The implications of El Salvador legalising Bitcoin

As part of our ongoing community competition in which we invited our Totem Warriors to predict which country would be best to adopt Bitcoin as legal tender, we wanted to provide a deep dive into the subject, to better inform our community about some of the implications of this decision, and to give a rundown of information required to make a more accurate prediction.

Last month, El Salvador’s President Nayib Bukele announced he was proposing bill that recognizes Bitcoin as “legal tender.” If enacted, El Salvador will become the first sovereign nation to formally recognize Bitcoin as its national currency, alongside the United States Dollar.

The longer term implications of this legislation are, obviously, very difficult to forecast at this point in time, but there are a few items that should be a part of this conversation. Once the excitement around this news settles down the reality of implementing this idea will come to the forefront. From a big picture perspective the issue is not a technological one; the technology works just fine. The main issues will be those connected to mindset and financial policy.

In short, Bitcoin being legal tender in El Salvador means that any business in the Central American nation has to accept it as a payment by law. El Salvador’s president Nayib Bukele clarified that they would go through a transitional period and help merchants accept Bitcoin payments in areas with unstable internet or lack of electronic devices.

El Salvador making this move isn’t as significant as it would be for most nations, because it is one of about a dozen countries — most of them micro-states such as Andorra and Nauru — without its own currency (or a common currency such as the Euro).

El Salvador abandoned its own currency in 2001 and adopted the US dollar as its legal tender. This process of “official dollarisation” was seen as a reform that would curb inflation and increase trade with the US (by far its major trading partner).

So El Salvador has less to lose than other nations in adopting a second currency as legal tender. There is no controversy about losing sovereignty and monetary policy autonomy. There will be no loss of “seignorage” — the profit made on issuing currency that’s worth a lot more than the cost of making it.

Why did El Salvador do this?

Remittances account for roughly 20% of the nation’s gross domestic product, and mostly come from Salvadorans working in the U.S. Bukele says that a large chunk of this gets lost in transfer fees, which Bitcoin can help to reduce. El Salvador is a so-called dollarized economy, which means that the fiscal and monetary decisions of the U.S. government and Federal Reserve have a tremendous impact. Adopting Bitcoin could give the nation more independence.

Bukele said that El Salvador could become a hub for Bitcoin mining, the process of verifying transactions in exchange for new coins. Bukele said in one tweet that if only 1% of outstanding value of Bitcoin ended up in El Salvador, then it would boost the nation’s gross domestic product by 25%, though he hasn’t spelled out clearly the mechanism through which it might boost GDP.

The Risks

Having two legal tenders will complicate matters — particularly when one of those currencies is subject to wild swings in its value.

Consider the provision in the new law that “all obligations in money expressed in USD, existing before the effective date of this law, may be paid in bitcoin”.

Even that is complicated. How, and by whom, will the amount of bitcoins necessary to pay a debt be determined? Will it be based on the Bitcoin price at the time the debt was incurred, or when the debt falls due?

The difference of even a few days could be significant.

If the expectation is the price of Bitcoin is going to rise, why would you want to buy things with it? Why not wait? If the expectation is the price is going to fall, why would you want to accept it? For most transactions, using US dollars will still make the most sense.

What’s Next?

As more global economies continue to feel the economic effects of the Covid-19 Crisis, governments will increasingly be looking around for new sources of funding. Digital money, but specifically cryptoassets, do increasingly look assured to form the foundation of the 21st century financial system. As the market develops and matures, however, it remains to be seen just which specific cryptoasset will rise to the leadership position.

If some market participants thought that interest and investment in crypto had plateaued after a flurry of activity earlier in the year, this recent news shows the folly of trying to perfectly time such a fast moving market. Bitcoin, after all, is decentralized, and not answerable to any central plan or authority.

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