For crypto enthusiasts, El Salvador’s bitcoin-backed "volcano" bond is extremely exciting. Tokenizing a billion dollar sovereign bond on the blockchain would be a first. So would sidestepping traditional financial institutions to issue debt by using a crypto exchange and taking half the proceeds to buy bitcoin (BTC) and using the rest to fund infrastructure and bitcoin mining powered by geothermal energy. Unfortunately for bitcoiners, the bond has major red flags.
Frank Muci is a fellow at LSE’s School of Public Policy. His research interests include economic growth policy and public financial management.
For context, El Salvador’s government postponed the sale set for last week citing market conditions related to Ukraine and the price of bitcoin. But the country’s finance minister explained that the issuance is ready and President Nayib Bukele tweeted March 23 that the sale will happen once a local pension reform is approved.
So what are the concerns?
1. Unsuitable issuer
Finance Minister Alejandro Zelaya confirmed that a small state-owned energy company, LaGeo, will issue the bond, not the Republic of El Salvador. This may sound like a trivial distinction, but it is not.
With a 6.5% coupon, the billion-dollar bond will generate $65 million in annual interest expenses, but according to LaGeo’s financial statements, the company only booked $136 million in revenue last year and $36 million in profits. As a result, the added interest payments will make the company very unprofitable. Plus, LaGeo already has $205 million in long-term debt, so the bond would sextuple its leverage. This last-minute change makes little economic sense.
Finance Minister Zelaya recently implied that LaGeo’s bond would be backed by the full faith and credit of El Salvador, but a sovereign guarantee is not real until it is codified in a legally binding debt contract, which raises the next concern.
2. Limited information and legal protections
El Salvador’s government has not circulated a prospectus for the bitcoin bond. Those are usually 100-plus page legal documents that disclose financial information, warn of risk factors and indicate terms and conditions. In fact, authorities have not even published a whitepaper or website with the formula for the bitcoin dividend, plans to safeguard the $500 million bitcoin purchase or for that matter, any other basic facts. At this point, potential buyers are running on information from photographs of an outdated PowerPoint slide describing the bond from last November.
In addition, it appears the bond is set to be governed by local law in El Salvador, not by New York law like all of the country’s other bonds. If so, that means that any future disputes must be resolved in El Salvador’s court system, which has a weaker rule of law than the United States. Just last May, El Salvador’s congress voted to dismiss five judges from the Supreme Court and hastily replaced them in less than two months.
In any case, the new legal framework that is meant to govern the new tokenized bond has not been presented to El Salvador’s Congress or approved, so potential buyers don’t know what kinds of laws will govern the instrument.
None of this matters if El Salvador’s government is willing and able to repay the debt until it matures in 2032. But a lot can happen in ten years, so if either willingness to pay or ability to pay changes over the next decade, investors will be stuck holding a bond with questionable legal status in a jurisdiction that may not treat them fairly. This is very relevant given the next point.
3. Unsustainable finances
El Salvador’s long-term bonds are currently trading for just a tad over 50 cents on the dollar because traditional financial markets expect that the country will stop repaying its debt soon, perhaps as early as next January when a large $800 million bond is due. Typically, countries in financial distress try to stave off economic crises by taking often drastic steps to regain fiscal sustainability, usually through some combination of spending cuts, tax increases and other structural reforms.
However, this does not appear to be the current plan in El Salvador, which raises the prospect of insolvency and a debt crisis. If El Salvador is widely expected to stop repaying debts in the next two to three years, it does not make sense for the country to issue yet more debt unless its government has charted a clear path to financial sustainability. That doesn’t seem to be the case right now.
4. Links with Bitfinex/Tether
In addition, the bond will be issued on Bitfinex, a crypto exchange that is banned in the United States and has been repeatedly fined by regulators. Bitfinex and its holding company iFinex have close ties to the Tether stablecoin through common shareholders and management. Tether also has a long record of run-ins with regulators, especially because of the opacity surrounding the U.S. dollar reserves backing its tokens.
Given these facts, it seems that partnering with another major crypto exchange, such as FTX or Coinbase, and using another stablecoin like USDC would broaden the universe of potential investors to include Americans and ease investor concerns about the questionable track record of bond’s sponsors.
Success breeds success
For crypto to compete with traditional finance and break into the sovereign bond market, the first debt issuance by a nation-state on the blockchain needs to succeed. If the volcano bond fails, it will be ridiculed and make it difficult, if not impossible, for other countries to attempt something similar.
But what we’ve seen in El Salvador is one red flag after another. A last-minute change of the issuer from the national government to a small, little-known energy company. A worrying lack of legal documentation and basic information. No plans to curb the budget deficit and avoid a likely sovereign debt default. And partnerships with eyebrow-raising organizations. That’s why the bitcoin community should pass on the volcano bond until a better opportunity comes around.
Clarification (Mar. 25, 2022 22:08 UTC): Other El Salvador long bonds have different coupon yields besides the one featured here, which has a 9.5% coupon.