The News: In an unprecedented move, the country of El Salvador has adopted the cryptocurrency Bitcoin as legal tender. For more on the news read the NY Times coverage here.
Bitcoin Becomes Legal Tender in El Salvador — and What This Means for FinTech
Analyst Take: Whether you are a Bitcoin maximalist, a skeptic, or somewhere in between (where I currently reside), you will certainly have heard of Bitcoin and no doubt the pros and cons. Wherever you are on the spectrum of adoption, today is a big milestone in the history of Bitcoin with the first nation state adopting the currency as legal tender. What does this mean, why should you care, and what does this mean for the overall landscape particularly relating to payments and remittances?
Fiat money is a currency established as money by regulation and is not redeemable against anything. To explain further, up until 1971, $35 USD was redeemable for one troy ounce of gold. Basically, you could go to the Federal Reserve and ask to have your dollar converted into gold at a fixed rate. Now admittedly, not very many people were doing this in reality, but at nation state level the countries that backed their currency with gold were ensuring that more currency was not printed arbitrarily, as the country would have to increase its gold reserves as a result. Since 1971, the U.S. Dollar has been backed by the U.S. Government and that alone.
For many countries in the developed world, the idea of a new form of legal tender is a somewhat alien concept. The US Dollar has been in circulation since April 2nd 1792, and the UK Pound even longer, dating back to 775AD, although not all currencies date back this far. Whether you believe the internet meme that the average age of global currencies is 27-years old (you shouldn’t and here is why) or not, new legal tender is not new. For instance, the Euro was only launched as recently as 1999 and the currency is used by 19 European nation states.
What Did El Salvador’s Government Do to Embrace Cryptocurrency?
El Salvador’s Millennial president Nayib Bukele recently ensured the country’s congress approved his plan to make the country the first to use Bitcoin as legal tender. According to the details in the bill, Salvadorans can now pay taxes in Bitcoin, and “economic agents,” basically anyone who accepts money for business purposes, will be obliged to accept the cryptocurrency as payment for goods and services. Bitcoin will create a parallel payments channel alongside the U.S. Dollar in the country. Prices will no doubt be quoted in bitcoin. The government is looking to incentivize bitcoin adoption by giving every citizen $30 in bitcoin in a state operated wallet. To support the system, El Salvador purchased 200 bitcoins over the weekend, making them also the first nation to purchase the cryptocurrency.
Why Is the Adoption of Bitcoin By El Salvador So Noteworthy?
According to numerous reports, remittances account for roughly 20 percent of the nation’s gross domestic product, and mostly comes from Salvadorans working in the U.S. President Bukele says that a large chunk of this gets lost in transfer fees, which typically run at five to nine percent of the money value transferred. The prevailing thinking is that if the same amount of money is transferred, but with zero fees, this will mean an inflow of between five to nine percent more money into the country as it will not be consumed by fees. While this is not proven and will take time to play out in reality, the logic is sound.
Up until now, every nation’s currency has been linked to either their own government or that of another government. For instance, up until today, El Salvador used the US Dollar as a medium of exchange and store of value. El Salvador is therefore a so-called dollarized economy, which means that the fiscal and monetary decisions of the U.S. government and Federal Reserve when it comes to topics such as monetary policy, inflation management and how much money is in circulation impact El Salvador.
The adoption today by El Salvador of Bitcoin as legal tender breaks the connection between money and the state. To go further, the issuance of the 21 million bitcoins that will ever be ‘minted’ is hard coded into the Bitcoin network, so therefore the monetary policy when it comes to issuance of the currency is known in advance by all participants.
El Salvador has taken the unprecedented step of unshackling its currency from central bank or government control. The US Dollar is still legal tender in El Salvador so it will be interesting to watch whether Bitcoin will become the long term store of value for the country with the dollar still being used as medium of exchange, or whether over time the country makes a full transition to bitcoin.
What Does This All Mean for Fintech?
So, what does this all mean for Fintech? Remittances are a $500-700 billion-dollar industry and represent a major source of wealth for emerging countries around the world. In addition, as much as 70 percent of the El Salvadoran population doesn’t have a bank account. The most fervent Bitcoin network supporters see the crypto currency as removing intermediaries and reducing the fees and costs of overseas remittances.
In a typical remittance payment, a customer in the originating country pays the local currency to a Money Transfer Operator (MTO). The recipient can then collect the money in the currency of the destination country, minus any fees charged by the MTO. MTOs operate through the network of a larger Remittance Software Provider (RSP), like Western Union or Moneygram. The MTO may only receive a fraction of the charges it takes from the customer, as the bulk is pocketed by the RSP.
This financial infrastructure is expensive to use, particularly for smaller remittances. The World Bank found that a remittance of $200 can incur average fees between five and nine percent, depending on the destination country and the type of service used. These services are expensive due to the cost of adhering to Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations, capital controls, or other restrictions. In addition, there is often a lack of transparency in the exchange rates, adding further invisible costs to the consumer.
Bitcoin was initially suggested as an attractive medium for international remittances because of the borderless nature of cryptocurrency. Since anyone can use the blockchain, there’s no need to send payments through a bank or RSP. However, Bitcoin has become less attractive for remittances due to the increasing cost of Bitcoin transactions. Some competing cryptocurrencies, such as Ripple Labs with XRP, are also focused on the remittance market with substantially lower fees.
Bitcoin, the network often referred to as a layer one solution, is the underlying blockchain enabler of bitcoin the asset. The Bitcoin network has many inherent features, including:
- Bitcoin is a global settlement network that operates 24x7x365
- Transactions are either unconfirmed or fully settled, meaning there is no credit and settlements are not delayed
- Participation in the networks does not require any identification
- The Bitcoin network code is fully open-source and permissionless
- Bitcoin has no single point of failure
- No country or entity has jurisdiction over Bitcoin
The existing payment or settlement networks like Visa, PayPal, Swift, Fedwire, are very different in the way they operate and could be considered as using the exact opposite approaches.
The Bitcoin Network is Not Enough
As attractive as it can be in some instances, the Bitcoin network alone is not enough. Transactions over the Bitcoin network can be slow to complete and costly, especially in times of high transaction demand. That’s why a payment layer operating as a layer 2 style solution, called the Lightning Network, is being actively developed on top of the Bitcoin network. The Lightning Network allows users to send bitcoin instantly and with almost zero cost. A payment within Lightning Network arrives within a second anywhere in the world, and transaction costs are minimal. Because many transactions can be packaged into a single block on the layer 1 blockchain, scalability is almost limitless. For a deeper dive on the Lightning Network, I encourage you to explore their site further.
The Bitcoin community sees the Bitcoin network, and more importantly, the Lightning network as an opportunity to disrupt the traditional payments networks and the providers of remittances and transfer services. One example of this is Strike. Strike is a payments application developed by Zap Solutions, Inc., that allows users to send and receive money around the world, at no cost. Strike is a mobile application that uses Bitcoin and blockchain to offer instant and free payments. Strike users can pay one another, buy goods and services, make micropayments, tip content creators, and also buy and sell Bitcoin. Strike is a prime example of a mobile application that looks to combine the legacy financial system with Bitcoin’s Lightning Network capabilities. The rationale for Strike using the Lightning network is that using bitcoin for daily transactions is problematic for two reasons. First, bitcoin is a store of value and bitcoiners often choose to hold bitcoin rather than transact with it. The second reason is the tax consequence: in many countries, including the U.S., a bitcoin transaction is a taxable event, as the currency is subject to capital gains tax.
The Strike solution to address both of these challenges is to leverage Lightning Network capabilities without exposing users to bitcoin the asset. Strike works as follows:
- User connects their traditional bank account to the Strike app
- User initiates a transaction of $10 from the US to Europe, where the recipient would like to receive €8.4
- Strike debits the $10 from the user’s bank account
- Strike converts the $10 to bitcoin on the Lightning Network
- Strike sends the bitcoin instantly via Lightning Network to its European branch
- Strike converts the bitcoin to €8.4
- Recipient’s account on Strike is debited €8.2
In the example above, neither the sender nor the recipient came into contact with bitcoin; rather they were using the Lightning Network built on top of the Bitcoin network to transfer and convert two fiat currencies. In this transaction, there is no foreign exchange (Forex) market involved. Instead, the dollars are first converted to bitcoin, and bitcoin is then converted to Euros. Given the liquidity of the USD/BTC and EUR/BTC currency pairs, the resulting rate doesn’t deviate from the Forex rate. Bitcoin markets operate 24x7x365, and bitcoin has ample liquidity across many currency pairs.
Now imagine you want to send US Dollars from your Strike account to El Salvador, the only steps required are steps 1 through 5. As bitcoin is legal tender in El Salvador and can be used directly to buy goods and services, steps 6 and 7 are not required.
Looking Ahead at the Cryptocurrency Market and Fintech
What’s ahead in the cryptocurrency market? It’s safe to say that even the most fervent Bitcoin maximalists don’t see bitcoin replacing the world’s top tier currencies anytime soon. The Dollar, Yuan, Euro, and Pound are safe for the foreseeable future. However, for emerging nations such as El Salvador, especially those where remittances are a drag on economic growth and despite the downside of the asset’s volatility, the case for bitcoin as legal tender is more obvious.
The emerging nations of the world and the IMF will be watching with interest how El Salvador’s experiment with adopting bitcoin as legal tender will play out. Given that we have four major world currencies and 195 nations, I predict it won’t be long before another nation follows El Salvador’s example. My money would be on either another Latin American nation or a Middle Eastern country looking to escape the confines of sanctions.
The fintech world is most certainly paying attention to this move by the El Salvadorian government, and there is no small significance here. Disruption of the fintech space as we know it is underway, and where there is money to be made, you can be sure the major players are already working on ways to capitalize. What this move means for decentralized finance (DeFi) and the payments and remittances space long term is tough to predict with certainty. As I mentioned, the crypto world is coming after the huge fees and resulting revenues in the money transfer business. Whether these nascent providers will usurp industry behemoths such as Visa, Mastercard, and Western Union is hard to predict, but disruption is ahead and the move by El Salvador to adopt bitcoin as legal tender is a significant inflection point in this journey.
Disclosure: Futurum Research is a research and advisory firm that engages or has engaged in research, analysis, and advisory services with many technology companies, including those mentioned in this article. The author does not hold any equity positions with any company mentioned in this article.