mechanism for replacement since the US Dollar is one of its core constituents and SDRs cannot be used in most circumstances especially when it comes to trade between states (Helleiner, 2010).

Enter Bitcoin

On the ashes of the Global Financial Crisis of 2008, a pseudonymous person(s) named Satoshi Nakamoto released a white paper conceptualising a trust-less platform called a blockchain, which would power a new form of currency based on principles of cryptography and decentralisation, which would eventually be called a ‘Bitcoin’ (BTC) (Nakamoto, 2008).

Bitcoin works as a decentralised currency where no one entity holds the key to its governance. Economic decision-making is done through the consensus of its users. The maximum supply has been capped at 21 million coins which means that there cannot be more coins made after all 21 million coins have been mined. This would mean that Bitcoin is a ‘deflationary coin’ where prices of goods and services denominated in Bitcoin would reduce over time since the value of the coin itself would rise. No more Bitcoin would be generated to replace lost coins either, which accelerates the deflationary economics of Bitcoin. Bitcoin is ‘mined’ when people or entities use computing power to run a node and validate the entries on a decentralised ledger by solving a complex cryptographic problem, which ensures a high level of security and a low likelihood of a successful hack, which is also referred to as a ‘proof-of-work’ system.

Mining Bitcoins has a relatively lower barrier to entry where you require computing power and ideally access to cheaper electricity to run a node. As Bitcoin appreciated in price, mining became a profitable prospect creating clusters of miners who scouted locations with cheaper electricity to run nodes. This would be analogous to miners acting as fractional central banks unto themselves, but in unison.

As the number of miners grew around the world, Bitcoin became less vulnerable to an attack since the computing power required to validate the entries has increased widely and is also geographically more spread out. Apart from miners, the open-source code of Bitcoin also attracted a large number of developers who are actively working on improving efficiency, introducing more features and improving its usability.

Bitcoin’s network has demonstrated significant resilience against events of sudden disruption such as a large-scale loss of computing power. In May 2021, the Chinese government forced all Bitcoin mining operations in the country to stop operations citing concerns about disproportionate consumption of electricity (Reuters, 2021). At the time of the shutdown by the Chinese authorities, Bitcoin mining by China-based miners constituted 78% of the total mining capacity around the world (Cambridge Centre for Alternative Finance, 2021). Despite the magnitude of this disruption, the Bitcoin network did not go down although the price of Bitcoin underwent a steep correction. Miners simply relocated to new places which were friendlier towards mining operations and the network re-acquired almost all lost mining capacity within a few months after miners moved to places like Kazakhstan, the United States, Russia and other countries (Volpicelli, 2021).

Cryptocurrencies by their nature are indifferent to hostile state action because it is decentralised. For example, China has doggedly tried to ban any cryptocurrency activity within China such as trading or even holding crypto-assets but has not been successful since it is difficult to ‘confiscate’ cryptocurrency or prevent its usage as long as there is a stable internet connection. At its worst, dealing with cryptocurrencies becomes slightly more laboured because cryptocurrency exchanges become inaccessible and local currency cannot be used for purchase or sale of cryptocurrency, but such restrictions fail to make a big impact on the network that powers cryptocurrency except volatility in the price levels, which oftentimes is temporary. Even in China’s case, state authorities have had to reiterate their bans several times, which indicates that their crackdowns are not as effective as they would like them to be since there is little evidence to believe that Chinese nationals have jettisoned their crypto-assets.

Except for the year 2014, Bitcoin has grown in value every year, often exponentially with a Compound Annual Growth Rate (CAGR) of 158% (Shing, 2021, p. 3). Bitcoin’s success and the underlying blockchain technology has also given an impetus to a new form of financial economy known as ‘Decentralised Finance’ which touts itself as a transparent, secure and cheaper alternative to traditional banking services which are prone to several problems of centralisation and opacity.

The maximum cap on the supply of Bitcoin along with a pre-decided schedule for the halving of the mining rewards creates a largely predictable monetary policy which is beneficial for long-term financial planning for its users.

With increasing market depth, long-term volatility of Bitcoin seems to be on a decline although a convincing explanation of its contributing factors has not materialised (Acheson & Noelle, 2021). Bitcoin holds the largest share of value in the cryptocurrency space. Increasingly, the global financial sector has also exhibited an interest in cryptocurrencies and are slowly purchasing Bitcoin and other valuable cryptocurrencies as an asset on their balance sheets (Wintermeyer, 2021). This demonstrates that Bitcoin is slowly emerging as a mainstream asset-class akin to gold or stocks.

Demonstrably, Bitcoin in many ways counters the inherent weakness of adopting any one state’s currency as an international reserve currency. Manski and Manski (2018) highlight seven tendencies of blockchain technology that forms the basis of the advantages blockchains have over traditional fiat, namely verifiability, globality, liquidity, permanence, ethereality, decentralisation and future focus.

Unlike the US Dollar, the supply of Bitcoin is decentralised whose decision-making is done far more democratically, it is secured through a verifiable ledger that protects against most forms of fraud and concerns like ‘fake currency’, its monetary policy is predictable which brings about stability in its use, and it costs a fraction of the cost and time to transact in Bitcoin when compared to traditional fiat-based banking. Citing their overdependence on the US dollar and need for a faster and cheaper way to transfer remittances from its nationals in the US, El Salvador became the first country to use Bitcoin as legal tender in the country in September 2021 (Sigalos, 2021). This represents the first time a state has decided to merge the crypto-economy with the national economy and the results of such an experiment are yet to be tested and examined for its long-term effects. But the fact that states are considering this at all gives an indication about the future of Bitcoin where it may find utility in either domestic policy or even in international relations.

India and Strategic Autonomy

That states are now considering the question of whether they must get into the cryptocurrency space necessitates a discussion about India’s prospects in the newly emerging crypto-economy and what it could mean for its relations with the world.

In principle, Indian Foreign Policy has always purported to work in a way that maximises autonomy in decision-making. India’s decision to commit to non-alignment is a manifestation of this deeply rooted principle where it would not discriminate between states or take sides, while at the same time reap all benefits of partnerships with the international community even if they are ideologically opposed to each other. To this end, it is not unusual for India to accommodate seemingly contradictory positions in their dealings with the international community which is a consequence of the diversity of its own interests.

This extends to Indian positions in international economics where domestic imperatives constrain India from taking any unidimensional positions. For example, India does not oppose free markets and the benefits that are derived from globalisation, but it does not accept full liberalisation as free-market economies would want from India. Instances of these assertions are seen in India’s decision to pull out of the Regional Comprehensive Economic Partnership (RCEP) negotiations (Sarma, 2020), or even in India’s posturing on agricultural trade at the WTO. In doing so, India often takes an adversarial position against largely western, liberal free-market economies, most of whom are India’s biggest trade partners such as the United States. India’s refusal to accept full liberalisation stems from genuine concerns about the Indian economy’s inability to withstand the market pressures from competition that comes as a result of these agreements. At the same time, India consistent opposition to the US is bound to breed resentment which can be perilous since the US is India’s largest trading partner.

India’s vulnerability is also seen in its inclusion as a part of the ‘Fragile Five’ economies that are heavily reliant on foreign investments for growth. Relatedly, India faces vulnerabilities during interest rate adjustments by the US Federal Reserve which sometimes triggers an outflow of foreign capital in India (Chadwick, 2019, p. 260). In the face of these realities, India will constantly feel the pressure to conform or compromise with Western-led assertions in international economic governance.

While India is able to assert a considerable degree of independence in certain economic matters such as trade issues, intellectual property rights and the like, we also see that India is not always successful in being able to resist pressure especially as we see in the case of American sanctions. Stringent US sanctions against Iran forced India to reduce and eventually end oil imports from Iran and become more reliant on Gulf crude oil (The Hindu, 2019). American sanctions on Iranian, Venezuelan and Russian oil industries in pursuit of its foreign policy interests have been a contributor to large price swings in the oil and natural gas market since shackles are being placed on the ability of major producers to supply oil into the market (Brown, 2020, p. 33). A recent dispute between India and Saudi Arabia on pricing agreements of crude oil is a reflection of these events (Kemp, 2021). Since the import of crude oil is a fundamental pillar in Indo-Iran ties, sanctions have created a significant barrier in its bilateral relations. The recent re-imposition of sanctions on Iran signifies that:

Due to the status of the US dollar as the world’s reserve currency and America’s centrality in international finance, the US holds disproportionate power of punishment in the international system.

Even though India is currently not placed under any sanctions by the US, India is not immune from them. India has a history of being sanctioned by the US in the past during India’s transition to a status of nuclear power and it is only after significant development in the relationship that India has managed to reverse its effects (Weiss, 2007).

American sanctions on India in 1998 mostly involved the denial of crucial technology for India’s space and nuclear programmes. India’s goals for strategic autonomy must also accommodate newer technological paradigms of which cryptocurrency will comprise an important evolution.

India and Cryptocurrency

India has the largest number of cryptocurrency holders in the world comprising retail investors mostly holding cryptocurrency for diversity in their investment portfolios. ¹ Indian cryptocurrency exchanges have clocked significant growth rates in the number of accounts opened over the years (Mint, 2021).

In a country with a fairly large IT industry, the emergence of a blockchain-based startup ecosystem could represent an evolution in India’s technological landscape and with it, its economic prospects. Some successful companies from India in the crypto-economy include Polygon Network, WazirX, Frontier, and Instadapps amongst others, all dealing with different blockchain-based products.

The government of India has consistently cast doubt on the credibility of cryptocurrencies and raised concerns about cryptocurrencies being a conduit for money laundering. Centralised cryptocurrency exchanges in India have to comply with anti-money-laundering regulations including ‘Know Your Customer’ regulations akin to banking or any other financial entity. In 2017, the RBI issued a circular to banks operating within India to not provide banking services for cryptocurrency-related entities, creating barriers in payment systems for people wanting to invest in cryptocurrencies from India (Reserve Bank of India, 2018).

However, over time there seems to be a change of position by the Indian government on cryptocurrencies. In 2020, the Supreme Court of India ruled against the RBI which had barred regulated banks from offering banking services to organisations that used cryptocurrencies (Jain, 2020). In 2021, RBI stated that the 2017 circular to deny banking services to cryptocurrency-related businesses was no longer in effect, implying that banking services may be offered to cryptocurrency-based businesses (Livemint, 2021).

As of this writing, most commercial banking operations are unwilling to extend banking services to crypto-based businesses despite no formal ban presumably due to fear of regulatory flip-flopping (Kaul, 2021).

Central Bank Rejection

The emergence of cryptocurrencies poses fundamental problems to the functions of a central bank. Central banks carry out the sovereign functions of creating and regulating national currencies as a monopoly. It carries out monetary policy based on its mandate to maintain the state’s monetary health and the decisions of the political executive. In many states, the Central Bank also acts as the regulatory authority over the functioning of commercial banks and the repository of a state’s foreign currency reserves. Most importantly, it makes decisions on what constitutes legal tender for transactions within the state (Herger, 2019, p. 2).

Normatively, Central banks need to be independent of the political executive and sometimes can be at odds with the short-term developmental goals pushed by the political executive (Herger, 2019, p. 135). In reality, this degree of independence varies from state to state. Monetary policy is rarely independent of the economic decisions of the political executive. Poor monetary policy can lead to harsh economic consequences including hyperinflation and the erosion of the value of currency which requires long-term interventions to restore the economy to a state of normalcy.

By virtue of monetary policies being decided by state fiat, no currency, not even the global reserve currency is above the dangers of inflation. If anything, inflation in the global currency is likely to set inflationary pressures around the world, especially since many states peg their currencies to the value of the US dollar. This also means that the purchasing power of Foreign Currency reserves held by many states in the form of the US dollar is likely to reduce.

Cryptocurrencies when perceived as currency take away the sovereign power of the Central bank to decide the medium of exchange that can be used by its citizens to transact with each other. Unsurprisingly, Central banks oppose cryptocurrencies for this reason and propose their own alternatives in the form of Central Bank Digital Currencies (CBDC), which are essentially their own fiat currency in digital form. However, CBDCs merely transfers the problems of fiat currencies onto the digital realm, namely the lack of democratic decision-making, centralisation of authority, and poses newer problems such as the lack of privacy as money will have a full digital trail. A retail investor would then consider CBDCs as an unattractive proposition since it is merely a technological upgrade on a fundamentally flawed system of money.

The failure of Venezuela’s ‘Petro’ is a cautionary tale that shows that already existing deficiencies in monetary policy cannot be remedied by blockchain and digitisation (Looney, 2018). Technological upgrades cannot be a substitute for good monetary policy in highly centralised structures like Central banks where foundational problems are merely hardcoded into their technological frameworks and can in fact be used to perpetuate abuses.

Central Banks will oppose any move that classifies Bitcoin as a constituent of a Foreign Currency Reserve since they are not willing to concede that Bitcoin is currency in the first place. Acknowledging the legitimacy of cryptocurrencies would undermine the use of state-issued fiat in the day-to-day lives of the population.

The Futility of Regulation

Many states and their central banks outrightly reject Bitcoin and have consistently warned investors against investing in cryptocurrencies owing to its ‘dubious’ nature. Many states highlight the need to regulate cryptocurrencies in the interest of their citizens citing investor protection and prevention of fraud. For the most part, regulation of decentralised cryptocurrencies is a fruitless endeavour, especially since regulatory frameworks have jurisdictional limitations.

For one, Bitcoin has no geographical origins. Since it is for all intents and purposes ‘money of the internet’, cryptocurrencies are extra-territorial for most national jurisdictions. The closest point of regulation and taxation of cryptocurrency for states are centralised cryptocurrency exchanges where national fiat currency is exchanged for cryptocurrencies.

Cryptocurrencies are location-agnostic given that there is no centralised authority that controls the movement of cryptocurrencies. Cryptocurrencies can be accessed anywhere with an internet connection without the need to be exchanged to traditional fiat currencies as long as the other party accepts cryptocurrencies as a means-of-exchange

Second, it is relatively simple to move cryptocurrency extra-territorially. China’s complete ‘ban’ on cryptocurrencies demonstrate that at best, bans create obstacles for a transition between national fiat currencies and cryptocurrencies. Once customers move their cryptocurrencies to non-exchange wallets, then central exchanges no longer control the flow of cryptocurrency, after which the individual holder of the keys to the wallet has full control over the cryptocurrency which can be accessed anywhere else through an internet connection.

These realities demonstrate the futility of regulation and taxation at a technical level which modern state bureaucracies are still unable to fully comprehend and keep up with (Hendrickson & Luther, 2017, p. 12).

Furthermore, India itself demonstrates the futility of even soft bans and restrictive banking access for conversion of fiat currency into cryptocurrency. Workarounds such as Peer-to-peer trading have countered this access problem without the use of banks which facilitates trade in cryptocurrencies with cryptocurrency exchanges acting as an intermediary and an escrow account. Despite the discouragement, Indians are one of the highest holders of cryptocurrency in the world. If access to cryptocurrencies is made further difficult, then Indians can merely move their existing assets to Decentralised Exchanges and other methods to carry on cryptocurrency transactions. This will also mean a death knell to an emerging crypto-economy taking root in India as cryptocurrencies are the lifeblood that facilitate innovations in the first place.

Under these circumstances, disproportionately focussing on regulation will not yield the desired results and may even backfire in long run. Instead, a more liberal approach that accounts for reasonable taxation along with existing anti-Money-Laundering safeguards will be a more practical solution to the question of state control over cryptocurrencies.

Taxing Cryptocurrencies

One of the challenges that emerges in the calculation of a ‘crypto-tax’, is the determination of what exactly is cryptocurrency. The ‘currency’ element implies a high level of liquidity, yet it also acts as an appreciating asset. It is clear then that applying a cookie-cutter approach based on regulations for other assets does not do justice to cryptocurrencies. The contradictory nature of both its liquid and illiquid characteristics mean that the scope for taxation is constrained unless the rules for taxation are highly specific.

Towards a New Crypto-taxation Model for India

Traditional taxation models tax the income generated from the realised profits after the appreciation of the underlying assets. As money moves between the crypto-space and the fiat-based currency system, the traditional model seems to be appropriate since cryptocurrencies are largely seen as assets rather than currencies. As adoption improves and payment systems develop for day-to-day transactions to happen in cryptocurrencies, it is likely that the traditional model for taxation which is calculated and collected in fiat currencies would be outdated. It is important in this case to observe the trends regarding consumer behaviour and cryptocurrency so that an improved model of taxation could be implemented on a national level.

This article proposes a hybrid taxation model for cryptocurrencies in India where the tax is collected in the form of Bitcoin rather than in the Indian rupee, by the means of a cess imposed on cryptocurrency exchanges for purchase and sale on cryptocurrency. In India, this would be equivalent to the Securities Transaction Tax (STT) imposed on purchase and sale of securities in stock exchanges. In exchange, the government must allow commerce in the cryptocurrency space without threat of sanctions and bans with full access to the Indian banking system so that Indian investors may convert their fiat holdings to cryptocurrencies.

Cryptocurrency exchanges are the primary gateway that on-boards individuals into cryptocurrency investment. The act of purchase and sale of crypto-assets underpins cryptocurrency commerce, including activities like trading, liquidity swaps or any other financial activity. Taxing the act of purchase and sale covers most of the transactions within the cryptocurrency space and is a very wide net resulting in a higher collection of tax.

Cryptocurrency exchanges must then assume the responsibility of collecting the tax from its users through algorithms that are similar to how cryptocurrency exchanges collect their own charges from users for transactions on the exchange. The cess method allows India to leverage the scale of users having cryptocurrency accounts in India and create a substantial reserve of Bitcoin without having to spend any budgetary resources on procuring Bitcoin for itself.

In exchange for the cess imposed on centralised exchanges, it is imperative that the government recognises the legality of cryptocurrencies in its use in commercial activity and allow unfettered access to banking and financial services. The volatile nature of cryptocurrencies is a reality that is to be contended with and retail investors are constantly reminded of its risks. Unlike traditional equity markets, cryptocurrency markets realistically allow for creative destruction since there is no concept of bailouts or other ‘market’ interventions to save failing companies. While this can be dangerous for smaller retail investors, it also incentivises the investor against taking reckless risks and engage in understanding fundamentals better before investing money. Preventing citizens from taking risks in the cryptocurrency market by the state is an infantilising notion that robs investors of the agency to participate in an emerging global financial paradigm, and is also futile since circumvention is not very difficult.

It is also noteworthy that regulation is mostly applicable on the demand-side (i.e., Retail customers, institutions), and not on the supply side (i.e., companies/entities which create cryptocurrencies). The state exercises regulation by depriving its nationals of the agency to transact, since supply-side regulation is very difficult to enforce owing to extra-territoriality.

The Indian government must also allow commerce in the cryptocurrency space since it also realises the potential of the underlying blockchain technology and recognises the benefits of these systems in economic development. Cryptocurrency and tokens act as yardsticks by which good projects can be identified and monetised and preventing access to these markets simply prevent the sector from developing. Taxing cryptocurrencies on exchanges also gives crypto-businesses sufficient grounds to seek state support in nurturing the sector as a whole through government schemes such as Startup India.

Cryptocurrency as Legal Tender

For the time being, a discussion on whether India must adopt cryptocurrency as legal tender could be considered premature. For one, the use of cryptocurrency around the world as a means-of-exchange has not been tested for the long-term effects on economic trajectories and the other problems that come with it. Second, within the cryptocurrency space itself, there is much debate on whether the state of crypto-infrastructure is ready for mass adoption in daily life, since many solutions are yet to achieve scale and user-friendliness.

Third, the Indian rupee is not pegged to the dollar and demonstrates reasonable resilience through intervention by the RBI which has been able to stave off any crippling hyperinflation events (Rajan, 2016). Introducing any cryptocurrency as legal tender requires large-scale changes to long-established economic frameworks and would be analogous to ‘shock therapy’ to the Indian economy, which is bound to have negative consequences.

Even though making cryptocurrency as legal tender at this time is not advisable, the state must resist actions on the opposite end of the spectrum pushed by the central bank. Any attempts by the RBI to liquidate Bitcoin into fiat currencies without a holding period must be resisted. This would be an imprudent decision that does not account for the long-term dependency problem on the US dollar, not to mention that it does not account for effects of US dollar-based inflation as a result of the printing of trillions of dollars during the COVID-19 crisis (Gopinath, 2021).

Principles of Bitcoin Reserve Governance

Risks

By virtue of the fact that India would not be purchasing any Bitcoin directly, the financial risk is minimal. The cost of procuring Bitcoin is effectively passed on to the Indian investor. Yet holding Bitcoin poses several risks on both the technological and policy fronts.

Risk Mitigation

While it is tough to prepare against black swan events such as technological failures, there are many ways by which risk can be managed to avert large-scale problems.

First and foremost is the fact that the potential Bitcoin reserve would be built with little expenditure on the part of the state, and is sourced from Indian cryptocurrency users through a cess on transactions made in cryptocurrency exchanges.

Second, given the proliferation of cryptocurrencies, the innovation in Bitcoin’s security is also improving. Several developers are working on Quantum-proof Bitcoin as well as other security features.

Bitcoin’s deflationary economics means that it is not a preferred currency to use for spending since the currency itself appreciates in value over the long term (Skalex, 2018). These realities mean that the transition envisioned by many cryptocurrency enthusiasts with widespread use of cryptocurrencies for day-to-day transactions bypassing fiat currencies completely is likely to take a long time to come to fruition. Cryptocurrencies may act as a complement to the traditional fiat currency-based economy. Fears of cryptocurrencies completely taking over sovereign functions of monetary policy is not convincing unless there is near-universal adoption of cryptocurrencies. Even with its surging popularity, cryptocurrencies are considered niche investments due to its technical complexity and a ‘Hyperbitcoinised’ world may not come to fruition in the short term.

Conclusion

The past few centuries have seen the adoption of any one currency, especially that of the hegemon of its time, to be the world’s reserve currency to be used between states and people for commerce and other transactions. The reserve currency status is an expression of economic hegemony and gives the hegemon immense power to shape international relations through the exercise of control over its creation and supply. The US dollar is all the more dangerous since it is backed almost entirely by the world perception of American power, which is subject to challenge and disruption if American power is significantly challenged.

Bitcoin presents the first real opportunity to have an independent reserve currency whose monetary policy is already fixed backed by mathematics and cryptography and is not swayed by the temperaments or politics of any one country. This article presents the natural advantage that India has in terms of cryptocurrencies owing to its large user base and how it can procure Bitcoin without expending large financial resources through the means of a cess on transactions made in cryptocurrency exchanges. India here has the chance to become the first-mover in a space that is only now being considered for competition between states.

India must shift its focus from regulation, which is mostly a futile activity and shift to becoming a player in the space and help shape the global economic landscape by helping other states transition to a non-dollar based system of exchange that no longer unduly favours the hegemon through ‘exorbitant privilege’. The creation of a Bitcoin reserve will not drastically cause the displacement of the US Dollar as the world’s reserve currency, but it would lay the foundation of a viable alternative that can be used in certain circumstances.

Bans and regulation in the name of investor protection is an unsophisticated belief that lacks a holistic understanding of the crypto-economy and has infantilising undertones preventing retail investors from participating in an emerging global financial paradigm. While cryptocurrencies are inherently risky, investors must not be deprived of their agency to account for risks in anticipation of higher rewards.

So-called ‘CBDC’ is unlikely to serve as an appropriate substitute for Bitcoin because CBDCs merely bring the problems of legacy fiat systems into the digital realm, while Bitcoin can be seen as a paradigmatic shift in the institution of money which creates pure monetary premium through a technological upgrade.

While Bitcoin poses certain systemic risks, we have also seen the resilience of Bitcoin in the face of great challenges. Through a gradual approach, India can mitigate many of these risks with a carefully calibrated cryptocurrency policy. The emergence of Bitcoin can be a game-changer for India to meaningfully participate in international economic governance as a king-maker in its own right.