The Reserve Bank of India moved to bar banks and other entities that it regulates from having any linkages to virtual currency dealers, leading to a plunge in Bitcoin and other cryptocurrencies on local exchanges on Friday.
The government and the central bank have previously cautioned the public on cryptocurrencies, with New Delhi earlier this year vowing to eliminate the use of digital currencies, which it considers illegal in the country's payment system.
Entities regulated by the RBI shall not carry out transactions with individuals or businesses dealing in virtual currency, the RBI said on Thursday after issuing its bimonthly monetary policy report.
In India, Bitcoin, a volatile cryptocurrency, plummeted to a low of 350,001 rupees or about $5,392, according to crypto-currency exchange Coinome, compared with its international market price of $6,617.
Before the announcement, Bitcoin had been trading at about a 5 percent premium to its overseas price, said Vishal Gupta, co-founder of Block Chain and Cryptocurrency Committee, an industry body, noting it is now trading at a significant discount.
"This seems to be a very aggressive move," said technology law expert Namita Viswanath, a principal associate at IndusLaw.
"Instead of the RBI taking a holistic approach and seeing how to curb potential misuse, it seems to be a rather broad-stroke approach of completely prohibiting this altogether."
Late on Friday, the RBI issued a more detailed that stated any regulated entities which already provide services to facilitate dealing with virtual currencies will have to cut all ties within three months.
The Indian government has previously likened cryptocurrency investments to "Ponzi schemes" that offer unusually high returns to early investors.
It has set up a panel to look into the issues relating to cryptocurrencies and plans to appoint a regulator to oversee unregulated exchanges.
But Thursday's announcement raised concerns about the exit options for investors who currently hold cryptocurrencies.
Gupta estimates that at least 4 to 5 million people in India hold some kind of cryptocurrency and that 60 percent of them entered the market between October and December, when prices were at a peak.
"Most of these people are already sitting on capital losses," he said. "Now the asset has become dead. You can't transact with it. If you transact with it, your bank accounts are going to be shut."
Virtual currencies raise concerns of consumer protection, market integrity and money laundering, among others, the RBI said on Thursday.
"If the government stands firm on their decision then we will have to eventually pivot our business model from crypto-fiat to crypto-crypto hence omitting the fiat part in totality," said Shivam Thakral, CEO of BuyUcoin, a cryptocurrency exchange.