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Can Cryptocurrencies Actually Be Legal Tender?

When the blueprint for Bitcoin was unveiled in 2008, the goal was to create a new form of electronic cash that bypassed traditional financial institutions. Since then, the original cryptocurrency and its descendants have primarily become investments rather than practical forms of payment. But now a handful of experiments are trying to bring the technology back to its roots by making it legal tender.

Legal tender refers to forms of money the law says must be accepted in payment of a debt. Most countries only designate their domestic currencies this way, though some adopt foreign currencies either exclusively or alongside their own. Last year, however, El Salvador became the first country to adopt a cryptocurrency as legal tender. The country had already adopted the US dollar as its main currency in 2001, but following new legislation Bitcoin joined it on September 7.

This has sparked similar efforts elsewhere, with the Central African Republic becoming the second country to make Bitcoin legal tender in April. Meanwhile, proposals to do the same at the regional level in the US and elsewhere. But this new push to legitimize cryptocurrencies as a form of payment is raising questions about how well-suited they are to the role.

“A good legal tender is something that is reliable,’” says Thomas Dimpfl, a professor of economics at the University of Hohenheim in Germany. “The biggest risk is that it [Bitcoin] is just so volatile.”

“My goal was to put it on the government’s radar and get them to start thinking about how to legislate in this space.”
—Ian Calderon, California State Assembly

While the value of all currencies vary over time, cryptocurrencies often fluctuate wildly, as demonstrated by the recent crypto crash that has seen the value of Bitcoin more than halve since last November’s highs. This makes using them as a true currency difficult, says Dimpfl, because unless you receive all payments in Bitcoin and can pay all bills in Bitcoin, at some point you need to convert it into traditional fiat currencies.

This exposes both everyday users and businesses to significant exchange rate risks, he adds. It’s also proven a significant problem for El Salvador’s government. As part of its effort to popularize the new currency, it has spent $104m buying Bitcoin, according to Reuters. But following the recent crash, the value of the heavily indebted nation’s holdings is just $67.9m.

Nonetheless, advocates for adopting cryptocurrencies as legal tender believe the dangers can be mitigated and the benefits could be substantial. The Swiss city of Lugano recently announced plans to accept Bitcoin, Tether (a stablecoin pegged to the value of the US dollar) and LVGA (a Swiss Franc-based stablecoin launched by the city in 2020) as “de facto” legal tender.

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While only the Swiss federal government can designate something as legal tender, the city will allow all payments to the authorities to be made in the three cryptocurrencies by October and is encouraging local businesses to accept them too. “Eventually you will, in practice, be able to live most of your experiences in Lugano in those three cryptocurrencies,” says Pietro Poretti, director of the city’s economic development division.

The city is currently negotiating with service providers, but the final solution will include the ability to instantly convert any cryptocurrency into Swiss Francs. This is partly because the local government is not legally permitted to hold cryptocurrencies on it books, says Poretti, but also due to feedback from local businesses who highlighted it as a priority.

That begs the question, why take payments in cryptocurrencies in the first place? But Poretti sees multiple benefits. For a start, the city is trying to establish itself as a center of excellence for blockchain development, and it’s hard to do that without supporting the technology’s main application. But beyond that it could give the local economy a boost by pulling in crypto enthusiasts, he says, and give the city a crucial head start in what he thinks is likely to be an important technology in the future. “It certainly doesn’t do any harm being equipped for what is coming, to be ahead of the curve rather than catching up,” he says.

Bitcoin is certainly free of the manipulation of central banks. But, says Thomas Dimpfl of the University of Hohenheim, it wound up only transferring that right “to traders and speculators to manipulate the price.”

Lugano isn’t the only place keen to get ahead of the curve. Last year, Texas ratified a bill recognizing the legal status of “virtual currencies” and lawmakers in both California and Arizona have tabled “legal tender” bills this year. Only the federal government has the right to designate legal tender, so the Arizona bill is doomed to fail—while the California bill ultimately settled for the less ambitious goal of affirming the legality of accepting cryptocurrencies as payment.

But that could still be significant, says Ian Calderon, a former majority leader for the Democrats in the California State Assembly who helped lead the effort. While there is nothing in the law preventing businesses or local governments from accepting payment in cryptocurrencies, he says legal ambiguity is suppressing adoption. The bill was designed to provide the confidence for people to experiment with the technology, which Calderon believes could play an important role in boosting financial inclusion thanks to its lower fees compared to traditional banking.

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The bill, which is unlikely to be debated this year, was also designed to force politicians to engage with the need to regulate the sector. “Historically California has always been the cradle of technology and we’ve always had the ability to impact tech policy,” he says. “My goal was to put it on the government’s radar and get them to start thinking about how to legislate in this space.”

But the case of El Salvador suggests that even with considerable government support, cryptocurrencies may struggle to establish themselves as viable cash replacements. Despite offering all residents $30 of worth of Bitcoin for downloading the government-backed Chivo wallet, a paper published by economists at the National Bureau of Economic Research, found that only 20 percent continued to use it once they’d spent the bonus. The leading reason for not using Bitcoin was a lack of understanding, but a lack of trust in the currency and its volatility also ranked highly.

Trust is an important ingredient for an effective currency, says Drimpfl. People trust the dollar because it is backed by the economy of the US—and because they know that the Federal Reserve can intervene if needed to keep prices stable. This is done by manipulating the supply of money through interest rate adjustments or buying government bonds.

To a certain extent, increased adoption of cryptocurrencies as a medium of payment could help reduce their volatility by boosting the size of the crypto economy, says Dimpfl. But supply is typically governed by mathematical protocols that set out rules for how new coins can be minted.

That is a deliberate choice, because advocates of cryptocurrencies claim the manipulation of money supply by central banks creates economic bubbles and financial crises. But it also takes away a vital lever to react to changing global circumstances, says Dimpfl, and the evidence suggests it hasn’t reduced spikes and crashes. “They left it to traders and speculators to manipulate the price,” he adds.

Stablecoins, whose value is pegged to a traditional fiat currency, offer a potential workaround to these problems, says Drimpfl. But the recent collapse in value of the dollar-based Terra and wobbles in the price of other prominent coins suggest this is far from guaranteed.

Source: Spectrum

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