Why the crypto industry is struggling to emerge from obscurity

A 22-year-old engineering student from Bengaluru, who also runs a small digital marketing firm, is in a similar mess. The student, who did not want to be named, had invested around ₹6 lakh in cryptocurrencies till date, “along with contributions from some friends”. He has gradually started shifting his holdings from Indian crypto exchanges to international ones to avoid paying the withholding tax (TDS). To save more money, he also moves the cryptocurrencies (mostly bitcoin and ether) from international exchanges to a peer-to-peer (P2P) platform, where he exchanges them for e-commerce gift cards.

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Until the beginning of this year, the crypto story in India was riding high on a wave of curiosity and interest, celebrity endorsements and influencer-speak. Like the two people mentioned above, just over 100 million people in India had gone to own assets in the form of digital currency. But the gloom and uncertainty now is a striking contrast, as authorities tighten controls, trading volumes crash, and stories of crypto scams and ED raids take the shine off the industry.

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The gray areas

While the Indian government and the Reserve Bank of India (RBI) have warmed to the use of blockchain – the underlying distributed ledger technology (DLT) for native cryptocurrencies and non-native crypto tokens – they remain uncomfortable with unregulated cryptocurrencies.

Native cryptocurrencies such as bitcoin and ether are issued directly by the blockchain protocol they run on, hence the term “native”. Non-native crypto tokens are created by platforms that build on blockchains for a specific purpose. These include utility tokens (to pay for a product or service of a company), governance tokens (where holders have voting rights in decisions about new feature proposals and changes to a project’s governance system), security/equity tokens, reward/loyalty tokens (such as Web3 tokens to reward contributions to the development of the platform), non-fungible tokens or NFTs (digital certificate of ownership of a unique asset on the blockchain), and even stablecoins such as tether (backed by fiat currencies such as the US dollar ). For example, social crypto token GARI, backed by Bollywood actor Salman Khan, was launched in October 2021 to help Indian creators monetize their content over a short video application, Chingari. The company claims to have over 1 million active wallet users.

The RBI, which is mulling its own central bank digital currency – legal tender issued by a central bank in digital form – does not rely on native cryptocurrencies. It has its reasons. While there are an estimated 20,000 cryptocurrencies in circulation, only 1,500 coins are regularly traded. The others are dismissed as ‘shitcoins’, which are mostly used to cheat people. On January 10, for example, the ED conducted several raids to unearth a massive crypto scam involving a fake crypto called Morris coin that was floated to dupe millions of investors in Kerala, Tamil Nadu and Karnataka of over ₹NOK 1,200 million.

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The RBI has long been suspicious of crypto. In 2018, it banned all entities regulated by it from dealing in virtual currencies. The Supreme Court overturned this ruling in 2020. But the apex bank said banks and financial institutions could “continue to carry out customer due diligence processes” such as know your customer (KYC), anti-money laundering (AML), countering the financing of terrorism ( CFT) controls, and “ensure compliance with relevant provisions under the Foreign Exchange Management Act (FEMA) for foreign remittances”. Banks took the cue and tightened the screws on crypto transactions routed through them, even as the government mandated that proceeds from the sale of cryptocurrencies be treated as income (30% tax rate) by the tax authorities, and investors will pay an additional 1% TDS on crypto transfers. But simply taxing a virtual asset does not make it legal tender. The government listed the Cryptocurrency and Regulation of Official Digital Currency Bill, 2021, in the winter session of Parliament in December 2021, but it has not yet been tabled.

The WazirX tangle

Meanwhile, some crypto exchanges continue to ignore rules. On 28 March, the Central Goods and Services Tax (CGST) authority returned ₹95.86 crore from 11 crypto exchanges that collectively avoided ₹81.54 crore in GST, Finance Minister Pankaj Chaudhary said in a written reply to a question in the Lok Sabha. Cryptocurrency traders pay a GST rate of 18% in India.

On August 6, the ED conducted searches on one of the directors of Zanmai Labs Pvt. Ltd, which operates cryptocurrency exchange WazirX, and froze the exchange’s bank balance worth ₹64.67 crore in a money laundering investigation. Among other things, the ED alleged that “…No physical address verification was done (read: KYC) nor was there any control on the source of funds (read: off-chain transactions) of their customers”.

A blockchain is a shared, immutable (cannot be changed), distributed ledger that can track orders, payments, accounts, production, etc. Therefore, most courts and law enforcement agencies accept blockchain records as legal proof of transaction history. A crypto transaction that does not take place on the blockchain is called ‘off-chain’, which cannot be traced unless the parties involved cooperate.

Supreme Court Advocate NS Nappinai says news reports of off-chain trading suggest possibly “a ‘hawala’ transaction and prosecution for money laundering is likely on reasonable grounds.” In a press release, the ED also alleged that Zanmai Labs had entered into a “web of agreements with Crowdfire Inc. in the US, Binance (Cayman Islands) and Zettai Pte Ltd in Singapore to hide its ownership of the cryptocurrency exchange. Zanmai Labs denies this.”

Things got scarier when Binance CEO Changpeng Zhao tweeted that his company does not own shares in Zanmai Labs. Nischal Shetty, founder and CEO of WazirX, responded with a tweet: “WazirX was acquired by Binance; Zanmai Labs is an Indian entity owned by me and my co-founders; Zanmai Labs is licensed by Binance to operate INR crypto pairs in WazirX; Binance operates crypto-to-crypto pairs, processes crypto withdrawals”.

Even as the ED investigation continues, the death continues. One employee, who had worked at WazirX since day one but left the company recently, said: “The company has been involved in controversy every time the rest of the crypto industry has come under fire. As a result, employees have become somewhat immune and don’t worry for their jobs.” The person, who did not want to be named, added that “Binance’s involvement with WazirX was minimal. As a result, we operated as an independent company. Even our salaries came from the company’s revenue in India and not from Binance.

Another employee, who joined WazirX last year, told a different story. “While Binance claims it has nothing to do with WazirX now, last year we received Apple Watches and AirPods as gifts from Binance as part of the exchange’s July 2021 anniversary celebration”. When contacted, a Binance spokesperson responded: “Binance celebrates its achievements and anniversaries with the Binance community, which includes our users and partners. …This does not mean that WazirX employees, or anyone in the community for that matter, are Binance- employees. WazirX is operated by Zanmai Labs, and Zanmai Labs is not owned by Binance.”

What worries WazirX staff, says the person quoted above, is not the confusion over ownership, but “the lack of trading volume on Indian exchanges since the government started levying tax on transactions”. In fact, trading volumes on crypto exchanges have fallen over 50% in the last couple of months. Sathvik Vishwanath, co-founder and CEO of cryptoexchange Unocoin, claims that “the government should lay down clear rules that we can then accept, otherwise it will lead to a lot of misinterpretation on both sides”.

Out of the regulatory quagmire

India is “still grappling with the form, structure and very position of cryptocurrencies,” Nappinai says, but believes it’s “important that we take a definitive stance, whatever it may be, and do it immediately.” In doing so, she suggests “a nuanced approach.” “The narratives of prohibition have been equated with the ‘off with your head’ syndrome. The very stakeholders most affected, i.e. cryptocurrency investors, are encouraged to oppose any form of restraint or regulation. Nor can legal and regulatory frameworks be built on assumptions that wrongs will be rectified later or in a staggered manner,” claims Nappinai.

Regulatory risks and cyclicality have always been important considerations when investing in centralized exchanges, despite the “extremely profitable business models”, argues Nitin Sharma, co-founder of Antler India and global Web3 head of Antler, a Web3-focused VC firm – the ecosystem. “Since 2017, I have been an advocate for a strong regulatory framework (as opposed to a ban), in the absence of which all institutional or private investors end up relying on self-regulatory mechanisms, which can often fall short,” he says. He acknowledged that recent developments “have certainly created more confusion and undermined confidence”.

“Investor confidence is shaken,” admits a venture capitalist (VC) who is also listed on one of India’s crypto exchanges and has invested in cryptocurrencies. The VC, who did not want to be named, believes the firm’s “investment” is safe and can survive the crypto downturn”. “These are emerging technology areas. They are developing so quickly that it is not easy for a regulator,” reasoned the investor, adding: “Finally, the authorities have a balanced view”.

But will it also affect investments in Web3 companies (those using decentralized blockchains, cryptocurrencies and NFTs)? Pareen Lathia, co-founder of Buidler’s Tribe, a Web3 incubator, isn’t worried. “Most VCs and institutional investors are quite diversified and there is a lot of interest in this space,” he said. He emphasized the need to disconnect cryptocurrencies from Web3 technology, explaining: “Crypto exchanges are not even Web3 businesses…Over the last month, DAOs (decentralized autonomous organizations), creative economy and metaverse startups have seen an increase in funding . The DeFi (decentralized finance) sector is much more mature and is also gaining significant interest.”

Antler India’s Sharma also believes that “as a forward-looking global investor focused on a 5-10 year time frame,” his firm will remain “mostly focused on software, data and middleware startups, creating the essential infrastructure for the new Web3 economy”. Nappinai concludes that while the future of crypto will “depend on what use cases, if any, the government may decide on with regard to blockchain”, India “must now lead from the front through legal frameworks that enable rather than hinder .”.

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