Banco Central de Reserva, the central bank of El Salvador, released a draft of proposed regulations related to interactions between the banking sector and the Bitcoin ecosystem this week, ahead of its planned launch of Bitcoin as legal tender. The hotly anticipated shift in the legal tender status of Bitcoin in El Salvador is slated to take place on September 7th, and will represent the first time that a non-government issued virtual asset will be designated by a country as a means of payment acceptable for all public and private debts.

El Salvador’s guidance is broken into two pieces. The first directly addresses the legal status of Bitcoin, and implements the legislation passed earlier this year, which seeks to redefine bitcoin as a legal tender monetary instrument within the country. The second piece discusses the technical and operational aspects of implementing the proposed regulatory transformation of Bitcoin, from being strictly a virtual asset to being a full-fledged currency-equivalent. While the central bank’s initial guidance speaks to the major outstanding issues related to policy implementation, there will likely be rounds of follow up guidance, following ongoing input from the business community.

The focus placed by this guidance on the traditional financial sector evidences the fact that partnerships between financial institutions and blockchain stakeholders will be vital. The government must ensure that customers are provided with both the user experience and controls framework that they are used to engaging with, while still leveraging the technological benefits of Bitcoin. Financial institutions will be required to apply to the central bank for permission to maintain Bitcoin custodial services or to offer wallet products. The regulatory regime is expected to heavily scrutinize the compliance operations of these firms, as proper program implementation will be pivotal to ensuring the overall success of virtual currency adoption by the public.

Though the El Salvadoran regulatory regime is taking a generally progressive and crypto-friendly approach, there are some key differences in the requirements applied for financial institutions dealing with Bitcoin as opposed to fiat currency. Noteworthy among these differences is the requirement that all Bitcoin funds held by a financial institution must be fully backed; fractional banking processes may not be leveraged.

The many positive developments for the El Salvadoran economy are tempered, however, by international uncertainty related to the long term viability of Bitcoin, given its penchant for volatility. Notably, Fitch Ratings has indicated that there will likely be negative credit rating implications for El Salvadoran firms, as the volatility risk of Bitcoin is materially higher than that of a traditional fiat currency. As Bitcoin becomes more mainstream and institutional adoption progresses, there is hope that this volatility will subside and the incremental risk noted by ratings agencies will be adequately mitigated.

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