El Salvador's crypto foray offers a cautionary tale for other countries

It will be fascinating to see how this experiment plays out in practice and central bankers everywhere will be able to gauge what difficulties arise in practice if bitcoin is used for a high volume of micro-transactions.

The tiny Central American nation of El Salvador has embarked on an interesting experiment by recognising bitcoin as legal tender.

This is proving painful for many of its citizens but it’s a useful “pilot” project for larger economies that are contemplating the peculiarities of this new asset class.

El Salvador has a population of 6.5 million and GDP of about $27 billion.

At a nominal per capita of less than $4,200, it is not a rich country.

In 2001, it “dollarised”, which is a traditional Latin remedy for high inflation.

It replaced its currency, then the colon, with the USD.

This month, at the urging of its President, Nayib Bukele, who is a crypto-enthusiast, it adopted bitcoin as legal tender as well.

This means it now has two parallel legal currencies, USD and bitcoin.

It created a government wallet for bitcoin, called Chivo.

Every citizen was given a grant of $30 worth of bitcoin, which they could download from Chivo to their wallets to encourage adoption.

Some 200 new ATMs are being installed to enable dollars to be converted into bitcoin.

The new law means every business must accept bitcoin as legal tender for goods or services, unless it is unable to provide the technology needed to process the transaction.

The adoption has led to turmoil in the cryptocurrency market and doesn’t seem to have been well-received in El Salvador itself.

The value of bitcoin crashed by 19 per cent on September 7, the first day of adoption.

Chivo was o­verwhelmed by users trying to register.

There have been riots and demonstrations against the new currency.

Most citizens don’t want to accept the crypto in normal transactions.

They are understandably wary of holding an asset, which often swings 10 per cent in value on an average day and 25-30 per cent on “swing sessions”.

The spread on the interest El Salvador pays on its national debt over US treasury rates has widened.

Rating agencies downgraded El Salvador once the bitcoin plan was announced in July.

The logic for adopting bitcoin, according to Bukele, is that it could help to give unbanked residents better access to financial services.

Crucially, it may also lower transaction costs for small cross-border remittances, which constitute 20 per cent of El Salvador’s GDP.

Some 2 million citizens live abroad (mostly in North America) and remit $4 billion-plus annually.

The government estimates bitcoin remittances could save the country $400 million a year in transaction fees.

Independent estimates suggest that this would be closer to somewhere between $150-200 million.

All these estimates have big error factors given bitcoin’s levels of volatility.

Bitcoins are created by solving complicated mathematical puzzles (“mining” in crypto jargon) and verifying transactions made in the currency on an open electronic ledger called the blockchain.

While this is, in theory, something anybody could do, it needs huge amounts of power to run the specialised servers used in practice for this task.

Bitcoin mining consumes more power than Belgium on a daily basis.

So this is not environmentally friendly.

That’s one of the reasons China has offered for cracking down on cryptocurrency.

However, various bitcoin mining consortiums are trying to set up operations using renewables or geothermal power, which could make mining greener.

Another issue is that the money supply increases at a fixed rate, and every transaction recorded on the blockchain involves a unique bitcoin.

This makes it hard to carry out normal lending operations.

Fractional reserve banking is difficult, except by converting every transaction to a fiat currency before lending, and converting back when servicing the loan.

This means accepting massive risks on the exchange rate.

This process will be doubly tricky in El Salvador, which relies on the US Federal Reserve for money supply changes on its “other” currency.

The Fed is very unlikely to tinker with its monetary policy for the sake of the tiny Central American republic.

On the flip side, we will get a sense of how crypto works as it’s used in normal daily transactions.

McDonald's, local groceries, taxi services, etc., have started accepting bitcoin in El Salvador, and it’s estimated that around 10 per cent of daily transactions by value are now being done in bitcoin.

It’s not a problem doing tiny transactions because every bitcoin can be split into one hundred million equal, unique pieces of code (each called a Satoshi, after the mysterious creator of the algorithm).

But it can take a long time for any transaction to be registered and verified on the blockchain since this must be confirmed by multiple blockchain-watchers.

One of the barriers to adoption is lack of understanding and another is lack of technology.

In a local survey, less than 5 per cent of Salvadoreans claimed to understand how bitcoin works, and 68 per cent were against adoption.

Transactions are hard without a smartphone, and smartphone penetration is less than 40 per cent.

Local businesses are citing this as a reason for avoiding bitcoin adoption.

It will be fascinating to see how this experiment plays out in practice and central bankers everywhere will be able to gauge what difficulties arise in practice if bitcoin is used for a high volume of micro-transactions.