Why the RBI Should Regulate Cryptocurrencies and Smart Contracts

Recognising cryptocurrencies and the transactions emanating from it will be a long drawn out and confusing process. But it will be a risk worth taking.

The frustration associated with enforcing contracts could be eliminated – if we replace humans with fiddly bits of code. Conducting business could be a whole lot easier if we embraced the blockchain, say digital currency enthusiasts.

The dream of smart contracts – legally enforceable agreements that aren’t left to the mercy of legal interpretation and lawyers – traces as far back as 1994. However, it  is only with advent of Ethereum, a new cryptocurrency and platform, that this dream now seems attainable. The digital currency comes with a new type of blockchain – a peer-to-peer database that provides a public and trusted record of transactions – that seems destined to kick-start the smart contract revolution.

This revolution is not only relatively new to India but is understandably clouded by uncertainty and a number of myths. If India is to take full advantage of the digital currency revolution, these myths and misunderstandings need to be tackled by India’s regulators and the government.

Myth No. 1: Smart contracts do not satisfy traditional elements of a legally binding contract, and are unaccounted for in international instruments

It is often argued that the traditional elements of contracts in India viz. offer, acceptance and intention cannot be gauged in a smart contract since negotiations happen electronically, with no clarity as to these components. It is believed that the difference between invitation to offer and offer also gets blurred causing confusion as to intention, and whether the parties agree on the same facts in the same sense. However, contract-creation through electronic negotiation has been addressed in several international instruments. The European Draft Common Frame of Reference and Article 2.1.1 of the UNIDROIT Principles of International Commercial Contracts cover contracts involving automated performance arrangements, where parties agree on self-executing electronic platforms without the involvement of a natural person to ensure performance. ICC e-Terms are used to clarify offer, acceptance and intention of the parties to enter into automatically-concluded contracts. The existence of these provisions in international instruments reflects global support for digitally concluded and enforced contracts which ensure greater compliance than traditionally executed contracts.

It is interesting to note that experts all over the world, most notably Joshua A.T. Fairfield, consider cryptocurrency as valid consideration for a contract, which is electronically released on satisfaction of contract terms. In India, most of the opposition for smart contracts emanates from the fact that the cryptocurrency employed, more specifically Ethereum, has not been recognised as currency in India, stands legally unregulated and hence does not form valid consideration. It has not been defined under the FEMA, RBI Act or Coinage Act and it is believed that by virtue of the Latin maxim expressum facit cessare tacitum, Ethereum is excluded from the definition of currency.  While it is true that this is how the law currently stands, there is no hindrance to legal recognition of Bitcoin and Ethereum as currency. State practice of several countries and blocks, Australia, E.U. and Japan to name a few, reveals extensive recognition and legalisation of cryptocurrency.

India too has adopted smart-contracts in many forms:

E-commerce: E-commerce creates legally-binding agreements based on electronic communication between parties, very similar to how smart contracts function, and this technology is recognised and promoted by the Indian government. The only difference being that instead of an online seller authenticating the receipt of the good/service by the customer, it would be done electronically on an Ethereum platform.

Algorithmic trading: The functioning of smart transactions in the financial sector is fundamentally the same as that of smart contracts i.e. release of cryptocurrency on the block-chain on fulfillment of preconditions. State practice and opinio juris in Europe and in the United States supports this technology; algorithmic trading governs over 50% of equity trades in these markets. Cryptocurrency transactions have been expressly recognized by the European Court of Justice in Skatteverket v. David Hedqvist. It is interesting to note than in India, 94% of overall orders in cash equity are through algo-trading, as part of the Direct Market Access Facility provided by SEBI.

Following from this, it seems that India has embraced the convenience and productivity that comes with smart contracts, and legalisation of cryptocurrency is the next logical step which will obliterate any obstacle to smart contracts being seen as ‘contracts’ in the first place.

Myth No. 2: Dispute resolution is problematic, as the jurisdiction of courts can be excluded

It is believed that smart contracts administered with block-chain technology make it impossible to identify the seat of the contract i.e. the place where the contract was concluded and by implication, the proper law of contract, and the courts which have jurisdiction over disputes. This is seen as a dangerous means of opting out of any legal system, which could lead to the development of a potentially unregulated system of contracting.

But this is far from the truth. As Aeron Buchanan, former researcher at Ethereum.org, points out, the Ethereum system powering smart contracts itself envisages a dispute resolution mechanism involving external arbitrators and/or courts, where the contract is frozen pending proceedings, and the award of the court is incorporated into the terms of the smart contract. With regards to evidence, a dual-integration mechanism comprising hybrid ‘code+paper’ contracts can be presented in court.

Further, several smart contracts involve damage computation by third-party experts, which is the basis of recognised forms of ADR like arbitration. The expertise of third-parties in computing damages is recognised, both as them forming independent adjudicatory bodies (like in an arbitration), as well as their opinion being presented before a court (as embodied in Article 50 of the Statute of the ICJ), or them being appointed by the Court as neutral experts (Rule 706, Federal Rules of Evidence). Smart contracts envisaging dispute resolution by third-parties makes the process efficient by providing judging of the dispute by experts as a service, saving the parties the time and effort of appointing a tribunal. Since the identity of the experts is unknown to the parties and vice-versa, the process is likely to be more fair and neutral. Further, technology for Decentralised Arbitration and Mediation Networks which transcend traditional legal systems is also being developed in the event that the contract itself does not involve any clauses or potential services for dispute resolution.

Myth No. 3: The blockchain technology used cannot be surveilled upon, and promotes illegal activities

Perhaps the biggest myth surrounding smart contracts (and in support of not legalizing them) is that surveilling the block-chain system for detection of illegal activity is very hard. It is widely believed that since smart contracts are easier to execute than traditional paper contracts and lesser formalities have to be fulfilled, it aids the parties in remaining anonymous and furthering illegal ends. The Sealed Complaint in the case of U.S.A. v. Robert Faiella is often used as a case in point about how transacting in code held parties maintain anonymity and evade identification by law enforcement agencies. Links between transactions recorded on blockchains and the IP addresses of the parties making them are blurred, and there are several other factors facilitating criminal activity (for reference, see NATO’s Defence Against Terrorism Review).

Countries often resort to the concept of existence of jurisdiction over transactions taking place in cyber-space, and invoke obligations under international treaties such as Article 3 and 8 of the International Covenant for Suppression of Financing of Terrorism, and Article 12(2)(b) of the International Covenant for Economic, Social, and Cultural Rights to argue that they cannot allow their territories to be used for potentially illegal activities arising from the block-chain technology on which smart contracts function.

However, blockchain technology can in fact be surveilled upon, and even aid in law enforcement. Here’s how: 

Myth of complete anonymityIt is pertinent to mention at the outset that the identity of the parties on a block-chain is not completely anonymous. The block-chain is a public ledger keeping a public account of all transactions which can be used by governments to track unusual and potentially illegal activities. In fact, block-chains are better than traditionally executed contracts which are not so easy to track.

Scholars like C. Smith have pointed out how cryptocurrency-transactions generate sufficient public data accessible by investigators on the blockchain, which connects transactions to sales and ultimately to sellers. Suppose there is an online platform for the sale of drugs, powered by the bitcoin. Buyers, sellers as well as law enforcement agencies can access this website. Granted, the buyers as well as sellers utilize anonymous signatures, but that alone does not allow them to escape recognition. Every transaction on this website shall be authenticated by ‘miners’, who are volunteers earning cryptocurrency in exchange for their services. Miners are able to determine the amount each buyer paid to the seller, and this information is publicly accessible on the blockchain. Equipped with this information, law enforcement agencies can work on tracking the IP address of the seller to identify him, and restore law and order.”

State practice: State practice also definitively reveals that blockchains can be surveilled. Australia has a nuanced system in place. The FBI in the US also effectively tracks down perpetrators of illegal activity on the block-chain network, and Ross Ulbricht’s arrest for ‘Silk Road’, an illegal drug empire built on Bitcoins, is a case in point. The Czech police too has means of tracking perpetrators, as demonstrated by the seizing of Tomáš Jiříkovský’s assets, who was suspected of using cryptocurrency to launder money. Recently, the European Cyber-Crime Centre has also taken steps to track and arrest perpetrators of crimes on block-chains, by partnering with Chainanalysis. These examples are a few of many which demonstrate that the block-chain technology can indeed be surveilled upon, and utilised to track perpetrators of crimes.

It is true that the practice of some states such as Bangladesh, Bolivia and Russia lends support to banning of cryptocurrency (and hence, smart contracts) due to its possibility for misuse. However, most electronic systems do present undeniable possibilities for misuse, but that per se is no grounds for refraining from granting them recognition, or declaring them illegal. Technology such as wire transfers, cash withdrawal and deposit facilities are widely used to deal in black money, launder funds and finance terrorism. These activities have been criminalised and states have put tracking and pattern-detection facilities in place, but the banking platforms themselves are not illegal. In fact, these platforms are widely used by the public due to their advantages and convenience of use.

India can follow in the footsteps of countries such as Canada, Hong Kong etc, and legislate to declare activities like money-laundering, financing of terrorism and drug trafficking using block-chains illegal, and put tracking mechanisms in place to fulfil its international obligations. Omri Marian, the eminent cryptocurrency publicist, also emphasises the great innovation potential of cryptocurrency transactions, and provides noteworthy models for regulation.

Vrinda Vinayak is a student at National Law University, Delhi.