Bitcoin is now legal tender, so what does this mean?

It has been quite a rollercoaster-ride in Bitcoin country again this year. After prices languished a bit after the collapse of the 2017 hype, Bitcoin has suddenly started soaring to new heights, even breaching the USD 60.000 mark before falling back to about half of that. While at first Bitcoin prices seemed to still depend somewhat on economics of supply and demand, as well as any market anxieties caused by exchange hacks and posturing by the Chinese government, prices now seem to be set mainly by Elon Musk’s tweets. And given that those tweets are generally not a prime example of mental stability, the yo-yo effect is back in full swing.

Adding fuel to the fire is the President of El Salvador, Nayib Bukele, who came up with the idea of adopting Bitcoin as legal tender. And then actually did it too. This accords Bitcoin the same legal status as that other legal tender of El Salvador, the US dollar – the country gave up on its own national currency in 2001. Citizens may now pay anywhere using Bitcoin, businesses will be obliged to accept Bitcoin, and even taxes may be paid in Bitcoin.

In this blogpost we will have a brief look at the reasoning behind this rather historic move and what it will mean in practice.

1. Why would you do this?

El Salvador has a number of issues with the traditional financial system. Around 70% of the population is reported to not have access to bank accounts, making it a nation with a lot of so-called underbanked citizens. Additionally, the country relies heavily on remittances from citizens working abroad, sending about USD 4 billion back home every year. Given that international remittances are still a costly affair, this leaves a lot of that money sticking to the hands of financial intermediaries.

A peer-to-peer cryptocurrency that can be made available to anyone with just a smartphone and Internet connection and which does not rely on intermediaries could then indeed sound like a reasonable alternative. After all, Bitcoin was years ago touted as the perfect solution for the underbanked. So, what happened in the meantime? Reality.

• First, Bitcoin can only process about 5 transactions per second. This makes the system completely unsuitable for mass-adoption as a means of payment. Just imagine a busy pre-COVID high street full of people doing last-minute Christmas shopping. Even well-established payment systems that can process thousands of transactions per second are put under severe stress by such a situation; Bitcoin would not even know where to begin.
• Second, Bitcoin miners have for some time now been imposing de facto transaction fees. If you want your Bitcoin transaction to be confirmed in a somewhat reasonable timeframe, you will have to pay the fee. And just like the price of Bitcoin itself, transaction fees can fluctuate quite a bit. Just this year, transaction fees have averaged between USD 4 and USD 62 per transaction. This already makes Bitcoin quite unsuitable for smaller transactions – since you would pay a higher fee than the value of the transaction – and may even make traditional financial intermediaries a cheaper solution.
• Third, as already mentioned, Bitcoin prices are quite volatile. A currency generally needs to fulfil the function of being a store of value. This means that it needs to retain its purchasing power somewhat reliably. This is of course a problem when having such wild fluctuations as Bitcoin.

There are solutions to some of these issues – such as the Lightning Network that acts as a second layer on top of Bitcoin – but these often come with issues of their own and are not all widely adopted. As a result, there is little evidence to indicate that Bitcoin is really actively being used as a means of payment. When prices go up, people are only incentivized to hold on to their cryptocurrencies, rather than spending them. Most Bitcoin transactions seem to be speculative, used to buy other cryptocurrencies, or to buy NFTs – at least before that market crashed as well. There are of course a number of cases – such as a pilot project in El Salvador and the rising use of Bitcoin in Africa amidst national currency deflation, next to other e-payment solutions such as M-Pesa – but certainly no widespread adoption.

And what about mining, which makes Bitcoin such a large energy consumer? The country will use its volcanoes to harvest geothermal energy that will power mining operations. While harnessing a volcano’s energy to power magic Internet-money would have sounded absolutely bonkers about 15 years ago, it now actually seems like one of the more realistic and feasible aspects of the plan.

2. How will they do this?

You would apparently be dead wrong to expect that adopting a cryptocurrency as legal tender requires a pretty substantial legal framework and thorough analysis to back this up. The law adopted in El Salvador is extremely brief and can be summarized as follows:

• Bitcoin becomes legal tender for all debts public and private, including taxes. No capital gains taxes are due on Bitcoin transactions. Everyone must accept Bitcoin as a means of payment, unless they can indicate not having access to the technology needed for this.
• The price of Bitcoin depends on the market, as is the case now.
• The USD remains the reference currency for accounting purposes.
• The State will offer automatic and instant convertibility to USD, if desired. The Banco de Desarrollo de El Salvador will create a trust for this. As a result, the government will essentially take on the fluctuation risk for those that do not want to do that themselves.
• The Government will promote a free and optional Bitcoin wallet, which will adopt Lightning.

There you have it, implementing a cryptocurrency as legal tender in an even more succinct way than a European Central Bank (ECB) press release.

3. What does this mean in practice?

It remains to be seen what this will mean in practice for El Salvadorans. The inclusion of Lightning may make Bitcoin more attractive for quicker and cheaper transactions, provided that the general population has the necessary ‘technological literacy’ to adopt the system – something the Government will promote. The main risk will be the value fluctuation, which the Government will take upon itself. In terms of monetary policy, El Salvador already has 20 years of experience depending on a currency that is not controlled by its own institutions. However, given that this lack of control – and aversion against the US Federal Reserve’s monetary policy – is cited as one of the reasons for adopting Bitcoin, it may be questioned whether adopting a currency that is beyond anyone’s control is the right solution. But even if this experiment fails, it is quite a monumental step for Bitcoin.

4. Will this have repercussions for the EU?

In any case not for the status of Bitcoin under e-money rules. E-money is not legal tender in the EU, and Bitcoin was already not considered as e-money. Bitcoin’s new status as legal tender does not change this situation.

There may be a possible concern for the anti-money laundering framework. The AMLD5 defines ‘virtual currencies’ as “a digital representation of value that is not issued or guaranteed by a central bank or a public authority, is not necessarily attached to a legally established currency and does not possess a legal status of currency or money, but is accepted by natural or legal persons as a means of exchange and which can be transferred, stored and traded electronically”.

Bitcoin did initially fulfil all elements of this definition and could therefore be considered as a virtual currency. However, it does now possess the legal status of currency in at least one country. The question is then whether that disqualifies Bitcoin as a virtual currency under this framework. The use of ‘and’ – as underlined here – could be taken to mean that all of these elements need to be satisfied, and that if one element is not, the qualification as virtual currency fails. After all, if the satisfaction of just one element would suffice for the qualification as virtual currency to hold, simple logics dictate that the connector ‘or’ should have been used. Moreover, the definition does not state that it only considers what is legal tender in the EU. As a result, it could be argued hat Bitcoin now no longer qualifies as a virtual currency under this legal framework.

Theoretically, that would mean that Bitcoin exchanges and custodian wallet providers no longer fall under the scope of the EU’s anti-money laundering framework. In practice, however, there are two caveats: (1) most, if not all, exchanges and wallets cover other cryptocurrencies as well and would thus continue to fall under the scope of the framework because of that; (2) regulators have been trying to get cryptocurrencies under the anti-money laundering framework for a while now are unlikely to let go that easily. It therefore seems unlikely that this would change much in practice.

It does, however, point out an important regulatory issue: it may be problematic to let the application of a legal framework depend too much on factors that are completely beyond the EU’s control – such as the designation of a cryptocurrency as legal tender. The reference to legal tender was, for instance, not present in the European Commission’s initial proposal for the AMLD5 but was only added later during the Council discussions. This was a reaction to the ECB’s desire to make a clearer distinction between virtual currencies and fiat currencies but may now prove to be an issue – albeit likely in theory only. It would be wise to take this into consideration for future legislative initiatives in this field.

Do you have questions about bitcoin as a legal tender or about other aspects of fintech? Please contact Timelex.