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.

Posted 29 June 2021 by Alejandro DuranCarrete, Economist, Banking Risk, S&P Global Market Intelligence and

Brian Lawson, Senior Economic and Financial Consultant, Country Risk, S&P Global Market Intelligence and

Paula Diosquez-Rice, Associate Director, Economics, S&P Global Market Intelligence