Stifling The Golden Age: SEBI’s Ban on Digital Gold

Introduction

The market watchdog Securities and Exchange Board of India (“SEBI”/ “Board”), in its press release dated October 21st, 2021, announced that it was barring SEBI-registered investment advisors (“RIAs”) from dealing in any unregulated products. According to the press note, the regulatory authority recently took cognizance of the fact that some RIAs were providing a platform for individuals to buy/sell/deal in unregulated products, including digital gold. The investment advisers have been directed to refrain from such activities as they are in direct violation of Section 12(1) of the SEBI Act, 1992 (“SEBI Act”) read with the SEBI (Investment Advisers) Regulations, 2013 (“2013 Regulations”). In light of the same, this article will attempt to portray the central argument that revolves around the contentious press release and the validity of the same. It intends to explore the ambiguity that arises from the press release, in the absence of any clear regulatory framework to address the lacuna. As part of the exploration into the topic, and following a background overview of the current scenario, the article is structured via two pillars – firstly, regarding the reason for the ban on digital gold, and secondly, dealing with the legal validity of the press release and whether or not it can be held up in a court of law. Lastly, it will also attempt to display the atmosphere regarding digital gold in the international atmosphere.

Section 12(1) of the SEBI Act requires any intermediary associated with the securities market to comply with the conditions of a certificate of registration obtained from the Board in order to trade in securities. The 2013 Regulations also provide strict guidelines to be followed by investment advisers when engaging in securities. ‘Investment advise', in this context, means advise relating to dealing in securities or investment products, and advice on investment portfolio containing securities. Advisers may also be involved in analysing a client's financial situation to identify financial goals and provide strategies to achieve the same.

The SEBI press release comes following another directive regarding digital gold released in the recent past. The National Stock Exchange (“NSE”), on August 10th, 2021, advised its members to discontinue the sale of digital gold on their platform by the effective date of September 10th, 2021. This direction originated via a letter dated August 3rd, 2021, to the stock exchanges from SEBI, warning them of the risks of trading in an unregulated product such as digital gold; except as a broker or agent, not undertaking any personal financial liability. According to the letter, the said activity was in direct contravention with Rule 8(3) of the Securities Contracts (Regulation) Rules, 1957 (“SCRR”). However, while these directives may have dulled the sheen of digital gold, enough new-age firms continue to market the product, which has accelerated its growth due to the lockdown and subsequent digitalisation. With that said, it is pertinent to understand the intention of SEBI in introducing the press release. Furthermore, due to the lack of clarity regarding the validity of press releases, the same will also be explored as an incorporation within the central theme.

What is digital gold?

The first concept of digital gold emerged in 1996 in the name of ‘e-gold’, introducing a form of investing in gold using smaller amounts. Digital gold is essentially a 24-carat, 99.9% pure gold investment that does not require any storage. The investment is online, either through internet banking or a UPI transaction. The money is paid online, and within a few minutes, the seller sends a digital invoice for the purchase. An individual may buy digital gold of a fixed value or weight across numerous platforms, as per current market values. The appeal in the commodity arises from its ability to be purchased in the smallest of denominations. At current values, one rupee is worth around 0.0001 grams of gold. Therefore, one may get roughly 0.0019 grams for Rs 10. This can either be resold at the current market pricing or accept physical delivery of the gold, which would incur additional expenses.

The process structure is similar across all major players in the current digital gold market. First, a custodian stores the gold in a vault, under the ownership of the customer. Second, a trustee ensures the quality of the gold and segregates the same, as per the availability. Third, a daily summary containing a list of transactions from each of its clients is sent to the custodian, who in turn adjusts the vault holdings to match the corresponding online movements. This structure relies on being insolvency proof, unlike accumulation schemes where there is a counter-party risk for the saver.

Why is it banned?​

According to the press release, it is noted that only members of stock exchanges, such as brokerage firms and wealth managers, will be subject to this rule. Any company that deals in stocks, commodities, derivatives, or other financial instruments will thus be prohibited from selling digital gold. However, digital gold may still be sold in an unregulated manner, as inferred from the fact that any establishment not dealing in securities may still trade the product. Therefore, SEBI and the exchanges seem to believe that selling digital gold has certain financial risks involved, and hence trading members are prohibited from doing so. Furthermore, the current capital market does not have any regulations surrounding digital gold. This is in contrast to regulated products like as the National Pension System (“NPS”) or insurance offered by trading members, which have no financial liability. Additionally, SEBI could be concerned about the potential misuse of clients’ money by brokers. Presently, no framework exists to verify whether or not the gold units traded digitally are backed by physical gold reserves. Financial entities that trade in gold would need to be monitored and therefore, it may be reasonable to express concerns about over-allocating virtual assets to customers. As a result, the move from SEBI can be seen as pre-emptive fencing, geared towards protecting regulated entities from any potential risks.

Validity of the press release

Secondly, the legality of the press release needs to be deliberated upon. Vital economic policy issues such as the Foreign Direct Investment (“FDI”) Policy have been announced via press notes in the past. These releases are not the result of a legislative procedure and are not debated in Parliament, but they seem to possess far-reaching economic policy implications. They are issued on an ad-hoc basis, when regulatory authorities are required to amend existing policies. Press notes become legally binding once they are issued.However, the question that may be posed is whether an allegedly legislative act (such as establishing limits of securities trading) can be sustained only by Executive directives, such as a Press Release, and whether there is any constitutional/legal obligation for ratification by Parliament.

The prevailing principle of jurisdiction states that executive action may be taken in all areas where Parliament's legislative power is exercised, except in matters of occupied field, i.e., if the subject matter has already been addressed by existing legislation. Additionally, since executive actions have the power of law, they must pass the same legal tests as laws, such as rationality, arbitrariness, fundamental rights violations, and the theory of ultra vires. In such a case, it could theoretically be subjected to judicial review. However, the Supreme Court of India, in M.P Oil Extraction v. State of Jammu and Kashmir, declared that courts must be aware of the "doctrine of separation of powers" when utilising their judicial review power against executive decisions. Therefore, courts must be wary of staying within the bounds of the law, but may intervene if the policy is completely capricious, arbitrary, devoid of reason, or based solely on ipse dixit. The Supreme Court in M. L. Sharma v. Union of India has also ruled that courts cannot intervene in policy decisions unless they are "unconstitutional or contrary to statutory provisions, arbitrary or irrational, or in abuse of power."

With that said, however, it would be difficult to challenge the validity of a press release merely because it is not ratified by Parliament, despite the fact that they are legislative in nature. No such argument is allowed under Article 73 of the Constitution. Therefore, in the case of a legal encroachment arising on the basis of the SEBI press release, the appellant would have to satisfy the court that the direction in question was arbitrary and unreasonable. It should also be noted that courts are generally hesitant to question or interfere with a governmental policy decision. As a result, the most likely scenario in the event of a challenge to the validity, would be rejection of the same citing national security concernssurrounding highly sensitive sectors of trade and finance. In any case, however, prudent investors and securities establishments alike would prefer to take the safer route and act in the interests of the regulating authority, in turn creating a trend that may carry over to a legislation or amendment in the near future.

What does it mean for investors?

Investors would no longer be able to invest in digital gold through brokers' or their subsidiaries' platforms, including those unauthorised by SEBI. Since only members of the stock exchange (BSE and NSE) are prohibited from distributing digital gold on their platforms, companies that do not fall under the purview of SEBI and thus are allowed to offer the product. This means that payment services and mobile wallets such as GooglePay and PhonePe can still offer digital gold to their customers. Furthermore, although SEBI may have reservation about digital gold investments, the business of gold-based micro-savings products are still a viable venture for many investors, proven by the rapid growth of the sector.In light of the same, SEBI and exchange-regulated firms may provide investors the opportunity of investing in gold exchange-traded funds (“ETFs”). Additionally, the finance minister had recently announced the establishment of a ‘gold exchange’ under the supervision of SEBI. While this is still in the conceptual stage, in May 2021, SEBI issued a consultation document asking for feedback from market players, possibly paving the way for more regulated gold-backed savings investments.

Conclusion

Moving forward, individuals may choose to invest in physical gold, gold stocks, gold ETFs and mutual funds, or speculative futures and options contracts, depending on their risk appetite. Investing in any form has some level of risk and gold is no exception. However, digital gold provided a solution to this shortcoming by providing all the benefits of traditional gold investment, without the hassle of securing safe storage and complexity of liquidation.

The move by SEBI may either be seen as a draconian crackdown on emerging technologies or as a developmental pavement for ushering in regulations regarding the same. In any event, the ban has served as a reminder for the federal government to seriously consider redefining of the term ‘securities’ in the relevant legislations, based on understanding the modern investor. A suggestion that may prove beneficial would be to include digital gold within the ambit of ‘securities’ via an amendment to the Securities Contract Regulation Act (SCRA) and SEBI Act. In such a scenario, the product would fall under the regulated sector, allowing investments advisers, brokers, and all other linked entities to freely trade in it.

India is the second largest consumer of gold in the world, and this propensity of appetite is bound to be reflected in its citizens’ investment decisions. This demand for financially stable assets is evidenced by the rise in gold prices during the shutdown. As the average investor's age changes, so will their investment preferences. For digital natives looking for a trustworthy instrument in the comfort of their familiar digital realm, investing in digital gold to generate long-term wealth is a smart and safe decision. The optimistic mood surrounding the future of digital gold will continue. Although the methods of obtaining and holding gold may change from generation to generation, the principle of investing in gold as a safe haven and auspicious asset stays the same in India.