Cryptocurrency & Private Equity – Not Quite a Match Made in Heaven

Cryptocurrency & Private Equity – Not Quite a Match Made in Heaven

Cryptocurrency investments have become popular over the last 2 decades, and there are now over 10,000 cryptocurrencies being traded across platforms globally. Although India has a large number of cryptocurrency investors (and the most first-time investors), cryptocurrencies remain unregulated in India. Attempts by the Reserve Bank of India to ban cryptocurrencies failed, and no further legislative steps have been taken in respect of these assets other than the imposition of a 30% tax on virtual digital assets (including cryptocurrencies).

Recently, several private equity (PE) investors have invested in cryptocurrency exchanges like Coinswitch Kuber, Coin DCX, WazirX, etc. 

Unfortunately, investments in cryptocurrency exchanges are fraught with risk. The fact that the legal status of cryptocurrencies in India remains ambiguous, leaves the door open to restrictions and regulations being imposed by regulators down the line – there were previously reports that the Government of India was considering banning private coins. Multiple government departments have expressed concerns that the use of cryptocurrencies may give rise to national security risks, money laundering and cybercrime. The Enforcement Directorate has, in recent years, targeted cryptocurrency exchanges for failing to comply with foreign exchange regulations and know your customer requirements. To the extent that the investigations result in the sharing of user data, this could raise privacy concerns and adversely impact the confidence of investors trading on the exchanges.

The impact of the tax on virtual digital assets remains to be seen. Given that the rate of tax is higher than that payable on gains from listed equity securities, it may deter further investment in cryptocurrencies or divert investments off the market or outside India, adversely impacting the revenues of cryptocurrency exchanges.

The volatility of cryptocurrencies also makes investment in cryptocurrency exchanges a riskier prospect. The recent crash in cryptocurrency valuations has impacted investor confidence and resulted in investors selling their holdings. As a result, Celsius Network, one of the world’s leading cryptocurrency lending platforms, suspended trading and withdrawals, further eroding investor confidence.

The regulation of cryptocurrencies varies globally. While, for the most part, substantive legislation on cryptocurrencies has yet to be promulgated, several countries have begun taxing gains and, or, income on cryptocurrencies. Some countries such as the United States, the United Kingdom, Australia, and Germany treat cryptocurrencies as capital assets; while others such as El Salvador, Venezuela and Malta recognise certain cryptocurrencies as legal tender. Japan and Canada treat cryptocurrencies as commodities. Recently, the Republic of South Africa has also declared cryptocurrency as a financial product. Depending on the jurisdiction, cryptocurrencies may be subject to capital gains tax or income tax on the basis of the activity being taken (i.e. trading, mining, gifting, etc.).

In addition to drafting substantive regulations governing cryptocurrencies, certain countries such as India, the United States, the United Kingdom etc. are considering implementing central bank digital currencies tied to their respective fiat currencies as an alternative to private cryptocurrencies. This would help ensure the registration of cryptocurrency exchanges and compliance with reporting and disclosure obligations. It would also make it more difficult to use cryptocurrencies for money laundering and, or, other illegal activities.

If the Government of India recognises cryptocurrency, it is unclear what form such legalisation could take – certain types of cryptocurrencies (such as private currencies) may be banned, cryptocurrencies other than the digital Rupee may be banned, etc. Additionally, the applicable regulatory framework may vary significantly depending on how the Government classifies cryptocurrency. Therefore, while legalisation may be a net positive in the long run, the legal intricacies may impact PE investors’ returns.

When investing in cryptocurrency exchanges, PE investors should bear the above risks in mind and negotiate transaction documents accordingly. While the complete elimination of risk may not be possible, PE investors may consider requiring the target to obtain cybercrime insurance, and implement a robust compliance framework. Given the evolving regulatory landscape, the definition of ‘force majeure event’ should expressly exclude changes in law and the transaction documents should specify exit options in the event of a ban or imposition of material restrictions on the operations of cryptocurrency exchanges.

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