A sovereign nation’s decision to adopt Bitcoin as legal tender raises interesting questions — and legal ramifications.

By Elena Romanova, Larry Safran, Yvette D. Valdez, Eric S. Volkman, Stephen P. Wink, Adam Bruce Fovent, and Deric Behar

On June 8, 2021, El Salvador’s Legislative Assembly voted to establish Bitcoin as unrestricted legal tender, making El Salvador the first sovereign nation to formally adopt the cryptocurrency. Bitcoin will assume the status as legal tender alongside the US dollar, not as a replacement for it. The US dollar has been the sole legal tender of El Salvador since December 2000, and will remain the country’s reference currency for accounting purposes.

The Bitcoin law, which will come into effect 90 days from its publication in the Official Gazette, holds that the state is obligated to promote financial inclusion and well-being for its citizenry. To that end, the state will promote the necessary training and infrastructure to its citizens to be able to transact in the new legal tender.

Among the benefits to the citizens of El Salvador are the ability to express prices in Bitcoin, transact on a day-to-day basis in Bitcoin, and pay taxes in Bitcoin (and presumably in satoshis, or fractions of a bitcoin). Transactions in Bitcoin will be exempt from capital gains tax. Salvadorans would also benefit from the ability of relatives and friends living oversees to conduct remittances in Bitcoin, sidestepping the costly transaction fees associated with cross-border US dollar remittance. And monetary obligations predating the law that are expressed in US dollars will be now benefit from the option to be settled in Bitcoin.

Global Reactions Are Sharply Divided

As expected, the crypto community cheered the announcement. The move by a sovereign nation to adopt Bitcoin as legal tender is seen as a validation of some of the digital currency’s key features: Bitcoin is globally transmissible, cryptographically secure, and tamper-resistant. Additionally, with a hard cap of 21 million bitcoin, the digital currency is not subject to inflationary pressure or debasement.

Critics hostile to Bitcoin cast aspersions on the announcement. Some reiterated that Bitcoin has not proved to be a valid means of payment, and that the Legislative Assembly’s decision to pass the bill on a countrywide scale without pilot testing or technical analysis was reckless. Others denigrated Bitcoin as a volatile and speculative asset, and stated that the decision was fraught with macroeconomic, financial, and legal ramifications.

Taking Stock of the Legal Ramifications

El Salvador’s Bitcoin law raises some interesting legal issues.

UCC

One notable consideration is how Bitcoin should now be treated under the US’s Uniform Commercial Code (UCC). El Salvador’s new law could mean that Bitcoin qualifies as “money” under UCC 1-201(a)(24), which provides that:

(24) “Money” means a medium of exchange currently authorized or adopted by a domestic or foreign government.

Under Article 9-312(b)(3) of the UCC, the sole method of perfection of a security interest in money (other than as proceeds) is possession. Of course, physical possession of the type contemplated by the UCC is not possible for an intangible digital asset such as Bitcoin. Thus, if bitcoin were classified as “money” under the UCC,” perfection of a security interest therein would be impossible unless the bitcoin involved were converted to a different classification under Article 9 of the UCC.

In such a scenario, the only way to perfect a security interest in bitcoin under current law would be to have it credited to a securities account and have the securities intermediary agree to treat it as a “financial asset” pursuant to UCC 8-102(a)(9)(iii), thus converting the bitcoin from “money” to a “financial asset.” To date, this has been very difficult to achieve in practice.

Another consideration is the transfer of money. UCC 9-332(a) states that “a transferee of money takes the money free of a security interest unless the transferee acts in collusion with the debtor in violating the rights of the secured party.” Establishing such collusion has proved to be a tough threshold for any secured party to meet. If the UCC classified Bitcoin as “money,” secured parties would want to lock up the bitcoin in a way that prevents transfer without consent of the secured party to avoid collusion.

It could be argued (and some have) that the courts should not treat Bitcoin as money given the absurdity of the result. Those who argue that Bitcoin should not be treated as money point out that not only does this render perfection of a security interest therein impossible (absent a conversion to a “financial asset”) but that it leads to unintended results under other Articles of the UCC.[1] Nevertheless, the plain language of the UCC would seem to compel that result.

The UCC’s permanent editorial board has been working on a new Article 12 to address digital assets (the Article will include “control” type provisions), and will propose amendments to the definition of “money” in Article 1. However, it will likely be a year or more until the new Article 12 is promulgated and probably a year or two after that until US states begin to enact the new provisions.

Finally, other cryptocurrencies (such as Ether) will likely remain general intangibles under current law, but if a country were to adopt any such cryptocurrency as legal tender, the same issues would apply.

CFTC

In terms of other potential consequences from a US legal perspective, El Salvador’s Bitcoin law in no way detracts from the now well-established proposition, both as a matter of judicial decisions and Commodity Futures Trading Commission (CFTC) enforcement actions, that Bitcoin constitutes a “commodity” for purposes of the Commodity Exchange Act (CEA). Whether El Salvador’s Bitcoin law could have other implications under CEA and CFTC regulations remains to be seen. For example, because the term “foreign currency” is not clearly defined in the CEA, some could argue that Salvadoran Bitcoin transactions may implicate Part 5 of the CFTC regulations, which governs retail foreign currency transactions. (To date, the CFTC has regulated Bitcoin and other virtual currencies as “exempt commodities,” a category that also includes gold.)

FATF

Some critics claim that El Salvador’s Bitcoin law will primarily benefit organized crime in Central America, aiding in sanctions evasion and money laundering efforts. The Financial Action Task Force (FATF) has assessed that Salvadoran law meets international standards on anti-money laundering and combating the financing of terrorism, but some commenters have suggested that the new law could cause the FATF to reevaluate that determination unless El Salvador introduces controls designed to comply with the FATF’s guidance on virtual currencies.

IRS

El Salvador’s Bitcoin law is not expected to affect the Internal Revenue Service’s (IRS’s) determination that Bitcoin is treated as “property” (rather than “foreign currency”) for US federal tax purposes per Notice 2014-21 and Revenue Ruling 2019-24. In particular, the definition of foreign currency that the IRS provides in Notice 2014-21 suggests that currency must be issued by a country, rather than merely accepted as legal tender there, in order to qualify as foreign currency for US tax purposes. El Salvador’s decision to accept Bitcoin as legal tender therefore likely will not change Bitcoin’s status for US tax purposes under that definition.

Bitcoin Forced Onto the Balance Sheet?

What about US-based multinationals with branches or franchises located in El Salvador? If the Bitcoin law requires all businesses to accept Bitcoin, does a US company now have to make room on its balance sheet for the digital currency? Not necessarily. According to El Salvador’s President, Nayib Bukele, vendors receiving Bitcoin payments will have the option to convert the bitcoin into US dollars through a government exchange before transferring earnings to their bank account. Furthermore, if the market price of Bitcoin fluctuates from the time of sale to the time of conversion, the exchange will apparently reference the Bitcoin price at the time of sale, thereby stabilizing volatility risk. According to President Bukele, merchants and service providers must accept Bitcoin, but they do not have to bear the risk: “they will translate that risk to the government.”

What’s Next?

In the wake of El Salvador’s announcement, government representatives in other countries in Central and South America have already hinted at the possibility of adopting Bitcoin as legal tender. The Central American Bank for Economic Integration has promised El Salvador technical assistance and support for integration, risk assessment, and regulatory issues. Support from the World Bank, however, is not expected. It has been reported that the World Bank rejected El Salvador’s request for technical assistance with implementing Bitcoin as legal tender due to Bitcoin’s “environmental and transparency shortcomings.” Concerns about the Bitcoin market’s transparency and potential susceptibility to manipulation are also preventing the Securities and Exchange Commission (SEC) from approving a Bitcoin exchange-traded fund (ETF), although Canada and Brazil have already done so.

Meanwhile, El Salvador is ratcheting up its efforts to attract blockchain and digital asset entrepreneurs to drive innovation, develop the industry, increase employment opportunities, and contribute to the country’s GDP. Given the potential advantages, El Salvador may not be the last sovereign nation to adopt Bitcoin as legal tender.

Endnotes

[1] See, e.g., UCC 3-104 and 4A-103.