I. Introduction
Law-making and regulatory authorities across the globe have long been pondering the issue of regulating cryptocurrencies and making them more mainstream. October 19, 2021 marked a milestone in the cryptocurrency universe when the first futures-backed Bitcoin Exchange Traded Fund was listed on the New York Stock Exchange.
Over the last few years, the cryptocurrency ecosystem has expanded exponentially with numerous other cryptocurrencies based on new blockchains and with unique use cases being developed. However, owing to the anonymous and virtual nature of cryptocurrency transactions, they have proven to be extremely difficult to regulate.
II. Cryptocurrency ETFs
One of the prominent approaches to regulating cryptocurrencies is to classify them as an asset class rather than a currency in itself. This approach enables investors to invest in cryptocurrencies as a store of value similar to government bonds, securities, gold and other such assets rather than using them as a means of exchange or a competitor to the national currency.
There are numerous means through which this approach can be adopted by the Government and its regulating authorities, ranging from something as simple as authorising investments via centralised exchanges to more complex strategies such as trading these cryptocurrencies on the stock market through Exchange Traded Funds (ETFs). ETFs are exclusively pegged to the value of an individual cryptocurrency or a group of them.
An Exchange Traded Fund refers to a tradable security on a stock exchange that tracks the value of an asset, index, or commodity. The fund comprises investments in individual assets, commodities, securities, or a basket of them and allows investors to diversify their holdings by buying a share of the ETF, rather than its investments individually. In a cryptocurrency ETF, the fund comprises of one or more cryptocurrencies. A cryptocurrency ETF, like other ETFs, can be bought and sold on a regular stock market instead of a cryptocurrency exchange. The price of an ETF share will vary in accordance with the price of the cryptocurrency in the fund. Cryptocurrency ETFs are of two kinds—physical-backed and synthetic.
A physical ETF is backed by actual cryptocurrencies, i.e., the fund comprises actual cryptocurrency that has been purchased by the AMC. This way, an investor can indirectly own cryptocurrencies without incurring the expense or risk of direct ownership. The Evolve Bitcoin ETF (100% Bitcoin), Evolve Ether ETF (100% Ethereum), and Evolve Cryptocurrencies ETF (both Ethereum and Bitcoin) traded on the Toronto Stock Exchange in Canada, and the QR Capital ETF (100% Bitcoin) traded on the São Paulo B3 Stock Exchange in Brazil are some examples of physical-backed ETFs.
A synthetic ETF is backed by derivatives of cryptocurrency, like futures contracts. A futures-backed ETF entails that the AMC doesn’t actually purchase the cryptocurrency, but contracts to purchase a certain amount of it in the future. The ETF will therefore track the prices of the cryptocurrency that is contracted to be purchased. ProShares Bitcoin Strategy ETF, a futures-backed ETF, began trading on the New York Stock Exchange in October 2021.
While cryptocurrency ETFs were first proposed in 2013 to the Securities and Exchange Commission, multiple applications were made since they were all rejected owing to the volatility in prices of cryptocurrencies and lack of liquidity. However, the US is now actively taking measures to join countries like Canada, UAE, Germany, Switzerland, and Brazil by enabling investors to gain exposure to these virtual assets within their trading or brokerage accounts by enabling their ETFs to be traded across the major stock exchanges.
III. Regulatory Benefits of Crypto ETFs
Allowing ETFs to be traded on the stock market and providing investors the opportunity to invest in cryptocurrency-based ETFs is advantageous to both investors and regulators. Firstly, since an ETF is traded on the stock exchange, it will afford a larger group of investors with an opportunity to gain exposure to this new asset class. This would prove beneficial as Bitcoin was found to be the the best performing asset of the past decade, giving investors an annualised return of over 230%.
Moreover, major cryptocurrencies like Bitcoin (over 45 lakh rupees per Bitcoin) and Ethereum (approximately 3 lakh rupees per Ether) are highly valued, making it impossible for ordinary investors to buy a complete token. Thus, a cryptocurrency ETF would enable investors to easily buy, sell and hold a share in the currency with relative ease. It also serves as a better alternative to investing through stand-alone cryptocurrency exchanges, which in the past have shown to be susceptible to hacks and crashes.
Secondly, regulators stand to benefit from sanctioning cryptocurrency ETFs since the stock market, especially in India and other developed nations like the US, is already heavily regulated. Since ETFs are traded in the exact same manner as stocks of a listed company, the pre-existing regulations put in place by the Securities and Exchange Board of India (SEBI) which are applicable to listed securities will seamlessly apply to such investments as well, with little to no amendments. India has faced extreme difficulties in regulating not only cryptocurrencies but also crypto exchanges.
Cryptocurrency ETFs would enable the Government to either restrict or place blanket bans on such exchanges, while still providing investors with a means for investing in these assets indirectly. Such ETFs would only require the Government to oversee the transactions made by the AMCs in relation to the ETF, rather than monitoring every transaction made by individuals across a wide array of exchanges.
Thirdly, Cryptocurrency ETFs will also resolve the dilemma of imposing tax liabilities on cryptocurrency investments and the classification of cryptocurrencies received as rewards from staking contracts and lending protocols”. Staking is the process through which the cryptocurrency owned by an individual can be locked for a specific period of time for validating transactions on the blockchain. For doing so, the owner of such staked cryptocurrencies is rewarded with a certain amount of the currency so staked.
There are no existing provisions that address the taxation of such assets and therefore highlights a major lacuna in the law. This issue could be done away with through ETFs because the AMC of the ETF entering such contracts or protocols will distribute the value of cryptocurrency they receive from such contracts among investors in the form of dividends or pay-outs. This would eliminate any ambiguities pertaining to the status of such additional assets handed out to investors. In India, ETF dividends will then be liable to taxation under Section 115-Oof the Income Tax Act, 1961 (the Act) and any profits arising out of staking or lending of cryptocurrencies by the AMC can be taxed under the said provision.
With regard to general taxation of cryptocurrency investments, the Internal Revenue Services (“IRS”) in the United States has stated that all gains on cryptocurrencies are subject to the general principles of taxation. However, this approach is not always viable as it is virtually impossible to trace transactions carried out on decentralised exchanges (cryptocurrency exchanges based on a blockchain) such as Pancake Swap and Uni Swap.
This problem can be overcome by allowing cryptocurrency ETFs, as they will be subject to long-term capital gains tax under Section 112 and 112A of the Act or short-term capital gains tax under Section 111A of the Act, as the case may be. Furthermore, since every transaction on the stock exchange is recorded, unlike certain cryptocurrency exchanges, it makes it possible for authorities to trace and locate the trader/investor.
IV. The Way Forward
The last two decades have been pivotal to the evolution and mainstream adoption of cryptocurrencies. Today, Bitcoin has been adopted as legal tender in El Salvador, and a bill proposing the same has been tabled in Paraguay’s legislative assembly. Investment in cryptocurrency as an asset has become a global phenomenon, facilitated by the emergence of cryptocurrency exchanges and support from payment firms and platforms like PayPal and Visa. However, difficulty in taxing cryptocurrency proceeds and the fear of cryptocurrency becoming a parallel currency have impeded the growth and adoption of the asset.
The growing popularity of cryptocurrency ETFs is on account of the ease in regulation and taxation. ETFs allow the adoption of cryptocurrencies as an asset, rather than a currency, and award an opportunity to investors to gain exposure to the benefits of cryptocurrency gains. Moreover, investors are shielded from the high risk and volatility of cryptocurrencies as they are indirectly purchasing them through AMCs. Cryptocurrency ETFs are a safe alternative to cryptocurrency exchanges and can potentially pave the way for the widespread adoption of cryptocurrency with necessary regulatory safeguards.
Written by- Yash Chadha & Aradhana Pandit
Edited by- Mallika Rahane