How El Salvador’s Bitcoin Experiment Got Off to a Rocky Start

(Bloomberg) -- Follow @crypto on Twitter for the latest news.

Ever since Bitcoin was launched as the world’s first cryptocurrency, its proponents have made big claims about its power to upend financial systems and change the very nature of money. But a simpler question has remained maddeningly unresolved -- can it work in the real world, for the mundane matters of buying and selling things and transferring money? El Salvador’s decision to make Bitcoin legal tender, a process that got off to a rocky start, may give an answer.

1. What did El Salvador do?

El Salvador’s 40-year-old president Nayib Bukele got congress to green light his plan to make the country the first to use Bitcoin as legal tender. According to the bill, Salvadorans can now pay taxes in Bitcoin, and “economic agents” will be obliged to accept the cryptocurrency as payment for goods and services. The U.S. dollar will continue to circulate alongside Bitcoin as the national currency in the Central American nation. The plan called for giving Bitcoin’s adoption an initial boost from the government’s cryptocurrency wallet Chivo, which comes pre-loaded with $30 worth of the currency for users who register with a Salvadoran national ID number

2. How would Bitcoin work as legal tender?

In theory, Bitcoin will create a parallel payments channel alongside the U.S. dollar. Prices may be quoted in the cryptocurrency, and exchanges using it will be exempt from capital gains tax. Bukele’s administration has installed 200 Bitcoin ATMs around the country that can be used to exchange the cryptocurrency for U.S. dollars. The Finance Ministry created a $150 million fund at state-run bank Banco de Desarrollo de la Republica de El Salvador, Bandesal, to back the transactions. Still, the dollar will remain the national currency for public accounting purposes and merchants who are technologically unable to receive the e-currency will be exempt from the law, the government has said.  

3. How did the kickoff go?

Twitter users reported being able to pay for services such as breakfast at McDonald’s with Bitcoin. But the cryptocurrency plunged as much as 17% to its lowest level in a month amid news that the government disconnected its Bitcoin wallet early on Tuesday to fix problems. It was reactivated later in the day and Bukele said his country had taken advantage of the crash to “buy the dip”, adding 150 coins to take its total holding to 550, worth about $26 million. 

4. What’s the thinking behind 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.

5. How else could it help?

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.

6. Could El Salvador do that?

Bitcoin mining, which involves complex calculations and vast amounts of computing power, has come under increasing criticism for its use of electricity and the pollution that causes. Bukele tweeted that: “I’ve just instructed the president of @LaGeoSV (our state-owned geothermal electric company), to put up a plan to offer facilities for #Bitcoin mining with very cheap, 100% clean, 100% renewable, 0 emissions energy from our volcanoes.” Whether that works out or not, the move is certainly in keeping with Bukele’s attempts to portray himself as a new kind of Latin American leader. He’s known, among other things, for communicating via tweets, surfing, and wearing baseball caps back-to-front. In the photograph on his his Twitter profile, for a time he even adopted the “laser eyes” motif popular among enthusiasts of cryptocurrencies.

7. Why is this such a novel experiment?

Bitcoin is used for some transactions in some places. For instance, it’s already used informally in parts of El Salvador, namely the beach town of El Zonte, which has two Bitcoin ATM machines and where more than 30 businesses already accept the cryptocurrency for payment. But its volatility -- its price swings -- make it unappealing for many businesses to use. Between mid-April and mid-July, it lost about half of its value. Many businesses don’t want to accept payment today in a currency that could be worth substantially less tomorrow, even if there’s a chance it could be worth more. Even in technology hubs such as Silicon Valley and Singapore, Bitcoin’s use as a medium of exchange is still insignificant. On the other hand, in El Salvador the government and the central bank are actively promoting its use, which may give its adoption a boost.

8. What other risks does this involve?

Cryptocurrencies have a long history of hacks, and Bitcoin can be “lost” by users who misplace the code that identifies them as the owner. Widespread adoption could also turn El Salvador into a tax haven -- or a haven for money laundering. And if it does lure Bitcoin “whales,” as large holders of the currency are known, into moving their coins to El Salvador, a repetition of the boom-and-bust price cycles Bitcoin has regularly experienced could have disastrous consequences for the $27 billion economy. The International Monetary Fund warned of the risks of using Bitcoin, which lost nearly half its value from April to May, and the World Bank declined a request from El Salvador’s government to help the government adopt it, citing environmental and transparency drawbacks.

9. What could this mean for the Bitcoin community?

In recent years, Bitcoin has drawn increasing interest from mainstream financial firms who see cryptocurrency as a potentially lucrative new field. But a basic question has remained unresolved: Is Bitcoin primarily a tool for conducting financial transactions, like the dollar and other traditional currencies? Or is it something worth buying because it’s a store of value that, like gold, is less directly tied to economic cycles than many other assets? What happens in this country of six million will be closely watched for clues to the answer to that question.

10. Are any other countries doing this?

Not really. Many central banks are developing their own digital currencies, but these are far removed from cryptocurrencies such as Bitcoin, whose owners value their independence from governments. The Bahamas Sand Dollar, for example, is simply an offshoot of the Bahamian dollar and trades one-to-one with it.

11. What might be prompting El Salvador to try this?

Its economy last year suffered its deepest crash in four decades while the fiscal deficit widened to more than 10% of GDP as tight lockdowns to contain Covid-19 hurt business. That’s left the government looking around for new sources of funding. The finance ministry is in talks with the International Monetary Fund for a $1.3 billion extended fund facility to help meet financing needs this year, but talks have stalled. The country remains dangerous. Bukele has credited his government’s security policies for bringing down killings, but the murder rate remains elevated at four times that of the U.S. And relations between Bukele and the U.S. have been strained by his mistreatment of prisoners, his party’s dismissal of constitutional court justices, and by a ruling by the top court that he can seek a second term.

The Reference Shelf

• Bloomberg QuickTakes with an overview of Bitcoin, a Bitcoin glossary and a comparison of Bitcoin and Ethereum.
• A Twitter thread from Frances Coppola, an economist, on El Salvador’s Bitcoin law.
• An Odd Lots column by Joe Weisenthal on the existential questions facing Bitcoin.
• A Bloomberg Businessweek article analyzing “get rich quick” trading fads like GameStop and Dogecoin.

©2021 Bloomberg L.P.