The Lightning-Fast Bitcoinization of El Salvador

The Lightning-Fast Bitcoinization of El Salvador

World’s First Crypto Tender Law Leaves Confusion
bitcoinization of el salvador
President Nayib Bukele made the announcement during a conference in Miami on June 5, 2021. (Bitcoin Magazine)

The Lightning-Fast Bitcoinization of El Salvador

710 350 Paz Gómez

As he had announced during a crypto conference in Miami, President Nayib Bukele has made bitcoin legal tender in El Salvador, a tiny nation in Central America with a dollarized economy since 2001.

Minutes past midnight on June 9, just five hours after he’d sent the bill to the unicameral Legislative Assembly controlled by his New Ideas party, 62 out of 84 lawmakers voted for the initiative. The Finance Committee rubber-stamped the bill without hearing any outside experts.

The Bitcoin Act will come into force in September, and the government has 90 days to flesh out exactly how Salvadorans will start using bitcoin in daily transactions. In the meantime, Bukele is enticing foreign entrepreneurs with residency-for-bitcoin offers and volcano crypto-mining.

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What does the bitcoin tender law entail for Salvadoran individuals and businesses?

The law clearly states its goal is to turn bitcoin into an accepted currency to settle any outstanding debt or spot transaction, including tax contributions. While they will continue using dollars for accounting purposes, businesses and individuals will not be able to refuse bitcoin payments. The law makes an exception for those who “evidently” do not have the means; although it does not provide specifics, at minimum bitcoin transactions require a smartphone and internet connection.

The potentially exempted population is large. El Salvador has the second-worst internet connectivity in Latin America, according to a 2020 study conducted by Microsoft and the Inter-American Development Bank. Further, the majority of Salvadorans do not understand how bitcoin works and how to use it. Many had never heard of bitcoin before the president decided to make it legal tender alongside the US dollar.

The law compels the government to provide citizens with the required technology and connectivity, as well as guidance on how to use bitcoin.

Unlike the rest of the world, where bitcoin is usually treated as property, El Salvador will not collect capital-gain taxes on the cryptocurrency. For those who do not wish to hold bitcoins and get exposed to price volatility, the government will enable a state-funded solution for custody and instant conversion to US dollars. The law states the exchange rate will be freely determined by the market.

To help draft the bill and facilitate special bitcoin wallets for the entire Salvadoran population, Bukele has hired Jack Mallers, founder of the digital payments platform Strike. Strike’s wallets are built on top of bitcoin’s Lightning Network, a patch to the original bitcoin software to enable faster and cheaper transactions. Using regular bitcoin wallets for daily payments of an entire nation is impractical and prohibitively expensive.

The government will create a $150 million trust fund worth of bitcoins managed by Bandesal, the country’s development bank, to ensure liquidity for the convertibility of bitcoins to US dollars through the state-backed wallets.

Bukele has claimed the fund will absorb bitcoin’s price volatility. In theory, businesses will get the US-dollar price tag of the service or product sold rather than bitcoin’s real-time market price.

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What are the opportunities and risks for the Salvadoran economy?

Opportunities

  • Bitcoin is a peer-to-peer electronic currency with a fixed supply of 21 million units. Just as dollarization has constrained monetary policy in El Salvador, the government has no control over bitcoin.
  • The unique law has placed El Salvador at the center of discussion within the crypto community. If the government establishes clear rules and ensures a friendly climate for fintech entrepreneurs, it could attract much-needed capital and jobs.
  • Over 70 percent of Salvadorans have no bank accounts; most transactions occur in the informal economy. Bitcoin could jumpstart financial inclusion and provide citizens with more economic opportunities.
  • Remittances from immigrants abroad represent 20 percent of the country’s GDP. Sending money to El Salvador could become cheaper if Bukele’s scheme subsidizes the bitcoin-to-fiat conversion fees.
  • Widespread adoption of bitcoin for payments in El Salvador could boost new business models. The gig economy, for example, could extend across the country.

Risks 

  • By forcing vendors, service providers, and companies to accept bitcoin, the government is exposing them to price-volatility risk. Even though the government has vowed to absorb losses through the trust fund, wallet-service interruptions or delays could undermine investor and business confidence.
  • Credit-rating agency Moody’s has warned El Salvador’s bitcoin law jeopardizes the country’s dollarized monetary regime and increases uncertainty. This could affect current loan negotiations worth $1 billion with the International Monetary Fund to cover widening fiscal deficits and could increase sovereign bond premiums.
  • Another risk, according to Moody’s, is the potential impact on the local banking system, because bitcoin wallets remove intermediaries. Banks would be limited to offering complementary services, not holding deposits.
  • The lack of knowledge about cryptocurrencies among the population could give rise to frauds and scams.
  • El Salvador could be blacklisted by financial watchdogs such as the Financial Action Task Force for money-laundering concerns.
  • Bitcoin price swings could easily deplete the trust fund, according to economist George Selgin, leading to taxpayer-funded bailouts.
  • US dollars in Strike wallets are actually denominated in Tether, a cryptocurrency that is pegged in a 1:1 ratio with the US dollar. Tether is coming under scrutiny of regulators for disputed reserves to maintain its peg.

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What is Bitcoin Beach and how does it differ from Bukele’s initiative?

A pilot project dubbed Bitcoin Beach emerged in 2019 in the coastal city of El Zonte. Using the Lightning Network, the privately run initiative powered small bitcoin payments and charity projects for some 500 families, but no conversion to US dollars.

The project has attracted tourists and enabled local merchants the alternative to save in bitcoins or withdraw cash through ATMs, which incur fees. Bukele has heralded Bitcoin Beach as a model for the rest of the nation.

However, Bitcoin Beach did not impose bitcoin on the population but rather provided incentives and tools for gradual adoption. Some merchants stopped accepting bitcoin payments because their old smartphones could no longer support the project’s app or due to spotty internet connectivity.

Unlike Bitcoin Beach, the Strike wallet will serve as a centralized bitcoin custodian app that opens the door to government intervention.

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Will the law spur investment or worldwide adoption?

The bitcoin law by itself does not provide additional benefits to foreigners. Bukele has promised to introduce an immigration bill to offer residence for those investing three bitcoins or more in the country. Nevertheless, foreigners will be able to visit El Salvador and use bitcoins to purchase land or other assets.

The regulatory framework that officials must present in the next 90 days can also establish incentives. Clear rules could attract foreign crypto and fintech businesses.

For Caitlin Long, former gubernatorial appointee to the Wyoming Blockchain Task Force, El Salvador’s law has far-reaching implications. It could be a backdoor to enabling US banks to handle bitcoin as foreign currency under commercial law and as cash under accounting rules.

El Salvador is also establishing a precedent for other countries. Peter St. Onge, a Mises Institute Associated Scholar, thinks adoption is feasible in dollarized economies such as Panama and Liberia, as well as countries with high inflation rates such as Argentina, Nigeria, and Turkey.

Those highly dependent on remittances such as India, Mexico, and other Central American countries could benefit from the trend, not to mention nations targeted with US sanctions, including Iran and Venezuela, which already issued its own cryptocurrency, the petro, in 2018.

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Paz Gómez

Paz Gómez is a market analyst for Econ Americas. She is cofounder and academic coordinator of Libre Razón, a liberal think tank in Quito, Ecuador. She holds a bachelor's degree in international relations and political science from San Francisco University of Quito and studies for a master's degree in digital currency and blockchain from the University of Nicosia. Follow @PazenLibertad.

All stories by:Paz Gómez

Paz Gómez

Paz Gómez is a market analyst for Econ Americas. She is cofounder and academic coordinator of Libre Razón, a liberal think tank in Quito, Ecuador. She holds a bachelor's degree in international relations and political science from San Francisco University of Quito and studies for a master's degree in digital currency and blockchain from the University of Nicosia. Follow @PazenLibertad.

All stories by:Paz Gómez
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