The month of June 2021 was an extremely eventful month for the cryptocurrency universe, with one positive development (from the standpoint of the industry) helping to offset two negative interventions from authorities, one in May and one in June.[1]
The positive development took place on 9 June, when the legislature of El Salvador, at the prompting of its 39-year-old President Nayib Bukele, passed a law declaring bitcoin “legal tender” in El Salvador. (The vague law, taking up two pages and only 16 articles, is expected to be fleshed out in regulations.) Panama and Paraguay also announced interest in expanding their crypto industries, although not to the extent of declaring legal tender status.
Later in the month, however, as one sign that regulators are beginning to push back against cryptocurrencies, the UK’s Financial Conduct Authority (FCA) on 26 June issued a consumer warning declaring that Binance Markets Limited, the unit of Binance Group that is authorized in the UK, is not permitted to undertake any regulated activity in the UK. The statement also reaffirmed that no other unit of the Binance Group holds any form of UK authorisation. This action by the UK authorities will seem to hasten a general retreat by the Binance Group, to date the world’s largest cryptocurrency exchange enterprise. The other negative development took place in May, when China’s vice premier Liu He announced in a speech on 21 May that Beijing intended to “crack down on bitcoin mining and trading behavior.”
This blog post looks at these positive and negative developments and analyses their likely impact on the cryptocurrency industry, which recognises that it has an image problem and is trying to rebrand itself as the “digital commodity money” sector. (There are currently around 8,000 cryptocurrencies in existence, but the sector is dominated by Bitcoin, Ethereum, Tether USD, Binance Coin and a handful of others.) The post dives into what it means for bitcoin to be declared “legal tender” in El Salvador and suggests that the poor Latin American nation may have overstretched the concept in an effort to bring investment and jobs into the country.
Narrow and expansive concept of “legal tender”
Across jurisdictions, legal tender is defined in different ways, narrowly and expansively. The narrow definition, as for example in a Bank of England KnowledgeBank document, is along the lines of “if you offer to fully pay off a debt to someone in legal tender, they can’t sue you for failing to repay.” This concept is narrow in the sense that it refers only to the repayment of debts, and is silent on other transactions (such as the buying and selling of goods and services) for which money might change hands. In the United States, a similar narrow definition applies. A Cornell University compendium of legal terms explains that “although the original creditor who is owed money is not necessarily obligated to accept the [legally] tendered payment, the specific act of tendering the payment absolves the debt.” The compendium goes on to say, however, that “…federal statutes do not require a seller to accept cash as a form of legal tender for payment of goods and services that were rendered” and that “…legal tender can only be used in regard to paying off debts.” In other words, it would be perfectly legal for a merchant to specify a certain form or forms of payment other than legal tender, or even to refuse a cash payment.
In a more expansive definition, expounded in an academic article by Helmut Siekmann focusing on the euro area, legal tender “is the formal qualification of an instrument of payment by an act of the competent sovereign which has to be accepted both by government entities and private persons to discharge monetary claims.” This kind of formulation seems to imply that banknotes and coins, which are legal tender throughout the euro area, must be accepted for any kind of payment.
However, whether they are formally stated in legislation or not, there should obviously be practical limitations on legal tender. Retailers have valid reasons for refusing cash payments. For example, the items sold, such as cars, can be so expensive that the retailer could face security risks or other difficulties in accepting cash for even the lowest-priced transaction. Or, the shop could be located in a remote area with no nearby bank where regular cash deposits could be made. Merchants should also have the right to refuse a large-denomination banknote disproportionate to the transaction amount. And then there is of course the increasing phenomenon of online sales (in the past, there were “mail-order” sales), where purchase takes place without any physical contact at all between buyer and seller.
It follows from the preceding discussion that legal tender status is usually given to means of payment that can easily be used, stored, transported, and transmitted. Usually the status is only granted to domestic banknotes and coins, although a few countries have declared certain foreign currencies to be legal tender. Montenegro and Kosovo, for example, have deemed the euro to be legal tender, and in extreme cases a foreign currency circulates, with or without legal tender status, far more in volume and value of transactions than does the local currency. In those cases, the economy is said to be “dollarised,” because the dominant currency is most often the US dollar. These concepts will be important when we look at the peculiar case of El Salvador.
Bitcoin as “legal tender” in El Salvador
The designation of bitcoin (or any other cryptocurrency) as legal tender in any jurisdiction, at present, is very problematic. The volatility of cryptocurrencies is well known, discouraging its acceptance by merchants, particularly for frequent, small transactions. The user is given only a short time to initiate payment due to this volatility, to minimise the risk to merchants. Sending cryptocurrency to the wrong address results in an unrecoverable loss to the user. With bitcoin in particular, there are high transfer fees, long processing delays and extreme price volatility, especially recently. Order confirmation delays are frustrating, and are caused by transactions bunching up in the so-called “memory pool,” where transactions are literally auctioned for the highest push-through fees.
The current difficulty of shopping with cryptocurrencies means, for now, the activity seems to be limited to a “niche” of individuals, mostly young men who work in the cryptocurrency sector, work for companies who accept cryptocurrency, and/or earn small, frequent sums as freelance programmers working on discrete tasks. A recent survey discovered that 30 per cent of so-called “crypto-shoppers” are also miners. And the range of products typically purchased with cryptocurrency is not very wide – “techie” items such as mobile top-ups, game credits, mobile apps and digital entertainment services make up the vast majority of such purchases.
Moreover, most shopping these days is done not by sending cryptocurrency directly to a merchant, but by the purchase (with cryptocurrency) of “gift cards” or vouchers denominated in fiat currency, which allow the merchants to receive payment in that fiat currency rather than having to bear exchange risk or undergo the possibly laborious process of either exchanging or spending the cryptocurrency. “Hybrid” payment systems also exist, such as debit cards funded by cryptocurrencies and credit cards backed by crypto assets. These hybrid systems ride the standard payment rails operated by Visa and MasterCard.
To assist both the customer and the merchant in overcoming some of the difficulties, many merchants offer a “Layer 2” solution to speed up the process and improve the so-called “user experience.” Lighting Network is the most popular. It sits on top of the blockchain, facilitating peer-to-peer payments and micropayments to merchants. Most frequent shoppers utilise only merchants supplying this solution.
Because of all of these limitations and workarounds, it seems that for the shoppers, the act itself of paying with cryptocurrency may provide utility and intrinsically enhance the shopping experience. Indeed, crypto-shoppers even seem willing to pay higher prices to compensate merchants for their trouble and risk-bearing. But will the general public accept these higher prices?
The question before us now is, how will these drawbacks play out in El Salvador, if the authorities follow through with their plans to implement an expansive concept of legal tender and require all enterprises, nonprofits such as hospitals and universities, and governmental units, including the tax administration, to accept bitcoin for payment?
President Bukele, it should be noted, is embracing bitcoin at all stages, from mining to exchanges to payments. He appears to believe that bitcoin will stimulate an economic transformation in his impoverished country, to the benefit of all Salvadorans. As for mining, Bukele has grand plans to invite miners – maybe even those leaving the soured environment in China – to set up operations in El Salvador, powering the energy-intensive activity with geothermal energy from the country’s more than 20 volcanoes. He has also announced than anyone investing three or more bitcoin in the country, without specifying how, will be granted permanent residency in El Salvador, and their bitcoin capital gains, if any, will not be taxed.
Perhaps the most radical plank in Bukele’s platform, however, is the notion that private enterprises and government entities will be required to accept bitcoin as payment if the customer offers it. This interpretation of legal tender is extreme and, at least as of this writing, doesn’t seem to allow for any exceptions. Would street vendors be required to accept bitcoin payments even for very small transactions? And would the average person be able to accurately sense the price of a product when it is stated in bitcoin beginning at the fourth decimal place?
As for the infrastructure for retail customers, an American company, Athena Bitcoin Global, has been tipped to install as many as 1,500 bitcoin ATMs in El Salvador, although progress has been slow. Potential investors seem to be excited about El Salvador. But will bitcoin catch on among the general population, even if it becomes easy to acquire?
One obstacle to expanded use is that only 45 per cent of the country’s population currently has internet access. Another possible factor discouraging bitcoin’s use in routine payments is if merchants begin adding a surcharge to the cost of goods bought with bitcoin, to offset the costs of transactions and higher risks. It will be instructive to observe whether the government actually permits these surcharges. If they don’t, merchants may find other ways to pass the costs onto the public. One Latin American economist predicted that bitcoin may well fail in El Salvador, as workers resent being paid in volatile bitcoin while industrialists continue to deal with each other using the US dollar, which became legal tender in 2001. To him, “the best case scenario for it is that no one uses it, and that everyone keeps using dollars apart from some narcos.”
The FCA’s actions against Binance Markets Limited
Generally, cryptocurrency exchanges are unloved by regulators. They usually lack a formal corporate structure, and if they do have one, it is often complicated, operating in many jurisdictions simultaneously. In the UK, registration with FCA is not required, and it’s been estimated that 90 per cent of those exchanges that initially sought registration, to enhance trust among the public, gave up in the face of the strict anti-money laundering regime. Binance Group has already left Canada, and may also leave Germany and the United States.
The FCA didn’t explain why it took the action to disallow Binance from conducting any regulated activity, but speculation is that Binance’s opaque structure (nobody is sure, but it is rumored to be headquartered in the Cayman Islands) and lax observance of AML/CFT regulations and best practices (when they are required to observe them at all) have soured regulators on the company. Indeed, the FCA had little influence over any of Binance’s activities, except for their involvement in selling crypto derivatives. Binance will also face hurdles in using the UK’s Faster Payments System in providing customers crypto trading services. However, UK customers can still legally access most of Binance Group services offered outside the UK, meaning that tackling the possible risks posed by cryptocurrency to financial stability, consumer well-being, and integrity of the financial sector must be a co-ordinated international effort.
China, crypto-miners and the shift to renewable energy
The unexpected statement against cryptocurrency mining by the Chinese vice premier set off a fire sale of equipment by Chinese miners, who constitute 65 per cent of those working on the bitcoin blockchain alone. Some seem to be moving to neighboring Kazakhstan, hauling mountains of heavy equipment across the border with them. Others are looking further afield, hoping to relocate their operations to the Americas or Europe. With key mining regions such as Sichuan and Inner Mongolia taking separate actions that could be perceived as negative towards the Bitcoin mining industry, the outlook for mining in China is far from reassuring to the cryptocurrency community. China may be taking these actions to polish its environmental credentials, since the electricity-devouring mining industry is largely dependent on coal-fired power plants (39 per cent of mining worldwide is already powered by renewable energy, primarily hydropower, but this is not the case in China).
The Bitcoin mining industry currently consumes enormous amounts of electricity, much of it produced by hydrocarbon-fired power plants. One recent estimate is that annual electricity consumption by the Bitcoin network is about 145 terawatt hours, which would make the network one of the top 30 consumers in the world if it were a country. However, the overall situation is changing for the better.
Increasingly, miners are turning to renewables, primarily in search of lower costs. Electricity produced with renewables is slowly but steadily falling in cost relative to hydrocarbon-generated power, and new mining operations are being set up in locations with underutilised electricity and plentiful renewables. Setting up in colder climates also reduces energy consumption, with less electricity required to cool the massive server rooms required. There is even an organisation, the Crypto Climate Accord, a partnership between Energy Web, Rocky Mountain Institute, and the Alliance for Innovative Regulation, whose goal is to shift the entire cryptocurrency industry 100 per cent to renewables by 2030.
Moreover, new techniques of mining also have lower energy costs. The “Layer 2” systems mentioned before can reduce energy consumption by batching large volumes of transactions and reaching down only occasionally into Layer 1 to verify their validity. So-called “proof of stake” (PoS) consensus mechanisms, which will soon be adopted on the Ethereum network, use considerably less electricity than the standard Bitcoin network “proof of work” (PoW) mechanisms.
Conclusion: the need for continued vigilance
Many cryptocurrency proponents are bullish on bitcoin and other cryptocurrencies, heartened by the fact that some investment banks, hedge funds and private equity funds are at least considering looking at it as a macro asset and an investible asset. Some of their claims seem presumptive, as a recent statement that “investors should be prepared for prices to overshoot fundamentals in both directions,” without specifying what these fundamentals for crypto really are. Indeed, they readily admit that a cryptocurrency is a creation of derived scarcity, claiming that it will be more “trusted” because of that.
Others are more pessimistic. Nouriel Roubini, a professor at New York University’s Stern School of Business (and who predicted the Great Financial Crisis) has pointed out concentration in both mining and ownership of crypto wealth, which could lead to oligopolistic behavior and market manipulation. He also reminds ebullient investors that cryptocurrencies have no alternative uses, unlike real commodities such as gold, oil, and copper, and acceptance and trust as a routine means of payment is still far off. And pro-cyclicality is also a concern to investors. At the onset of the COVID-19 shock, bitcoin declined in value by 50 per cent, far more than any financial assets.
These rapidly-developing and changing trends in opinion, technology and acceptance mean that regulators around the world must co-operate on common global standards for preserving financial stability, protecting consumers, and preventing money laundering, terrorist financing and financing the proliferation of weapons of mass destruction. Whether these efforts at co-operation result in a free-market approach, comprehensive regulations or total bans on these new products remains to be seen.
[1] This blog post uses the term “cryptocurrency” to denote a decentralised, bi-directional virtual currency scheme. A virtual currency, in turn, may be defined (as in the Uniform Law Commission’s Virtual Currency Business Act), as “a digital representation of value that (i) is used as a medium of exchange, unit of account, or store of value; and (ii) is not legal tender, whether or not denominated in legal tender.” This definition does not include merchant rewards that cannot be converted to cash, bank credit or other virtual currency. This definition also does not include e-money, which may be defined as monetary value stored in an electronic device that can be used to make payments, such as a stored-value card or value stored on the server of a mobile network operator and accessed via SMS.