Analysis l ED action against crypto exchange WazirX underscores RBI’s concerns on virtual currencies

The RBI fears that crypto dealings will lead to possible money laundering activities.

Indian central bank’s communications are well-worded, and it is important to understand not just what it says, but also what it doesn’t.

On May 31, when the Reserve Bank of India (RBI) clarified its position on the 2018 circular on virtual currencies, many missed an important part—abundant caution on various laws that could be associated with Crypto dealings. The pro-Crypto lobby interpreted the RBI clarification that the 2018 circular is invalid post the March 2020 Supreme Court order, as the central bank's silent approval for crypto transactions. That wasn't the case.

In its May 31 clarification, among the various regulations the RBI cited cautioning banks to follow due diligence process were the crucial Foreign Exchange Management Act (FEMA) and Anti-Money Laundering (AML) rules.

Incidentally, these legal provisions have been cited by the Enforcement Directorate (ED) on June 11 while issuing a show cause notice to cryptocurrency exchange WazirX and its directors Nischal Shetty and Sameer Mhatre for allegedly violating guidelines in connection with transactions worth Rs 2,790.74 crore.

The notices were issued under the Foreign Exchange Management Act (FEMA), 1999, after the ED initiated an investigation on the basis of an ongoing money laundering probe into “illegal” Chinese-owned online betting applications, the ED said in a statement. This is the first instance of a major crackdown by an Indian agency on cryptocurrency firms.

Now, take a closer look at the ED statement on WazirX.

The ED claims Chinese nationals had laundered the proceeds of crimes worth about Rs 57 crore by converting Indian rupee deposits into the cryptocurrency Tether and then transferred them to Binance Wallet, an exchange registered in the Cayman Islands, based on “instructions received from abroad.”

Further, the agency said users of WazirX, via its pool account, received cryptocurrency worth Rs 880 crore from Binance accounts and transferred out digital currencies worth Rs 1,400 crore to Binance accounts. The  ED show cause notice refers to serious allegations and will likely intensify probe agencies' scrutiny on the operations of crypto firms operating in India.

More importantly, the ED action underscores the importance of RBI caution on crypto and, at least partly explains the concerns raised by the central bank. These are among the concerns raised by the central bank with the government in the context of cryptocurrencies. The RBI fears that, among other factors, crypto dealings will lead to possible money laundering activities. The central bank's worry is indeed valid considering the growth of cryptomarket in India even in the absence of regulations.

According to data from crypto exchanges, there are approximately 1.5 crore Indians who have invested in cryptocurrencies holding Rs 15,000 crore. There are 350 startups that operate in blockchain and crypto. Crypto exchanges WazirX, CoinSwitch Kuber and others have seen a big rush in demand from users and crypto exchanges are advertising heavily on investments. The government and the central bank can't ignore the growth of this market.

In its May 31 circular, the RBI had mainly cited the following legal provisions to warn investors and banks in connection with the virtual currencies: Know Your Customer (KYC), Anti-Money Laundering (AML), Combating of Financing of Terrorism (CFT) and obligations of regulated entities under Prevention of Money Laundering Act, (PMLA), 2002 in addition to ensuring compliance with relevant provisions under Foreign Exchange Management Act (FEMA) for overseas remittances.

This and the subsequent reminders about "major concerns" had prompted legal experts to see this as the central bank's way of warning investors. "It seems the RBI wants to caution investors with respect to crypto currencies while acknowledging that officially they can't do so after the Supreme Court set aside the 2018 circular," said Akshay Nagpal, Partner, L&L Partners. "It seems the RBI is interacting with the government to bring some regulations against or regulating cryptocurrencies," Nagpal said.

The Indian government is working on crypto regulations but this is yet to take the final shape.

The regulator, in the absence of a national law to govern crypto and against the backdrop of March 2020 Supreme Court order, was not in a position to advise banks against the use of crypto but the statement had left enough indications for banks and other regulated entities on what it wants to convey to all stakeholders. One needs to see the latest developments in the context of these warnings.

In fact, the central bank has repeatedly said it has major concerns with cryptocurrency and has raised these concerns with the government. On June 4, in his post monetary policy presser, RBI Governor Shaktikanta Das said the central bank's position on cryptocurrencies has not changed. "With regard to advice to investors, well, central banks don't give any investment advice. It's up to each investor to make his own appraisal, to do his own due diligence and take a very careful call with regard to his own investments," the governor said.

Lack of transparency alleged

The ED statement on WazirX emphasises the lack of transparency in the crypto exchange's dealings.

“None of these (above mentioned) transactions is available on the blockchain for any audit/investigation,” the ED said. The platform allows transactions with cryptocurrencies, including exchange of digital currencies with the rupee and vice-versa; exchange of cryptocurrencies; person-to-person transactions, and transfer or receipt of cryptocurrencies held in its pool accounts to wallets of other exchanges, which, the ED claimed, could be held by foreigners overseas.

“WazirX does not collect requisite documents in clear violation of the basic mandatory Anti Money Laundering (AML) and Combating of Financing of Terrorism (CFT) precaution norms and FEMA guidelines,” the ED statement said, adding, "It was found that the WazirX clients could transfer ‘valuable’ cryptocurrencies to any person irrespective of location and nationality without any proper documentation whatsoever, making it a safe haven for users looking for money laundering/other illegitimate activities.”

There are multiple rule violations cited here including the critical KYC norms, AML and FEMA violations which are quite serious from the point of view of financial stability, national security and investor protection. The central bank and the government cannot remain a mute spectator on unregulated financial activities.

What now? The ED's show-cause notice will likely have an impact on the investor psyche and may make them even more cautious. As such, the crypto industry in India is operating in the absence of clear regulations. The government has not yet come with a national law to regulate cryptocurrency. The central bank will await the crypto regulations before making its stance clear.

WazirX response

Nischal Shetty, WazirX's CEO, has said that his company was yet to receive any show-cause and has defended his company’s position. “WazirX is in compliance with all applicable laws. We go beyond our legal obligations by following Know Your Customer (KYC) and Anti Money Laundering (AML) processes and have always provided information to law enforcement authorities whenever required. We are able to trace all users on our platform with official identity information. Should we receive a formal communication or notice from the ED, we'll fully cooperate in the investigation.”

Will ED buy this argument? Are there indeed rule violations on the part of WazirX?  The details will be known only after the ED completes its probe. But the key message from the ED action to the crypto investors and other stakeholders including banks is clear-- the central bank’s concerns on cryptocurrencies indeed have merit and need to be taken with desired seriousness by common investors.