El Salvador Bitcoin Plans: The Immense Strains on the Bitcoin Network
August 3rd 2021
On June 8, 2021, El Salvador shocked the world—particularly the cryptocurrency industry—when it passed into law President Nayib Bukele’s proposal to make Bitcoin one of its legal tenders.
This isn’t the first time the country made people question its fiscal policy. In 2001, it abandoned its supposed national currency called colon in favor of the US dollar.
Either way, while the ardent fans and users of Bitcoin and crypto may rejoice, many financial experts are already expressing their concerns over this brand-new law. One of the possible significant effects is the strain it may place on the Bitcoin network.
China’s Ban, El Salvador’s Gain?
There are two ways that El Salvador’s new legal tender could increase Bitcoin strain: China’s ban of other cryptocurrencies and the increased number of people who will tap into blockchain technology.
China Ban on Mining
China is one of the world's economic power players, even in the cryptocurrency industry. According to Motley Fool, the country controls about 70 percent
of BTC’s mining capacity. It is also home to at least a hundred thousand miners.
However, although it positions itself as liberal and welcoming of digital assets, the reality seems not to match that. Since 2013, China has been gradually cracking down on cryptocurrency, starting with banning Bitcoins from purchasing products and services. About four years after, it prevented platforms from doing initial coin offerings (ICOs).
Then, in 2021, the government began shutting down Bitcoin mines, including those in Sichuan Province, which has the most significant mining bases. If this continues, it could mean that about 90 percent of the country’s mining capacity
would eventually shut down.
The mines' closing eventually leads to a significant drop in the Bitcoin hash rate. In July, it decreased by 54 percent
since the market peak in May. The decline was so substantial that Bitcoin re-adjusted its code to be 28 percent easier to mine.
To deal with the situation, miners in China were either selling their rigs to quit entirely or moving their business overseas like BIT Mining, relocating to Kazakhstan.
El Salvador Stands to Gain
In effect, miners in El Salvador will stand to gain a huge profit because of China’s harsh crypto policies. Moreover, the new law will make the country more attractive to those who want to continue the business.
But one has to keep in mind that crippling the leader doesn’t make the entire system efficient. This only severely limits the capacity of Bitcoin trading for the next few weeks or even months.
This isn't the only problem, in any case.
Bitcoin Isn’t the Soundest Cryptocurrency
One of the staunchest critics of El Salvador’s new law is JPMorgan. In its report, it believed that Bitcoin is not suitable as a legal tender
- of the way Bitcoin works; and
- illiquidity of its assets.
According to JPMorgan's data, Bitcoin is highly illiquid, which means it doesn't quickly convert to cash or any other more acceptable currency. About 90 percent of Bitcoin had not changed hands in over a year. Some may have also remained in digital wallets with low turnover.
Although the Bitcoin trading volume could go over $50 billion a day, most of this is via major cryptocurrency trading exchanges and mobile trading applications.
If this cryptocurrency becomes one of the country’s legal tenders, then the daily transactions of El Salvador would then have to account for at least 4 percent of the daily payment activity and 1 percent of the total token value transferred between wallets over the last 12 months. That’s too much for Bitcoin’s present network condition.
The Volatility of Bitcoin
Cryptocurrencies are developed based on decentralization, anonymity, and less control from traditional institutions like the central bank. But they can be littered with problems, including high volatility.
According to Investopedia, BTC's volatility rate once hit 8 percent
within only three months between October 2017 and January 2018. This volatility may be due to any news that may dampen its adoption or its unpredictable perceived value against fiat currencies.
JPMorgan thinks that, at some point, it could create an imbalance of demand for the US dollar and Bitcoin conversions. This could then "cannibalize" the liquidity of the onshore dollar, leading to more significant fiscal issues and payment risks.
What is the best solution? It’s possible that El Salvador can still use Bitcoin as a legal tender, but they will run into blockchain congestion issues and fees that need to be paid for each transaction. Small transactions will inherently "clog" the network over time. A decentralized layer-2 option could be viable, where all local “channel” transactions are open and closed essentially for free, with these transactions synced to the main bitcoin blockchain later. Ideas for layer-2 solutions are complex, challenging to explain to new users, and currently very centralized introducing additional risks.
The El Salvador government could also choose to issue their own Central Bank Digital Currency (CBDC), either backed or pegged to bitcoin. An algorithmic peg could inflate or deflate the amount of CBDC tokens in circulation, matching bitcoin price fluctuations while still offering a stable price for everyday goods and services. Transactions could be set low or even free if powered by renewable energy to mine and secure the blockchain. If a new CBDC is to be printed, more bitcoin can be transparently acquired from the open market to boost the country's circulating supply of usable currency.
The El Salvador Bitcoin Boom could be just the first of many countries to put Bitcoin on their balance sheets and do something good. The world has been using Fiat currency in the same way we've been burning fossil fuels; eventually, they will run out of steam. The shift to renewable energy and crypto could be a viable alternative for the future of finance at a state-wide level.