The Crypto-Tokens Debacle

Part I: Introduction

The Parliament’s tryst with the complexities of the issue produced two bills: Banning of
Cryptocurrency & Regulation of Official Digital Currency Bill, 2019 and the Cryptocurrency
and Regulation of Official Digital Currency Bill, 2021; both of which have failed to get
enacted. In the light of this, if it had not been for the IAMAI judgment 1, we would have been
stranded in complexities of the crypto-sphere. Albeit the judgment took cognizance of
budding investments in this paradigm and gave them a green signal; on second thought, it did
not address the true nature of the tokens and method of regulation.

Part II: To be regulated like a security?

Rather viewing cryptocurrency as an alternative to fiat currency, a compelling approach

would be to see it through the lens of security market. The tokens take the value from the
startup behind the project and give the holder a stake in that startup through ICOs (Initial
Coin Offerings). People buy these tokens solely with the idea that their value will increase in
the future along with the underlying value of the cryptocurrencies.

Howey Test

The Howey test finds it origins in the USA which was formulated by the US Supreme court
in the case of SEC v W.J. Howey Co2, to pinpoint whether a financial instrument would be in
nature of an investment contract.

The broadest prong of the Howey test surrounds the issue of actual investment of money.
One of the crypto-networks founded in India known as Polygon has a market capitalization
of $13 billion3. In the secondary market the method followed by the crypto-exchanges
involves the exchange of fiat currency of the buyer with the seller of the cryptocurrency.
Since, there is a prima facie initial investment of money, the first condition of the test stands
satisfied.

In respect of the second test where the investor expects profit, it is paramount to cite SEC v
Kik4 in the context of ICO. Kin, the future tokens of Kik Interactive Co was sold on the

1
Internet and Mobile Association of India v Reserve Bank of India, W.P. (C) No.528 of 2018
2
328 US 293 (1946)
3
https://www.businessinsider.in/cryptocurrency/news/cryptocurrency-polygon-founded-by-3-indians-has-
touched-13-billion-in-market-cap/articleshow/82770196.cms
4
SEC v Kik Interactive Co., Case No. 19-cv-5244
promise of huge returns on completion of project which incentivized the investor. In fact, a
relatively new ICO could average the return rate of 50% in the first 30 days5.

To satisfy the third test, the profits drawn should have been a result of others’ efforts. The
effort here can be construed to be managerial efforts of the crypto-network to contribute to
the development of the network and in creating a demand of the tokens. The tokens would be
issued only when the overall project would be successful which depended heavily on the
managerial effort6. Hence, the profit is drawn from the active effort of others.

In this context, the crypto-exchanges perhaps stand out because of functions that they
perform such as maintaining liquidity, compiling the aggregate information of buying and
selling price and thereby depicting the token value accurately 7. Further, investors will choose
the crypto-exchange depending on the quality of their whitepaper, their business plans, and
their ease of transaction.

SEBI can come within purview only when the transactions involve securities within the
meaning of Section 2(h) of the Securities Contracts (Regulation) Act, 1956:

“(h) “securities” include—

(i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities
of a like nature in or of any incorporated company or other body corporate;

[(ia) derivative;

(ib) units or any other instrument issued by any collective investment scheme to the investors
in such schemes;]”

On a plain reading, it is reasonable that the definition of securities is befitting for

cryptocurrency. Furthermore, the price of crypto-tokens on the secondary market derives its
value from the development of the crypto-network. Hence correspondingly SEBI can become
the regulatory body for crypto-exchanges in lieu of RBI.

It was noted in Sudhir Shantilal Mehta vs. Centra Bureau of Investigation by the Supreme
Court bench that: “The definition of `securities' is an inclusive one. It is not exhaustive… The
term `securities', thus, should be given an expansive meaning.”8

Lastly, in Sahara India Real Estate Corporation Limited and Others vs. SEBI and another,
the Supreme Court opinionated that,

5
Hugo E. Benedetti and Leonard Kostovetsky, “Digital Tulips? Returns to Investors in Initial Coin Offerings”,
66, J. Corp. Finance (2018), available at SSRN: http://dx.doi.org/10.2139/ssrn.3182169
6
Ibid
7
Kristin N. Johnson, “Regulating Cryptocurrency Secondary Market Trading Platforms”, available at:
https://lawreviewblog.uchicago.edu/2020/01/07/298/
8
(2009) 8 SCC 1
“Section 2(h) of the SCR Act gives emphasis to the words “other marketable securities of a
like nature” …. Any security which is capable of being freely transferrable is marketable.
The definition clause in Section 2(h) of SCR Act is a wide definition, an inclusive one”9

Thus, in either nature of investments, we find that tokens qualify as a security which would
enable the SEBI to regulate it.

Part III: Conclusion

Prohibitions are “economically inefficient means of regulation” because they may eliminate
any potential benefit that could have stemmed from the banned technology and also dampen
any subsequent future innovation10. Japan has made it a legal tender under the - Payment
Services Act, 2005 while Canada has trodden cautiously by placing it under -Proceeds of
Crime (Money Laundering) and Terrorist Financing Regulations, 2002.

All the while USA and Indonesia have categorized it as a commodity. Under Section 1a(9) of
the US Commodity Exchange Act, the Commodity Futures Trading Commission, USA
defines “commodity” to include, among other things, “all services, rights, and interests in
which contracts for future delivery are presently or in the future dealt in.”11

Cryptocurrency through the advent of blockchain can avoid traditional banking system opted
during international trading which in turn prevents any extra transaction fee and lowers down
the cost of cross-border payments.

9
(2012) 10 SCC 603, p. 111
10
Jay P. Kesan & R. C. Shah, “Shaping Code”, 18, Harv. J.L. & Tech, 319, (2005)
11
Supra note 13