Bitcoin Could Increase Regulatory, AML Risks for El Salvador Banks

By Fitch Ratings

New York/San Salvador-25 June 2021: El Salvador’s recent legislation establishing bitcoin as a legal tender would increase financial institutions’ regulatory, financial and operational risks, including the potential of violating international anti-money laundering (AML) and terrorist financing standards, Fitch Ratings says. Regulators have yet to announce detailed implementation guidance, however, the high level of bitcoin price volatility will challenge its use as a store of value and means of payment.

The recently passed bill will make bitcoin a legal tender along with the USD on Sept. 7, 2021, if the recent appeal of unconstitutionality does not modify its implementation. During this ambitious timeframe, the country must create the regulatory framework pertaining to bitcoin, and finalize payment platforms and systems for the conversion of bitcoin to USD.

All businesses must accept bitcoin as legal tender unless they do not have access to the technology needed to process the transactions. The actual rate of acceptance may be muted given the implementation challenges, as well as the country’s low levels of financial inclusion and internet access.

All existing obligations in the country may be payable in either bitcoin or USD, including bank loans. Capital gains will not be taxed and taxes can be paid in bitcoin, which could attract foreign inflows of bitcoin to the country. This may increase the risks that proceeds from illicit activities pass through the Salvadorean financial system.

Bitcoin’s lack of transparency could increase the risk of money laundering if regulations do not fully comply with Financial Action Task 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.

The ratings of El Salvador’s largest banks are support driven. Fitch believes foreign parent banks would provide operational and technical support to manage the risks associated with the implementation of bitcoin as all operations are consolidated at the parent level. However, the impact of reputational and regulatory risks will be incorporated in Fitch's assessment of parent support propensity once the scope of the new regulation is defined.

El Salvador has yet to meet Basel II or Basel III standards (with no capital requirements for market or operational risk) or IFRS accounting standards, which increases the likelihood of an inadequate accounting and/or risk-management framework. 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. The lack of adequate regulations to manage banks’ balance sheet exposure would be a credit negative based on a recent Basel prudential consultation. This would effectively fully deduct open positions from banks’ regulatory capital.

Customer deposits have remained stable for banks amid recent political tensions, the 2020 economic contraction and the 2017 sovereign restricted default. Ongoing discussions with the IMF, which stated that the use of bitcoin as a legal tender faces macroeconomic, financial and legal issues, could weigh on investor confidence. The World Bank also rejected El Salvador’s request for help in implementing bitcoin, citing concerns over transparency and the environmental impact of Bitcoin mining.

A rushed implementation of the new alternative payment system platform will affect financial institutions’ management framework for operational, cyber/ransomware, currency and liquidity risks, with additional implications for banks' underwriting standards. How the platform will operate and the extent of the government's involvement are not yet clear. Although the government has stated that will it provide a mechanism for the immediate conversion of bitcoin to USD and will create a USD150 million trust managed by a state-owned bank, it remains unclear as to how this will work in practice.