Death by Bitcoin. El Salvador edition

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Macro Afternoon

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On June 8, El Salvador approved in congress a law that granted bitcoin status as legal tender, which will be implemented on September 7, assuming as we do the Supreme Court of Justice rejects challenges to constitutionality. We provided a first assessment on the matter after the approval, but as focus shifts to its implementation there are more questions on the challenges it poses. We explore some of the potential issues, even though we recognize that regulation is still forthcoming and many aspects likely are still being deliberated. Broadly speaking we focus on whether Bitcoin could become widely adopted in El Salvador, on what could follow in such scenario, and also touch upon, briefly, on some of the systemic risks that could arise, as highlighted by some involved parties.

Could Bitcoin become widely used?

A key aspect to its implementation is just how widespread Bitcoin’s use can become in the country. Outside legal, regulatory, or macroeconomic risks, a starting point is the confidence people have in, and the efficiency seen in, adopting it. There are some early signposts that adoption could struggle, at least initially. A survey conducted by the eEl Salvador Chamber of Industry and Trade shows doubts among the population. Both businesses and consumers expressed they would prefer the usage of Bitcoin to be optional (over 90% in both cases), with many pointing to lack of understanding of Bitcoin and its volatility as key issues. Among the business sector, 51% would convert Bitcoins to USD after receiving the former in payment.Consumers showed large rejection to being paid (93%) or receiving remittances(82%) in Bitcoin. Over a third across both sectors distrust transacting in Bitcoin (Exhibit 1).

This skepticism likely relates in part to the many practical hurdles that stand in the way of integrating Bitcoin into everyday economic activity at scale.Individuals, merchants, service providers, and other businesses would need a means to send and receive Bitcoin, presumably a wallet or some other service provided by local financial institutions. Interoperability complicates returns and exchanges, which, in principle, expose businesses to unwanted FX risk. And there is the issue of settlement finality, which though one of the advantages of blockchain payment systems in some contexts could introduce logistical issues in retail transactions.

These concerns are complicated by the extreme levels of volatility in Bitcoin/fiat exchange rates. Despite increasing institutional sponsorship, BTC/USD has been realizing roughly ~75% annualized based on daily moves, almost the same as over a 5-year horizon. Looking across global currencies, including emerging and frontier markets,few come closer to that level of volatility over such a sustained period even at their most extreme (Exhibit 2). And, of course, bitcoin pairs can be considerably more volatile during periods of stress in cryptocurrency markets, approaching ~100%annualized over the same 1-year horizon at times over the past five years. This puts practical limits on the interoperability of bitcoin and fiat currencies, which poses a longer-run challenge to its adoption as a store of value and especially as a medium of exchange.Though these hurdles are considerably lower in the theoretical end state of large crypto-native economic activity, it remains a key challenge to incorporating bitcoin into a bimonetary system that is otherwise dollarized, as is being proposed in El Salvador.

From an efficiency perspective, President Bukele has highlighted, for example, that remittances (US$5.9 billion last year, or some 23% of GDP) would become easier and cheaper, but a study by Johns Hopkins University shows otherwise.The cost of transferring remittances in Bitcoin compared to that in USD is estimated to beat least nearly double, according to the study.In our view, the comparison overlooks a couple of factors. First, the fact that likely forthcoming infrastructure to ease its usage would reduce costs. Also, it is likely that a large share of the spread in costs stems from FX risks due to Bitcoin’s volatility. To this latter point, the government has emphasized since the initial announcement that while everyone would be forced to accept bitcoin, except when there are technology barriers, they will not be forced to hold it, and immediate convertibility to USD would be guaranteed through a specialized Trust ran by a state-owned bank (Bandesal), which the government will capitalize with a US$150 million trust for that matter. This would suppress FX risk, or, more precisely, transfer it from the private sector to the government, which could be problematic. In turn, this should in our view reduce some of the extra costs and likely increase usage (ironically use of Bitcoin would depend on trust in the government). Poor internet connectivity and access, and lack of financial penetration are also cited as hurdles to Bitcoin adoption.

What if Bitcoin becomes widely used?

The transfer of FX risk from the private sector to the public sector could become a bigger problem if bitcoin is adopted on a larger scale. At a retail level, leaving cash transactions aside, retail transactions amounted to roughly US$100billion last year (for an economy with a GDP of roughly US$26 billion), with about one third being electronic transfers (Exhibit 3).

Were bitcoin to equate the dollar in this segment, it would imply roughly US$135 million of daily Bitcoin settlements. As said, this does not consider Bitcoin replacing cash transactions, which ultimately could be an aim of adopting the cryptocurrency.Government sponsorship of a platform (Chivo) designed to ensure easy convertibility between BTC and USD presents no significant concerns if the flows are balance.However, if there is a directional bias (more likely BTC to USD than the other way around), it could cannibalize onshore dollar liquidity over time. Though BTC can in principle be exchanged back for USD offshore, the transaction costs associated with doing so (mining and brokerage fees) can be significant, particularly for the larger transactions associated with an institutional platforms like Chivo.One can easily imagine circumstances under which ensuring convertibility in this way could be become difficult to maintain without adverse consequences, including eventual fiscal and balance of payments risks. The actual extent to which this becomes problematic depends on a host of factors outside of the actual amount of convertibility needs. These include market conditions (volatility and liquidity of Bitcoin), which could limit the ability of Bandesal to unwind its positions, but also the policy choice of whether some of their positions are kept open or not.

There is also the question of whether the Bitcoin blockchain can plausibly handle a significant fraction of this payment activity. Though trading volumes commonly exceed $40-50bn per day, most of this activity is internalized by major exchanges. On-chain transactions, which represent the transfer of tokens between wallets, have averaged around $10bn daily in recent months. Of that total, not only does a very small fraction (~0.2% in June, less than illicit entities at 0.3% over the same period) represent economic activity in the sense bitcoins are transferred to merchant services provides, but that represents a substantial decrease relative to even a few months ago (Exhibit 4). Relatedly, a large fraction of Bitcoin are locked up in illiquid entities (liquidity sinks), with more than 90% notchanging hands in more than a year as well as a significant and rising fraction heldbywallets with light turnover (Exhibit 5). Though these aspects do not necessarily challenge the use of Bitcoin as a store of value, they are potentially a significant limitation on its potential as a medium of exchange.

A similar logic follows from a macro perspective, for example in external accounts. If El Salvador is successful in its aim to attract inflows of Bitcoin into the country, part of it could follow benefits from asymmetric fiscal regulation or possibly be related to activities with AML concerns, in which case dollar outflows could take place, also creating a mismatch. Assuming immediate, guaranteed convertibility holds, this would raise dollar needs for a country that is already struggling to meet its financing needs. After all, the dollar would still be used for public accounting purposes and remains the currency in which the country’s debt obligations are denominated—at least for some time to come.

Potential regulatory risks

Adding to these challenges, regulatory challenges will also arise for both the government and systemically important economic agents, such as the financial entities that outside of Bandesal (or facing Bandesal) would be providing the off-onramps into traditional FX. The risks to banks were recently highlighted by Fitch ratings, which pointed out that“Bitcoin’s lack of transparency could increase the risk of money laundering if regulations do not fully comply with Financial ActionTask Force (FATF) standards. Correspondent banks could require more detailed due diligence and checks on El Salvador’s financial institutions if regulations and controls are not robust enough to avoid tax evasion, money laundering and terrorist financing”, while also stressing that“financial institutions could face potential volatility in the USD value of their balance sheets if bitcoin assets/liabilities are not quickly converted to USD or if positions remain open…[and could] effectively fully deduct open positions from banks’ regulatory capital”. The problem is of particular relevance given the large presence of foreign banks in the country’s financial system; according to data from the financial regulator, foreign banks account for almost 80%of the banking sector’s US$20.7 billion AUM (Exhibit 6). Of these Colombian banks account for a predominate share.

IMF deal out on the limb

Over the past weeks, El Salvador’spotential deal with the IMF for financial support has come under the spotlight. To be sure, Finance Minister Zelaya has insisted in local media that “well advanced” talks for an EFF are continuing and remain the government’s priority. That said, we think actions in recent months spanning from the suppression of antic orruption bodies to replacement and appointment of new Supreme Court Justices had already seen as challenging in terms of governance and transparency, which we deem important to the deal. As the Fund’s spokesperson has explicitly recognized, the adoption of Bitcoin adds to the IMF’sconcerns, as it raises both regulatory and macroeconomic risks that in our read could lean against ElSalvador’s macro stability. The Fund as reiterated that these issues require “careful analysis. ”Furthermore,t he capitalization of Bandesal and US$30 bonus provided by government to individuals opening a wallet should add to fiscal pressures (potentiallyUS$150 million and US$75 million, respectively, and combined some 0.8% of GDP). We continue with a base-case that a deal will come through, but think it’s an increasingly close call and a final deal may take more time. Indeed, despite ongoing negotiations and the recent visit of US officials to El Salvador, we think progress may be slow in coming months, at least until Bitcoin implementation is seen through(Sep 7), and perhaps most likely months after that.

Houses and Holes

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