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El Salvador's Legislative Assembly has recognized the
cryptocurrency Bitcoin as legal tender in the country, the first in
the world, after a vote in its Congress approved draft legislation
on 8 June with support from 62 of 84 deputies. The move has
attracted widespread interest elsewhere in Latin America but is
likely to trigger strong international concern over the adoption of
an unregulated cryptocurrency without anti-money-laundering (AML)
controls, with the possibility that El Salvador could face
penalties from the United States and elsewhere if it proceeds with
Bitcoin use as planned.
Bitcoin Law leaves details open to interpretation by the
government.
The law states that Bitcoin will become legal tender alongside
the US dollar in El Salvador that entities must accept as a means
of payment for goods and services. Only those who do not have
access to the technologies required to process transactions are
exempt from its use (which the government proposes to rectify over
time by training programs), although who is included under this
definition is not established in the law. The bill permits all
existing obligations previously contracted in the USD to be paid in
Bitcoin going forward (after a 90-day period) and states that the
state will accept tax payments in the cryptocurrency. IHS Markit
sources indicate that the law's lack of detail creates space for
government interpretation over its use, including permitting the
government to pay public-sector salaries and suppliers with
Bitcoins, with this potentially extending to payment obligations on
treasury bills and certificates (LETES, CETES). The US dollar will
remain the reference currency for accounting purposes in the
dollarized economy, with a variable exchange rate between the USD
and Bitcoin to be set by the market. Transactions converting
Bitcoin to USD will be handled by the Development Bank of El
Salvador (BANDESAL). There are no current indicators that El
Salvador plans to abandon its current use of the USD as its primary
national currency, and we assess that this is unlikely to change in
the short term, not least given the time needed to implement the
new measure and obtain popular traction for Bitcoin, as measured by
the number and size of transactions.
The law's passage threatens to worsen El Salvador's
fiscal position and provoke US and other international
penalties.
El Salvador's strained public finances are a key risk, with a
debt-to-GDP ratio over 90% in 2021 necessitating multilateral
financing. The country is currently in negotiations with the
International Monetary Fund (IMF) for the approval of a
USD1.3-billion Extended Fund Facilities (EFF) agreement. Already
compromised by ongoing political issues, the passage of the Bitcoin
Law is likely to slow IMF negotiations further. Ahead of its
emergency meeting with Salvadoran President Nayib Bukele, the IMF
warned on 10 June that the move presents significant macroeconomic,
financial, and legal issues: such open criticism suggests that it
is less likely to offer support while the bill remains in place. El
Salvador's approach to cryptocurrency transactions is also contrary
to recently announced Bank for International Settlements (BIS)
guidelines, which seek to apply the maximum possible capital
charges to global bank exposures to unregulated cryptocurrencies.
It is also contrary to the posture of the Financial Stability Board
and other major national regulators globally that promote the use
of cryptocurrency only within regulated frameworks and linked to
regulated currencies while warning of the risks of theft and money
laundering related to unregulated instruments such as Bitcoin. The
US is also likely to react negatively to the Bitcoin Law, with US
Treasury Secretary Janet Yellen highlighting the importance of AML
regulatory controls to cover cryptocurrencies during her January
2021 nomination hearings. A particular problem is the potential use
of Bitcoin for criminal purposes, such as remitting the proceeds of
drug and human trafficking, with the proposals in El Salvador
seemingly permitting Bitcoin to be exchanged freely for US dollars
within the country. This raises the probability that the
international Financial Action Task Force (FATF), which supervises
and sets sanctions for AML/CFT deficiencies, will respond to the
potential exposure created by El Salvador's Bitcoin adoption with
penalties hindering external correspondent bank transactions with
the country. This would include the Caribbean FATF, in which El
Salvador currently participates. US pushback could lead to it
taking blocking action against IMF and other multilateral loan
approvals, or even implementing sanctions similar to its response
to Nicaragua if unable to negotiate the withdrawal of the
legislation within 2021.
Even if the law comes into force in September, the
domestic adoption of Bitcoin is likely to be slow owing to the lack
of technology infrastructure and regulatory
capacities.
Under the law, the Central Reserve Bank (BCR) and the Financial
System Superintendence (SSF) have 90 days (to 8 September) to draw
up relevant regulations. A primary concern over a two-currency
system will be the fluctuation of the exchange rates between the
two currencies, and its impact on direct and indirect currency
risks within El Salvador's financial system. The least risky, but
most onerous option, would be to require El Salvador's banks to
maintain Bitcoin-indexed capital reserves equal to or above the
value of their exposure to Bitcoin-denominated assets in keeping
with the BIS's proposed capital treatment for bank exposures to
unregulated mechanisms. A high-risk regulatory stance setting
Bitcoin-indexed reserves below the proposed international norm
would increase direct financial-sector exposure to Bitcoin's high
volatility, with the risk that if its value declines, unmatched
assets would be worth less than liabilities, threatening
financial-sector solvency. If regulations are developed on a
streamlined schedule, as appears likely, this would increase the
probability of loopholes and regulatory gaps, exacerbating
associated macroeconomic and crime risks. El Salvador also lacks
the domestic human resources and technical expertise needed to
implement this precedent-setting project. This means that it will
rely on outsourcing to international experts and startups such as
electronic wallet provider Strike to develop its infrastructure,
retaining limited oversight. Bitcoin mining facilities are planned
at the state-owned LaGeo geothermal energy plant. Bukele has
justified Bitcoin's adoption as providing financial benefits for
remittance-receiving Salvadorans who pay high fees for
international money transfers. However, many lack the knowledge or
advanced-model mobile phone technology to process cryptocurrency
transactions, indicating that uptake and growth in Bitcoin
penetration rates among this sector of the population will take
several years (as in El Salvador's surfer hotspot El Zonte where
cryptocurrency has been adopted for everyday use with electronic
wallet "Bitcoin Beach" and with instant conversion to the USD via
automatic tellers).
Bitcoin adoption increases AML and corruption risks,
increasing security costs for companies.
Transnational criminal organizations are likely to profit from
weakened financial transaction oversight to move and convert
currencies through El Salvador, with Mexican cartels and Colombian
narco-traffickers among over 300 criminal groups reported by US and
European enforcement agencies in June 2021 to be using
cryptocurrencies. Former Salvadoran BCR president Oscar Cabrera
warned on 9 June that the adoption of Bitcoin has increased the
country's attractiveness as a tax haven, particularly since Article
5 exempts Bitcoin from capital gains taxes and exchange rate
commissions, risking El Salvador's introduction to the list of
non-cooperative tax jurisdictions. The difficulty of Bitcoin
traceability also increases the risk of wider, increased corruption
within government institutions. Business-related costs to adapt to
El Salvador's new operating environment include security upgrades
to IT infrastructure and the potential need for firms to develop
and implement internationally compliant AML transactions
(monitoring and reporting mechanisms to the extent that domestic
government oversight capacities fall short of international
requirements). For the 70% of the population receiving remittances,
the majority of whom connect to the internet via mobile phones on
open Wi-Fi networks, exposure to digital theft and extortion by
criminals is also likely to rise. As a result, telecommunications
and internet service providers face knock-on demands for security
investment upgrades.
