Estimated reading time: 17 minutes.
On June 5th at the Bitcoin 2021 Conference in Miami, the President of El Salvador, Nayib Bukele, announced to the world his intention to introduce a new law recognising Bitcoin, a cryptocurrency, as legal tender. A few days later on June 9th, the bill was passed into law by the Legislative Assembly of El Salvador. This law, referred to as The Bitcoin Law (or Ley Bitcoin in Spanish), has been the subject of widespread debate.
Some technologists and crypto-enthusiasts have praised The Bitcoin Law as a bold first step towards the adoption of a new global monetary regime centred on inclusivity, transparency, and freedom. In contrast, some pundits and politicians have decried the law as an ill-conceived experiment in monetary tomfoolery, which deprives the people of El Salvador of basic freedoms. Both arguments are worthy of careful consideration.
First, a brief history of “dollarization” in El Salvador
To make sense of President Bukele’s seemingly unusual embrace of Bitcoin, we must first develop a basic understanding El Salvador’s recent monetary history. Following a decade-long civil war, which ended in 1992, the government of El Salvador implemented a series of policies to bolster economic development, while attempting to control double-digit inflation. In 1994, this included pegging the domestic currency, the Salvadoran Colón, at a new fixed exchange rate of 8.755 colónes to 1 US dollar.
In 2001, the sitting President of El Salvador, Francisco Flores, passed the Monetary Integration Act which established the US dollar as an official legal tender, and signalled that the Salvadoran Colón would be gradually replaced by the dollar. By 2004 the Colón was no longer in circulation, with the US dollar becoming the de facto currency of El Salvador — this process is known as “dollarization”. The specific reasoning behind El Salvador’s transition from a fixed exchange rate to a dollarized economy is somewhat ambiguous. Prior to dollarization during the 1990s, El Salvador experienced consistent economic growth, and inflation remained somewhat stable at roughly 10% per year, well below Latin American peers, Ecuador, Brazil, Argentina, Bolivia, Nicaragua, and Peru. Some have argued that dollarization was likely driven by a fear of hyperinflation, following Brazil’s currency crisis in 1999, and Ecaudor’s crisis and official adoption of the US dollar in 2000.
Today, El Salvador and Panama are the only two countries, other than the Unites States, where the US dollar is the sole legal tender that freely circulates (Some include Ecuador on this list, however Ecuadorian Centavo coins still freely circulate as a secondary currency).
Dollarization has had important social and economic implications for the people of El Salvador, both positive and negative. First, dollarization has led to lower interest rates on loans for individuals, businesses, and government ministries by reducing currency devaluation risk (learn more). Second, it has lowered the transaction costs associated with investment and trade with the United States, El Salvador’s largest trading partner, because there is no longer any need to convert dollars into a local currency, once received (and vice versa).
However, the significant drawback of dollarization is that the people of El Salvador are left exposed to the whims of monetary policy decisions made by the United States Federal Reserve. As a result of relying upon the US dollar as the de facto currency, the Central Reserve Bank of El Salvador has limited ability to set interest rates and adjust the money supply. The consequences of this are most evident in the aftermath of the Coronavirus Pandemic: as of this writing, US Congress has passed three stimulus packages equating to $5 trillion, largely to assist American citizens and businesses, financed by the Federal Reserve purchasing Treasury Bills under a policy referred to as “quantitative easing” (in other words, the Department of the Treasury spends money and the Federal Reserve creates new money to fund that spending). In contrast, the government of El Salvador does not have the luxury of creating new US dollars to stimulate their domestic economy.
How does Bitcoin fit into the picture?
Select municipalities of El Salvador has been experimenting with bitcoin as an alternative currency for several years. For instance, in the small coastal village of El Zonte, local merchants have been accepting bitcoin as an alternative form of payment since mid 2019, and a relatively obscure app for bitcoin transactions, Galoy Money, has achieved widespread use (learn more).
So what is Bitcoin and why has it gained prominence in El Salvador? Bitcoin is an open protocol for money, governed by a decentralised peer-to-peer network that collectively uphold a set of rules that all actors must adhere to. This set of rules is used by network participants to determine the authenticity of transactions, and is known as Nakamoto Consensus. In contrast to the US Federal Reserve, the Bitcoin network operates independently of any individual nation. Indeed, Bitcoin is in itself a sovereign monetary network, more akin to gold than state-backed “fiat” currency.
Bitcoin can potentially solve a critical issue for the people of El Salvador: it’s too expensive for Salvadoran’s working abroad to send money home. According to the World Bank, Salvadoran’s working abroad send ~$6.5 billion home to El Salvador each year to family members and friends (these payments are called “remittances”), and this figure represents 24% of El Salvador’s economy. However, the fees charged by banks and other service providers that facilitate these transactions are incredibly expensive, ranging from 10%–15% of the principal amount for the small transfers typically sent home by working class migrants (learn more). As a result, the people of El Salvador are deprived of over $600M per year, due to the fees charged by remittance service providers.
The broader problem is financial exclusion across the developing world. To put things in perspective, in El Salvador 71% of the adult population do not have access to a bank account, and as a result, they cannot easily save money or apply for a loan in an emergency. Exclusion from the financial system is highly correlated with poverty, and 39% of Salvadoran’s live below the poverty line, earning less than $5.50 per day. Despite these factors, mobile phone penetration is incredibly high with 8.9 million mobile SIM connections for a population of 6.5 million individuals, and a unique subscriber penetration of 80% according to Deloitte. This combined with rising broadband connectivity (32% of Salvadorans have access to 3G or 4G mobile broadband) provides the backdrop for Bitcoin’s potential success as an alternative payment system. The legacy financial system is too inefficient to provide affordable banking services to low income households in developing countries. However, with an internet connection and a mobile phone, anyone can set up a “digital wallet” and begin transacting and saving using Bitcoin, no bank account required.
Remittances, Bitcoin, and the Lightning network
Bitcoin and a “second layer” protocol that interacts with the Bitcoin network, called the Lightning network, can potentially reduce the cost for Salvadoran’s remitting money home to near zero. The core idea behind the Lightning network is that a single Bitcoin transaction can be updated several times before it is broadcast to “nodes” in the Bitcoin network and subsequently incorporated into the blockchain, allowing for incredibly fast and cheap payments (learn more here and here). Using the Lightning network, transactions take less than 10 seconds and cost less than 10 satoshis (a satoshi is one-hundred-millionth of a bitcoin, or a fraction of one cent). You can watch a demo of Lightning at the beginning of this interview, with Lightning Labs CEO & Founder, Elizabeth Stark.
In writing this post, I couldn’t resist testing out the Lightning network myself. I sent 5 transactions between two lightning wallets using Wallet of Satoshi and BlueWallet. Transactions between the two wallets were near instantaneous, and the fee per transaction was less than one cent. It’s worth noting that Wallet of Satoshi charged an initial fee to conduct the “on-chain” transaction sending my bitcoin to my Lightning wallet held by Wallet of Satoshi, equal to 0.3% of funds sent (in addition to this, network fees paid to Bitcoin miners to include my transaction in the blockchain equated to $1.23). However this was a one-off payment for accessing the Lightning network node run by Wallet of Satoshi — a relatively small sum to pay for infinite instantaneous transactions between Lightning wallets at close to zero cost.
Here is where things become really interesting: in theory a consumer facing application, like Venmo or CashApp, could offer international transactions for any currency, anywhere in the world, at a fraction of the cost and time of the current system, by swapping the senders currency for bitcoin, sending that bitcoin internationally over the Lightning network and then swapping that bitcoin again for the desired local currency of the recipient on the other side of the trade. In this system, bitcoin becomes a highly liquid internet native reserve asset, and the Bitcoin and Lightning networks together form internet native payment rails (where the Bitcoin network is the base layer for final settlement, and the Lightning network is a complimentary second layer for everyday transactions).
This concept of internet native payment rails is fast becoming a reality. A consumer-facing payments app, Strike, is already partnering with the government of El Salvador to implement the system described above. Here is a blog post from Strike’s CEO, Jack Mallers, explaining how this system works in detail.
“The world now has an open network that offers real-time, cheap, global settlement and self-clearing to the world’s first natively digital asset class. We’ve put in the work to make this network interoperable with legacy fiat. The result ties everyone on the planet together, making any payment anywhere at any time as easy as sending a text.”
— Jack Mallers, Founder & CEO of Strike
So, what does El Salvador’s Bitcoin Law actually say?
Now, let’s dive into the specifics of El Salvador’s Bitcoin Law. You can read an English translation of the of the law itself here.
The law places Bitcoin on equal footing with the US Dollar, with Article 1 outlining an overarching purpose:
Article 1. The purpose of this law is to regulate bitcoin as unrestricted legal tender with liberating power, unlimited in any transaction, and to any title that public or private natural or legal persons require carrying out.
What is mentioned in the previous paragraph does not hinder the application of the Monetary Integration law.
The “Monetary Integration law” referred to above established the US dollar as an official legal tender in 2001. So there is no change to the role of the US dollar in El Salvador’s economy.
It’s also worth drawing attention to article Article 5 of the law, which clarifies bitcoin’s tax treatment:
Article 5. Exchanges in bitcoin will not be subject to capital gains tax, just like any legal tender.
Excluding bitcoin transactions from capital gains tax is critically important for the effective operation of the law, because merchants and individuals choosing to transact in bitcoin will not incur an additional tax liability for doing so.
Article 7 is largely seen as the most controversial aspect of the law:
Article 7. Every economic agent must accept bitcoin as payment when offered to him by whoever acquires a good or service.
The critical word here is “must”, which is controversial because it implies that merchants have to accept bitcoin as payment. I provide an in-depth analysis of this clause in the following section.
Interestingly, Article 8 indicates that the government of El Salvador is planning to implement a system of instant convertibility from bitcoin to US dollars. If implemented successfully, this system may alleviate concerns regarding Article 7.
Article 8. Without prejudice to the actions of the private sector, the State shall provide alternatives that allow the user to carry out transactions in bitcoin and have automatic and instant convertibility from bitcoin to USD if they wish. Furthermore, the State will promote the necessary training and mechanisms so that the population can access bitcoin transactions.
Article 12 suspends the operation of Article 7 (i.e. economic agents must accept bitcoin, if offered) for individuals and businesses that do not have access to the necessary technologies. This is an important clarification and further alleviates concerns regarding Article 7, however the specific scenarios in which Article 12 applies is ambiguous.
Article 12. Those who, by evident and notorious fact, do not have access to the technologies that allow them to carry out transactions in bitcoin are excluded from the obligation expressed in Art. 7 of this law. The State will promote the necessary training and mechanisms so that the population can access bitcoin transactions.
Finally, it’s worth taking note of Article 16 of the law:
Article 16. This decree will take affect ninety days after its publication in the Official Gazette.
The Bitcoin Law was published in El Salvador’s Offical Gazette on June 9th, and so according to Article 16, the law will take effect on September 7th. Many have noted that a 90 day implementation window is incredibly short, given the complexities involved for individuals, businesses, and the government. The 90 day window is particularly concerning, given that President Bukele’s government is attempting to build a system for instant convertibility between bitcoin and US dollars, accessible by all citizens — a world-first foreign-exchange system.
Why is Article 7 of the The Bitcoin Law problematic?
As noted above, Article 7 of The Bitcoin Law is arguably the most controversial aspect of the law because it places an obligation on businesses (and potentially individuals) to accept bitcoin as payment, if offered.
Article 7. Every economic agent must accept bitcoin as payment when offered to him by whoever acquires a good or service.
First, the definition of an “economic agent” is ambiguous, and so it is currently unclear whether this article exclusively applies to businesses, or also captures individuals engaging in private transactions.
If we assume that Article 7 applies exclusively to businesses, at face value this sounds like a reasonable strategy to encourage merchants to adopt bitcoin, however some have argued that this clause resembles a coercive legal tender law (which is distinct from a non-coercive legal tender law) because Salvadoran merchants are being compelled to transact in bitcoin.
For instance, George Selgin, a Professor of Economics at the University of Georgia, argues quite convincingly that the obligation to accept a specific currency implied by the word “must” in Article 7 is highly unusual in modern legal tender laws.
“Article 7 [of The Bitcoin Law] is a horse of a different color. Unlike most legal tender legislation, including El Salvador's 2001 law, it compels sellers of ordinary goods and services to accept bitcoin, not merely in payment of unpaid debts, but in "spot" payments. As Bukele put it in a Q&A session concerning the new law, ‘If there is a lady selling fruit on the market, she is obliged to be paid in bitcoin.’ Despite what many Bitcoiners seem to think, few countries have such laws.”
— George Selgin, Professor Emeritus of Economics at the University of Georgia
So, what distinguishes coercive and non-coercive legal tender laws?
To better understand the key difference between coercive and non-coercive legal tender, we can contrast El Salvador’s Bitcoin Law with the US Coinage Act (1965), which regulates legal tender in the United States. The US Coinage Act states that:
“United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues.” — US Coinage Act (1965)
While this might sound similar to El Salvador’s Bitcoin Law, the US Coinage Act crucially does not require merchants to accept payment in US dollars for everyday transactions — instead, it refers specifically to “debts, public charges, taxes, and dues”, and this phrase is interpreted narrowly in a court of law. Essentially, within the US, a creditor must accept dollars as payment for debt, and the government mandates that taxes and certain legal settlements are paid in dollars. You can read more about the interpretation of the US Coinage Act here and here; the core takeaway is that El Salvador’s Bitcoin Law appears to go far beyond the typical obligations of a legal tender law by compelling merchants to accept Bitcoin as “payment [for]… a good or service”. This is deeply troubling because coercive legal tender laws are typical of totalitarian regimes attempting to consolidate power by monopolising money.
It’s unclear exactly why Bukele’s administration feels as though it is necessary to mandate that merchants “must” accept bitcoin. In my view, The Bitcoin Law would be more effective if it simply established bitcoin as a co-equal monetary system, alongside the US dollar, under which no capital gains tax was incurred for transacting, and merchants had the option, but not the obligation, to accept it. Bitcoin does not need a mandate to spur adoption; Article 7 runs counter to the ethos of “freedom of exchange” that sits at the heart of the Bitcoin community.
To learn more about Article 7 of The Bitcoin Law, I would highly recommend reading Nic Carter’s analysis here.
Assessing risks in the implementation of The Bitcoin Law
The primary risks associated with the implementation of Bukele’s Bitcoin Law concern exchange rate volatility, poor internet connectivity across many parts of El Salvador, and inadequate financial education. These risks are further compounded by the law’s relatively short 90 day implementation window.
Obviously, bitcoin as an asset is incredibly volatile — occasionally experiencing a 30% price rise or decline within the space of a few days is to be expected. This is not a desirable characteristic for a currency, as it creates uncertainty for businesses and citizens of El Salvador accepting bitcoin as payment for goods and services. This could also create additional operating costs for businesses that may need to develop strategies for hedging downside price volatility if they hold bitcoin on their balance sheet. To mitigate this risk, it is critical that Article 8 of The Bitcoin Law, which specifies that the “State shall provide… automatic and instant convertibility from bitcoin to USD” is implemented effectively. Bukele’s government is partnering with Bitcoin payments startup, Strike, to implement this provision, in collaboration with El Salvador’s top five banks and two largest cashpoint distributors (learn more here and here). Strike's success in El Salvador will be critical for the overall success of The Bitcoin Law.
Inadequate internet connectivity is perhaps the largest factor limiting the potential positive impact of The Bitcoin Law. Roughly, 32% of Salvadorans have access to 3G or 4G mobile broadband according to Deloitte, however access is heavily concentrated in San Salvador (the capital city of El Salvador) and Santa Ana (the second largest city). (You can view an interactive map of mobile broadband connectivity in El Salvador here). Outside of major cities, internet penetration appears to be minimal across El Salvador. Article 12 of The Bitcoin Law specifies that “Those who… do not have access to the technologies that allow them to carry out transactions in bitcoin are excluded from the obligation [to accept bitcoin]”. While Article 12 is an important clarification, the risk is that large swathes of the population in remote parts of the country are left out of the digital revolution, and the existing inequality between cities and regional areas is only exacerbated by the implementation of the The Bitcoin Law. To mitigate this risk, Bukele’s government must continue to invest in expanding broadband infrastructure across the country.
El Salvador consistently ranks among the lowest performing countries in Latin America for financial inclusion and literacy, according to the Global Financial Inclusion Database. While The Bitcoin Law is intended to help improve financial inclusion, it will require large scale educational programs to ensure individuals and merchants understand how to leverage the Bitcoin network in their day-to-day lives. To add to the complexity, there are multiple versions of Bitcoin that have resulted from previous “forks” of the network — the two most prominent alternate forks are “Bitcoin Cash ABC” and “Bitcoin Cash Satoshi Vision”. If a customer arrives at a store in San Salvador and offers to pay for an item using “Bitcoin Cash ABC” is the merchant required to accept it? These are after all, legitimate forks of the Bitcoin protocol, and Bitcoin may very well fork again in the future. To minimise confusion and prevent fraud, it is critically important that the government of El Salvador provides comprehensive education about Bitcoin across the country, with the buy-in of local community leaders.
Under the existing global monetary regime, the citizenry of the developing world are largely excluded from the formal financial system. Many do not have access to basic savings accounts and pay extortionate fees to middlemen in order to receive money from relatives working abroad.
El Salvador is a prime example of the injustice that exists within this system: one third of Salvadorans live below the poverty line, two thirds lack access to basic financial services, and Salvadorans spend ~$600 million each year on fees to remittance service providers, equivalent to 2% of total income.
President Bukele’s Bitcoin Law is a bold experiment to address these problems by embracing an emerging monetary technology. Given the recent development of the Lightning network, Bitcoin offers the possibility of dramatically reducing the cost of financial services in any community with access to the internet.
However, the implementation of The Bitcoin Law presents several risks that Bukele’s administration must seriously consider and mitigate. Notably, Article 7 of the law potentially places a significant burden on merchants to adopt a highly volatile medium of exchange that they may struggle to understand, and the 90 day implementation period specified by the law seems very brief given the complexity of the change.
Irrespective of these risks, my conviction that Bitcoin is on the brink of upending global payments remains unshaken. The potential success or failure of President Bukele’s Bitcoin Law will be an important milestone in our collective journey towards a more inclusive financial system.
— Armah D. Blay
*Note on the naming conventions of Bitcoin: Given that Bitcoin is both a network protocol and a currency, confusion can often arise as to “which Bitcoin” is being referenced. It is accepted practice to use “Bitcoin” (singular with an uppercase “B”) to refer to Bitcoin the protocol, and “bitcoin” (singular or plural with a lowercase “b”) to refer to the currency.
References and further reading
Aaron Mak, What Happened When a 3,000-Person Village in El Salvador Became “Bitcoin Beach” (2021) Slate Magazine (read more)
Andrea Wong, The Untold Story Behind Saudi Arabia’s 41-Year U.S. Debt Secret (2016) Bloomberg (read more)
Andrew Swiston, Official Dollarization as a Monetary Regime: Its Effects on El Salvador (2011) IMF Working Paper (read more)
Ben Bernanke, Inflation in Latin America - a new era?, Bank for International Settlements (2005) (read more)
Digital inclusion and mobile sector taxation in El Salvador (2017) Deloitte (read more)
Dror Goldberg, Forced money: legal development of a criminal economic rule (2016) Comparative Legal History, Vol. 4, Iss. 2 (read more)
Ezra Fieser, World's Biggest Bitcoin Experiment Is A Surf Town In El Salvador (2021) Bloomberg (read more)
George Selgin, The Bitcoin Law: Nayib Bukele's Counterfeit Free Choice in Currency (2021) Alt-M: Ideas of an Alternative Monetary Future (read more)
Global Financial Inclusion (Global Findex) Database (2017) World Bank (read more)
Henry Lancaster, El Salvador: Telecoms, Mobile and Broadband - Statistics and Analyses (2021) BubbleCom (read more)
Jack Mallers, Announcing Strike Global (2021) (read more)
Joost Jager, Lightning Node Performance: Exploring the Path to 1000 TPS (2021) Bottlepay (read more)
Junaid Ahmed, Mazhar Mughal, Inmaculada Martínez-Zarzoso, Sending money home: Transaction cost and remittances to developing countries (2021) The World Economy, (Vol. 44, No. 8) (read more)
Legal Tender Status (2011), US Department of the Treasury (read more)
Nic Carter, El Salvador Doesn't Need a Bitcoin Mandate (2021) CoinDesk (read more)
Pedro Argumedo, Financial Inclusion in El Salvador (2018) (pp. 81–109) UN Library (read more)
The World Bank In El Salvador: A Country Overview (2021) World Bank (read more)
The 1997 CIA World Factbook (1997) (read more)
Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System (2009) (read more)