Engineers have defined the cutting-edge of financial innovation since computers entered trading floors in the US in the 70s. What was once a veritable Wild West of fast-paced algorithmic trading is now a regulated status quo, and accounts for well over half of total stock trading. India was a late adopter of financial technologies, so much so that a ‘national share bazaar’, unified by a network of connected computers only became a reality towards the early 90s. Algorithmic trading was allowed much later, in 2008. Unlike conventional financial markets, however, India is not a laggard in developing a virtual asset trade.
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Information technology is our largest export. Indian developers have also provided a fillip to financial inclusion, with rapid innovation in areas such as payments, brokerage and insurance. The entry of Indian technical talent into the financial world is a cause for celebration. Virtual asset markets represent another facet of this progression of engineering-driven finance. Thus, India must draw the right lessons from the FTX saga that will likely bookend the under-regulated era of this disruptive new market.
The first takeaway is the importance of encouraging localization or onshoring digital businesses that have a fiduciary duty towards their customers. That is, they hold a legal or ethical relationship of trust with them. Fiduciaries like crypto exchanges buy, sell and hold assets, and thus play an active role in the management of customer deposits. Similar activities must be subject to similar legal requirements as other financial fiduciaries.
Most of the trading on FTX took place offshore via its Bahamas-headquartered operations. This allowed regulatory arbitrage over onshore trades in countries like the US, where the world’s largest number of crypto investors reside. America’s fragmented approach to the regulation of virtual assets contributed to a boom in offshore exchanges. For instance, crypto exchanges require different licences to operate across almost each American state. Such exchanges are not yet allowed to list complex derivative products. Consequently, many Americans use virtual private networks to access non-US exchanges.
Cut to India, where, unlike the US, onshore crypto-exchanges accounted for a large share of domestic crypto-trade until a few months ago when a penal tax regime kicked in. Earnings in crypto are now subject to a flat 30% income tax, which cannot be set off against losses. Additionally, 1% of each transaction is taxed at source. Naturally, the volumes of crypto-trading on domestic exchanges have fallen precipitously, and moved offshore. Like the US, India stares at the risk of its citizens losing money online, and no gains for the exchequer either. The history of trade suggests that governments cannot suppress what a critical mass of people want to exchange; and therefore, it’s important to focus on good regulatory design.
India must not allow new digital fiduciaries to operate in grey and red zones. It must instead establish a framework to regulate such services locally. Local registration may seem antithetical to the impetus for decentralization, exemplified by blockchain and Web 3.0. But governments and engineers needn’t be on opposite sides. The FTX saga makes it clear that more oversight is warranted on fiduciary services until there is fool-proof international regulation.
Second, India must standardize transparency in onshore virtual asset markets. A big reason for the sudden run on FTX assets was a lack of basic corporate hygiene. Altruistic as he was, Bankman-Fried effectively siphoned customer deposits to a sister entity, which meant he didn’t have the collateral necessary to remain solvent in a liquidity crisis. He allegedly routed billions in customer deposits held with FTX to backstop his own proprietary trading shop Alameda Research. Reports suggest that Alameda owed FTX around $10 billion. This may not have happened if he had to disclose such transactions.
Standardized disclosure requirements, combined with local registration and audits, can mitigate FTX-like crises. They are commonplace in stock markets. For instance, in India, key management personnel of stock exchanges are subject to codes of conduct to ensure fair and transparent market practices. This includes trading limits and requirements to make disclosures on any security transactions carried out by them.
India can easily establish a pragmatic accountability framework for new digital fiduciaries. Taking the lead in fashioning such a regime will help cement its stature as an innovation hub and encourage onshore trading. Citizens have a right to feel safe online, and it is for government and industry to ensure that they do.
Vivan Sharan is partner, Koan Advisory Group.
Elsewhere in Mint
In Opinion, Manu Joseph tells what the success of T20 teaches us about the old school. Vivan Sharan writes on the lessons for India from the FTX saga. Barry Eichengreen explains the trilemma of CBDCs. Long Story reveals how the Chinese use Indians as fronts for scams.
