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El Salvador’s Bitcoin City: how will it shape the crypto’s future?

By Indrabati Lahiri


Updated

El Salvador flag draped around a bitcoin
The bitcoin mining at the centre of the innovative city’s existence will be fuelled by geothermal energy from the Conchagua volcano – Photo: Shutterstock

El Salvador created history earlier this year by becoming the first nation in the world to accept bitcoin as legal tender. The country has now doubled down on this decision by recently announcing that it would be building the world’s first Bitcoin City, funded by a series of bitcoin bonds worth $1bn (£757m) with a 6.5% yield.

The Bitcoin City will be circular in shape and located close to the Conchagua volcano. The bitcoin mining at the centre of the innovative city’s existence will be fuelled by geothermal energy from the volcano. The crypto metropolis is also supposed to be tax-free, with the exception of a 10% sales tax.

The audacious plan is part of the Central American country’s strategy to use one of the most popular cryptocurrencies in the world to encourage foreign investment in the nation. This move has been heralded as very progressive, especially at a time when many other countries – such as India – are still reluctant to legalise cryptocurrencies and are considering banning them altogether.

El Salvador’s strategy also brings up a lot of questions swirling around the global bitcoin revolution. These include the crypto coin’s acceptance by different countries, its regulation and the kind of position it may occupy in global financial systems in the foreseeable future.

Will other countries follow El Salvador’s lead?

One of the most pertinent questions on investors’ minds following this announcement has been whether we will see other countries following in El Salvador’s footsteps and also issuing bitcoin bonds, or building cryptocurrency-themed cities and promoting them in other ways.

Addressing this, William Je, CEO of Hamilton Investment Management, says: “El Salvador is the first country to adopt bitcoin as legal tender. El Salvador is the smallest country in Central America and has a long history of adopting other currencies as a means of exchange. It is at the forefront of this innovation and other regional nations are looking on with interest – not least Guatemala and Honduras. But we need to be careful when looking at this.”

Elaborating further, he points out: “El Salvador is planning to issue the bitcoin bond to fund the building of the Bitcoin City. To build a city, you need hard currencies (especially for overseas materials and labour costs) and a long-term bond. Given the price volatility of bitcoin, El Salvador has assumed that the price of bitcoin will continue to rise robustly and this may not be the case. Given the poor credit rating of El Salvador, institutional investors would be reluctant to invest into its bitcoin bond. I think there will be some countries issuing the bitcoin bonds in the future, but it is difficult for the funds to finance a long-term project like building a city unless there is some form of a good credit rating and guarantee of the repayment.”

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India on the cryptocurrency fence

Although bitcoin has been around for more than a decade now, countries such as India are still reluctant to legalise it, preferring instead to plan to launch their own official digital currency, backed by the country’s central bank – in this case, the Reserve Bank of India. This is due to numerous public concerns about regulation and rug pulls, as well as the possibility of cryptocurrencies funding potentially illegal activities. A rug pull happens when a cryptocurrency developer abandons the project, delists the token from all exchanges and vanishes along with investors’ money. There has also been considerable debate about whether cryptocurrencies should be taxed akin to digital assets maintained in foreign countries.

El Salvador’s decision may help encourage countries such as India to jump on the cryptocurrency bandwagon in the future, says Je, but for now the nation is sticking to its no-crypto guns.

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“India is an interesting case in point. In April 2018, the Reserve Bank of India (RBI) issued a circular instructing banks to make sure customers dealing in cryptocurrencies were not allowed access to banking services. The circular came after years of suspicion about the legitimacy of virtual currencies,” he says, adding: “The central bank has repeatedly warned about the supposed risks that these unregulated private currencies pose to investors and the financial system. By barring banks from facilitating cryptocurrencies, the RBI effectively banned any significant rupee investment in cryptocurrencies. We do not see this changing any time soon.”

Bitcoin bonds and ETFs have seen increasing popularity. ProShares Bitcoin Strategy ETF (BITO) was the first to launch, with VanEck Bitcoin Strategy (XBTF) and Valkyrie Bitcoin Strategy ETF (BTF) quickly following suit. Now with El Salvador also launching bitcoin bonds, it is highly probable that other countries which have historically struggled with currency devaluation may consider adopting bitcoin as well as other cryptocurrencies as legal tender and issuing cryptocurrency bonds in an effort to pull up the economy.

Institutional investors still need persuading

When it comes to how far bitcoin bonds could go in stabilising some smaller economies by attracting foreign investments – like El Salvador is attempting to do – Je believes the biggest hurdle will be to gain the confidence of key investors.

“Institutional investors now generally appreciate that digital assets are here to stay, with investors increasingly attracted to the finite quality of assets like bitcoin – which is verifiably scarce – as a way to hedge against inflation and currency debasement and to diversify their portfolios in the pursuit of higher risk-adjusted returns. Smaller economies could issue bitcoin bonds, especially to those smaller investors and crypto enthusiasts, to attract investments. However, unless there is some form of a good credit rating guarantee of the repayment of the bitcoin bond, it would be difficult to attract institutional investors to invest,” he says.

Bitcoin: a balm for struggling economies?

In regards to the question of which other countries are likely to adopt bitcoin as legal tender, managing partner at Ascension Capital, Petro Levchenko, says: “The next likely candidates are other countries in Latin America. Suriname, Bolivia, Guyana and Venezuela have all historically struggled with inflation and local currency weakness, so Bitcoin could attempt to solve some of those problems.”

The MD of Authentix Management, Gareth Randle, is of a similar opinion. “The adoption of bitcoin for a country is fantastic and though some may think it’s risky. bitcoin has outperformed all financial instruments for the past 10 years. It could lead bitcoin into a more recognised reserve asset, like gold. There are only 21 million bitcoins, so if all the countries start buying them up then there will be a supply crisis as demand outweighs the supply,” he says.

Randle goes on to clarify that El Salvador adopting bitcoin as legal tender may have a domino or chain effect, saying: “Once one country adopts bitcoin, game theory could kick in. Either it’s the next best asset for store of value like gold or it’s not. However, the risk for not taking bitcoin seriously and considering having even a little on the books could be financially devastating in the future for these countries that don’t adopt or research the asset class further. It wouldn’t surprise me if Central and South America countries start adopting this in the next year along with the likes of Malta.”

Although bitcoin is yet to be fully regulated and is still predisposed to great volatility – with sudden crashes and soaring highs – investors and cryptocurrency enthusiasts alike expect the leading cryptocurrency to take a more prominent position in global financial markets in the foreseeable future.

Read more: Gold or bitcoin? What's the best buffer against inflation in 2021?

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