Type: op-ed snap

Context

The government has decided to introduce a bill that seeks to prohibit all private cryptocurrencies in India.

Background of the bill

• In 2018, the three-judge bench of the Supreme Court set aside the RBI circular that prevented crypto exchanges from dealing with the formal financial system on grounds of proportionality.
• Purpose of the bill: The current bill now attempts to define the rules of the game so that the RBI, tax authorities, SEBI and other agencies have much better legal guidance in deciding the course of action with respect to VCs in their respective domains.
• The rules can, therefore, range from a ban to controlled interaction with the formal financial system.

Issues involving cryptos

• Issues involving cryptos can be seen at three levels, each of which is equally important.
• The first is its impact on sovereignty.
• The second is its interaction with financial markets.
• Third is the value proposition that the entire concept of crypto brings to the economic debate.
• Incorporation of price stability mechanism: Some of the variants of cryptos such as the stable coin clearly indicate that these are attempts to create systems of money that incorporate features of price stability that imply a parallel monetary system.
• Diluting the sovereign function of money creation: Unrestricted co-opting of VC clearly dilutes the sovereign function of money creation, clearly impacting the revenues of RBI.
• Concerns pertaining to money laundering, terrorist threats and narco-trading also come under this category given the high value and anonymity offered by cryptocurrencies.

Challenges in cryptocurrencies interaction with the formal system

• As of now cryptos have been recognised as assets or commodities and as a medium of exchange. Their role as units of account or legal tender is rather limited.
• They may offer a store of value given their short supply. From a banking point of view, certain issues do arise.
• Since VCs are not legal tenders, they cannot be used in the discharge of debt.
• Thus, banks cannot accept VCs to close a loan account.
• Second, can banks lend in fiat by accepting VCs as collateral assuming the VC is an asset?
• Incompatible with the fractional system of banking: At a deeper level, the very idea of VCs and the way they are designed are incompatible with the fractional system of banking.
• The fluctuations in interbank liquidity require that money supply adjusts to system requirements.
• If money supply undergoes compositional change in favour of VCs, this ability will be curtailed thus accentuating the crisis.
• In financial markets, crypto such as ICOs bring another set of issues.
• The ICO is a creature that disrupts the very concept of limited liability in corporate finance.
• ICOs are, at times, designed in such a way that the beneficial owner identity is concealed.
• SEBI is yet to convey a position on various issues surrounding this idea.
• Issues with making VCs medium of exchange: VCs have emerged as a medium of exchange and many countries have permitted VC ATMs.
• But how does this proposition fare given that considerable advances have been made in the payment systems domain in India.
• Is it worthwhile that additional competition is introduced in a market that is hyper-competitive?
• It will have impact on existing investments in mobile payment and UPI technology.
• Impact on poor states: It is well known that the Indian population exhibits significant behavioural divergences in their savings and credit behaviour across regions.
• Such wide behavioural changes have profound implications on bank strategies and product designs.
• In the past, there have been several instances of states having low per capita income being more prone to chit fund investments that have negatively impacted the savings of many poor households.
• The issue of consumer protection needs to be addressed and the current laws may have to be reviewed considering this innovation.

Conclusion

The bill must meet many important objectives. While there are obvious concerns of money laundering and benami transactions, there are equal concerns with respect to company laws, payment systems and banking, securities and other commercial laws.

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Back2Basics: About Stablecoin

• Stablecoins bridge the worlds of cryptocurrency and everyday fiat currency because their prices are pegged to a reserve asset like the U.S. dollar or gold.
• This dramatically reduces volatility compared to something like Bitcoin and results in a form of digital money that is better suited to everything from day-to-day commerce to making transfers between exchanges.

What is ICO?

• ICO stands for “initial coin offering,” and refers to a formerly popular method of fundraising capital for early-stage cryptocurrency projects.
• In an ICO, a blockchain-based startup mints a certain quantity of its own native digital token and offers them to early investors, normally in exchange for other cryptocurrencies such as bitcoin or ether.

Context

Monetary Policy Committee (MPC) voted to maintain status quo on policy rates, with one member continuing to dissent on the “accommodative” stance of policy.

What is accommodative stance of policy?

Accommodative monetary policy is when central banks expand the money supply to boost the economy. Monetary policies that are considered accommodative include lowering the Federal funds rate. These measures are meant to make money less expensive to borrow and encourage more spending.

Overview of RBI policy measures during Covid-related lockdown

• Cut in policy rates and injection of liquidity: The RBI had moved proactively to cut the repo and reverse repo rate and inject unprecedented amounts of funds into banks and other intermediaries.
• The short-term interest rate at reverse repo level: a combination of the lower reverse repo rate and the large liquidity injection had resulted in a drop in various short-term rates down to (and occasionally below) the reverse repo rate, making it the effective operating rate of monetary policy.
• Gap between repo and reverse repo increased to 65 bps: In addition, both the repo and reverse repo rates had been cut to 4.0 and 3.35 per cent, respectively, with the gap – the “corridor” – between the rates widening from the usual 25 basis points to 65 bps.

Central bank’s role in modern monetary policy

• Determining basic overnight interest rate: A central bank’s main role in modern monetary policy operating procedures is to determine the basic overnight interest rate, deemed to be consistent with prevailing macroeconomic conditions and their economic policy objectives, in balancing the ecosystem for sustained growth together with moderate inflation.
• This is achieved through buying and selling very short-term (predominantly overnight) funds (mainly) from banks to keep a specified operating rate (the weighted average call rate in our case) very close to the policy rate.

Liquidity management: Key pillar of monetary policy normalisation

• Liquidity management: Liquidity management in the extended banking and financial system (which includes non-banking intermediaries like NBFCs, mutual funds and others) will now be the key pillar of normalisation.
• This process is the domain of RBI and not MPC.
• These operations will be conducted within RBI’s liquidity management framework.
•  There are two sources of liquidity additions:
• (i) Exogenous: which are largely due to inflows of foreign currency funds and outflows of currency in circulation (cash) from the banking sector.
• (ii) Voluntary or endogenous: which is the result of the creation of base money by RBI through buying and selling of bonds, thereby injecting or extracting rupee funds.

How RBI is managing liquidity surplus?

• Stopped GSAP and OMOs: Post the October review, RBI had stopped buying bonds under the Govt Securities Asset Purchase (GSAP) and done negligible Open Market Operations (OMOs), thereby stopping addition of voluntary liquidity injection into the system, our own version of “tapering”.
• Union government balances with RBI, arising from cash flow mismatches between receipts and expenditures, has hybrid characteristics and also impacts liquidity.
• Use of reverse repo window: RBI has used the reverse repo window to absorb almost all this liquidity surplus from banks.
• Allowed repaying TLRTOs: It has again allowed banks the option to prepay the outstanding borrowings from the Targeted Long Term Repo Operations (TLTROs), thereby potentially extracting another Rs 70,000 crores.

How RBI is managing interest rate in the policy normalisation process

• Increased rates and closed the gap between repo and reverse repo: RBI – post the October review – has gradually guided short-term rates up with a sure hand from near the reverse repo rate to close to the repo rate.
• It has shifted its liquidity absorption operations from the predominant use of fixed rate reverse repos (FRRR) into (largely) 14-day variable rate reverse repo (VRRR) auctions to guide a rise in interest rates.
• Since early October, these rates had steadily moved up in a smooth and orderly fashion up to 3.75-3.9 per cent.
• The VRRR rates moving up have also resulted in various short-term funding interest rates like 90-day Treasury Bills, Commercial Papers (CP) and banks’ Certificates of Deposits (CD) moving up from the reverse repo rate or below in September to 3.5 per cent and higher since December.
• The OMO and GSAP operations have also helped in managing medium- and longer-term interest rates in the yield curve.

Way forward

• There is a likelihood of further additions to exogenous system liquidity.
• Other instruments to absorb surpluses: There might consequently be a need for other instruments to absorb these surpluses apart from VRRR auctions.
• Liquidity surplus of non-banking intermediaries: Managing liquidity surpluses of the non-banking intermediaries, especially mutual funds, will be another challenge since they do not have direct access to VRRR operations.

Consider the question “Since the onset of the Covid-related lockdowns, RBI had moved proactively to cut the repo and reverse repo rate and inject unprecedented amounts of funds into banks and other intermediaries. In this context, what are the challenges in monetary policy normalisation as RBI plans to absorb the excess liquidity and increase the interest rates ?”

Conclusion

The shift to the tightening phase, with hikes in the repo rate, is likely towards the late months of FY23, with shifts “if warranted by changes in the economic outlook”.

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Back2Basics: Monetary Policy Corridor

• The Corridor in monetary policy of the RBI refers to the area between the reverse repo rate and the MSF rate.
• Reverse repo rate will be the lowest of the policy rates whereas Marginal Standing Facility is something like an upper ceiling with a higher rate than the repo rate.
• The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.

Context

The fact that crypto exchanges successfully managed to signal legitimacy for their services and offer these tokens to a mostly-uninformed public for over a year provides lessons on how the government and sectoral regulators may need to act before the game gets out of hand.

Regulating the technology innovation

• Technology innovation typically remains a step ahead of regulatory frameworks, which are designed with current practices in mind.
• Problems occur when these innovations push the envelope beyond accepted codes of social and ethical behaviour.
• Digital lending apps: The joint parliamentary committee (JPC) on a proposed data privacy law that recently released its controversial report has pointed to dubious “digital” lending apps proliferating on the Android platform.
• Blockchain technology, of which cryptos are a part, is an innovation that can facilitate transactions across assorted functions.

Issues with unregulated cryptocurrencies in India

• Some estimates show that over 15 million Indians have invested in cryptos, many of whom live in Tier-II or Tier-III towns.
• But crypto exchanges in India have pushed the boundaries of this invention.
• Important disclaimer not communicated properly: They have been advertising aggressively across media platforms often announcing important disclaimers at warp speed.
• These provisos were supposed to communicate that cryptos are neither currencies nor strictly “assets”, and that these trading platforms are not truly “exchanges”, that crypto values are not determined by the usual dynamics governing other income-yielding assets, and that investing in cryptos was an exceedingly risky proposition.
•  In the meantime, with advertising overload stimulating viewer interest, many scam crypto issuers and exchanges have sprung up in attempts to separate the gullible from their savings.

Regulation challenges and how government is tackling it

• The government has now stepped in, seized with the political perils of speculative investments turning sour.
•  Unfortunately, sectoral regulators, such as the Reserve Bank of India (RBI) and Securities Exchange Board of India (Sebi), were unable to step in and act earlier because they are governed by specific Acts which do not mention cryptos as a category that needs regulation.
• Need for enabling clauses: This episode provides a valuable lesson on how these Acts should perhaps include some enabling clauses that allow financial sector regulators to intervene whenever any intermediary tries to sell a financial service or any new innovative financial service poses the risk of disrupting financial stability.
• Two important documents have recently been released which discuss entry norms into formal banking, both further strengthening RBI’s hands.
• Think-tank Niti Aayog’s paper on licensing digital banks recommends an evolutionary path for digital banks that’s RBI-regulated at all stages: first a restricted licence, then a regulatory sandbox offering some relaxations, and finally a “full-stack” digital banking licence.
• Simultaneously, RBI has accepted some of the suggestions of its internal working group and modified a few to make entry norms stricter, but has maintained silence on the entry of private sector corporate houses into banking.
• The JPC’s concerns over unregulated digital lending have also focused attention on an RBI-appointed committee’s report on digital lending, given that multiple fintech-based online lenders have mushroomed during the pandemic.

Conclusion

This highlights the need for principle-based regulations, rather than rule-based regulations, to allow for flexibility and adaptability in a fast-changing technology environment.

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