Explained | How does El Salvador plan to use Bitcoin as legal tender?

What is the rationale for using Bitcoin? How is El Salvador mitigating the risks?

The story so far: On June 9, El Salvador became the first sovereign nation to make a cryptocurrency legal tender. The law pushed by its 39-year-old President, Nayib Bukele, passed with 62 out of 84 votes. It mandates that Bitcoin should now be accepted as a valid payment by all establishments, except those that do not have the technical wherewithal to do so. This puts the digital currency that does not answer to any government monetary policies on the same footing as the country’s primary currency, the United States dollar.

Why is the U.S. dollar the currency in El Salvador?

El Salvador fully ‘dollarised’ its economy in 2001. Countries adopt the U.S. dollar as their official currency for several reasons, such as when their local currencies fail (for example, Zimbabwe, which saw inflation in multimillion percentages), or to take advantage of the stability that it offers and attract investments. One of the downsides is that the economies of ‘dollarised’ countries get linked to the monetary policies of the Federal Reserve in Washington. The U.S. central bank could set rates that may benefit the U.S. economy but end up hurting economies that use the same currency.

What is the rationale for using Bitcoin?

The Bill that Mr. Bukele proposed said that “Central banks are increasingly taking actions that may cause harm to the economic stability of El Salvador” and that Bitcoin was being adopted “in order to mitigate the negative impact from central banks”. The country’s economy is also heavily reliant on remittances from El Salvadoreans working abroad. According to World Bank data, remittances made up almost $6 billion in 2019, which was about 20% of the country’s GDP — one of the highest ratios in the world. By enabling the transfer of money via Bitcoins, Mr. Bukele says El Salvadoreans will save on transaction fees of banks and agencies.

Politically, the current government in El Salvador and the Joe Biden administration in the United States are at odds. Recently, some of President Bukele’s right-hand men found mention in a U.S. State Department list of corrupt officials in central America. The United States’s international aid agency is also moving money away from the Bukele government after it voted to remove all members of the Supreme Court.

How does Bitcoin work?

Bitcoin is the first and biggest of decentralised cryptocurrencies, which are online payment systems that are increasingly becoming mainstream. Etherium, Tether, and Binance Coin are some of the many others that have emerged after Bitcoin. Cryptocurrencies are built on the back of blockchain technology, a system of distributed, cryptographically-secured account keeping. In this system, the users keep a tab on every digital ‘coin’ and transaction rather than a banking system with a governing body at its centre.

Why are governments wary?

Due to their core nature that shuns centralised control, governments globally have been wary of cryptocurrencies. A report from the U.S. Library of Congress notes that most countries have warned their citizens against investing in cryptocurrencies, let alone allowing transactions in them. Some have tried to use the technology to create government-sanctioned digital currencies. China, a hub of cryptocurrency activity, has issued a digital Yuan on blockchain while it cracks down on other cryptocurrencies. The Bank of England has also proposed a digital Sterling.

However, many countries, including India, have allowed the treatment of cryptocurrencies as commodities, resulting in a rising tide of investment in them. After its introduction in 2009, Bitcoin saw its biggest gain in value last year, having started 2020 at $7,200 per coin and touching $65,000 in April of 2021, before falling to $30,000 in May.

Cryptocurrencies as commodities are highly volatile, a recent example being the massive swings in the values of Bitcoin and Dogecoin, based merely on the tweets of cryptocurrency ‘evangelist’ Elon Musk.

Another problem is the increasing energy use associated with cryptocurrencies. The ‘mining’ of Bitcoin, where individuals or companies set up powerful systems to support the blockchain network, for which they are rewarded in the currency, consumes “about the same amount of energy annually as the Netherlands did in 2019”, says a Reuters report citing data from the University of Cambridge and the International Energy Agency. “Bitcoin production is estimated to generate between 22 and 22.9 million metric tonnes of carbon dioxide emissions a year, or between the levels produced by Jordan and Sri Lanka,” says the report.

How is El Salvador mitigating the risks?

According to Mr. Bukele, the government will protect citizens from the volatility of Bitcoin prices by guaranteeing quick convertibility to dollars. If a shopkeeper does not want to hold the Bitcoin which they now have to accept from customers, the government will purchase it through a $150-million trust created at the country’s development bank.

As for the carbon footprint, Mr. Bukele says he has asked the State-owned geothermal electric company, LaGeo, to connect renewable energy from the country’s volcanoes to bitcoin mining facilities.

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