What is fiat currency? Types and examples of fiat. The difference between fiat and cryptocurrency
Types of money
As more and more transactions become digitized and physical currency is used less, many do not fully understand the difference between fiat currency, digital fiat currency and cryptocurrency. When considering the implications of scaling cryptocurrency, it is important to understand the basic history of money. Before we get into what fiat money is and how it differs from cryptocurrency, we should first cover the different types of money.
In economics, money is defined as a generally accepted way of exchanging goods and services. Virtually anything can be considered money if it fulfills what we call the three basic functions of money (i.e., medium of exchange, store of value, unit of account). Given this, it is not surprising that there have been different kinds of money throughout history. To give you a brief overview, we will look at four of the most important ones: commodity money, paper money, fiduciary money, and commercial bank money.
It is the simplest and probably the oldest kind of money. It is based on limited natural resources, which serve as a medium of exchange, a store of value, and a unit of account. Commodity money is closely related to (and comes from) the barter system, where goods and services are directly exchanged for other goods and services. Commodity money facilitates this process because it acts as a generally accepted medium of exchange. The critical thing to note about commodity money is that its value is determined by the intrinsic value of the commodity itself. In other words, the commodity itself becomes money. The most popular commodity money is gold, but for centuries even commodities such as spices or shells have served in this capacity.
Fiat money is a form of money backed by the government. It is used as the primary method of payment for goods and services as well as taxes.
Fiat money is money issued by a government as legal tender and not backed by gold or other physical commodities. The value of fiat money is based on the strength and creditworthiness of the issuing authority, and almost every country today issues fiat currency. Although digital paper money now exists in every bank transaction or credit card purchase, this money is still tied to physical paper currency and thus controlled by governments.
Unlike commodity money, paper money is not backed by any physical commodity. By definition, their intrinsic value is much lower than their nominal value. Consequently, the value of paper money is determined on the basis of the relationship between supply and demand. Most modern economies are based on a system of fiat money.
The value of fiduciary money depends on the certainty that it will be accepted as a medium of exchange. Unlike paper money, the government does not declare it to be legal tender, which means that people are not legally obligated to accept it as a medium of exchange. Instead, the issuer of fiduciary money promises to exchange it for commodity or paper money at the bearer's request. As long as people are confident that this promise will not be broken, they can use fiduciary money like regular paper or commodity money. Examples of fiduciary money include checks, bills, or securities.
Benefits of fiat money
Commercial bank money can be characterized as a claim on financial institutions that can be used to buy goods or services. It represents the portion of the currency that consists of commercial bank debt. Specifically, commercial bank money is created through what we call fractional reserve banking. Fractional reserve banking describes a process in which commercial banks lend more than the value of the actual currency they hold. Let's just note here that commercial bank money is essentially debt obligations of commercial banks that can be exchanged for "real" money or the purchase of goods and services.
Disadvantages of fiat currency
Paper money has disadvantages as well. Despite the introduced systemic checks, inflation can greatly affect fiat money. There is also the problem of a corrupt government bringing the issued currency close to zero.
This is not some dystopian future of fantasy novels, there are indeed countries with this problem, and it is a very real threat. Hyperinflation is a serious problem, and it can happen if the government is too zealous in its actions to print new money.
How cryptocurrency differs from fiat currency
Like fiat currency, cryptocurrency can be used as a medium of exchange. The main difference is that unlike fiat currency issued by a central bank or government, cryptocurrency is not issued and controlled by a central authority. Governments and banks can decide to print new paper money when needed. And the Bitcoin network, for example, has a limited number of coins to be issued over time, a policy that will never change.
Currencies and cryptocurrencies function differently. Cryptocurrencies are more democratic in their approach, and while the system is not 100% reliable, it is much harder to disrupt because all those with power must agree on changes.
Cryptocurrencies tend to resist inflation because they have limited reserves. Unfortunately, crypto-assets also have trouble maintaining stable values, and this can make it difficult to depend on them for everyday expenses and business use, when even small price fluctuations can cause profits to disappear, leaving traders at a disadvantage.
Can cryptocurrency replace paper money
This seems like a real possibility, and in fact there are already governments working on issuing their own cryptocurrencies. For a decentralized cryptocurrency to replace fiat, it must first prove that it is reliable, and it is likely that it must also be a pegged asset that could perform similar tasks to the U.S. dollar, while still providing the benefits of crypto.
The strength of any fiat currency derives from the strength of the government or bank that issues it. While the intention of introducing fiat currency should be stable, in times of recession and rapid inflation we have seen that this is not always the case. For example, the country of Venezuela has been plagued by hyperinflation in recent years, with an annual inflation rate of at least 60,000 percent in 2018. Compare that to the inflation rate in the United States for 2018, which is estimated at about 2 percent.
Some economists even estimate the inflation rate in Venezuela to be much higher, with the IMF estimating more than 1 million percent. The reason for such sharp differences in estimates can be partly explained by the enormous magnitude of inflation. With hyperinflation, the magnitude of inflation is so great that a small change in the calculation can lead to a huge difference in the estimate. The difference can also be explained by the lack of transparency of governments when it comes to financial policy. This is not the case with cryptocurrencies. One of the main value propositions of blockchains is their transparency. We know how many coins exist and have records of every transaction on the blockchain.
In times of rapid inflation, people need the ability to convert their wealth into a more stable stock or risk losing huge sums just by leaving their fiat currency unattended. This represents another huge reason why cryptocurrencies are valuable. Because there is no central bank or government to change monetary policy, digital currency serves as an escape from a centralized currency that may be subject to bad monetary policy.
- Fiat currency is money that a country's government has established as legal tender. In contrast, cryptocurrency refers to a decentralized and digital medium of exchange that uses encryption techniques to facilitate the transaction.
- While the issuance and control of fiat currency is regulated by a country's central bank, cryptocurrency operates independently of the central bank.
- One of the main features of cryptocurrency is that transactions between parties are direct because it eliminates intermediaries such as banks, which is mandatory in the case of fiat currency.
- When it comes to supply, paper currency has an unlimited supply because it can be printed as needed. Conversely, cryptocurrency has a limited supply.
- Fiat currency is a physical, that is, a common means of exchange, while cryptocurrency allows for digital exchange.
- Fiat currency is often represented by coins, paper bills and banknotes. Cryptocurrency is represented by open and closed pieces of code.
- Cryptocurrency transaction costs are higher compared to fiat currency.
- If we are talking about storage, individuals' wages are stored by them in their bank accounts. In contrast, cryptocurrency is stored by people in their digital wallet.
As you can see, there are important differences between the two coin models. While paper money is more widespread in the market and offers unlimited consumption opportunities for its users, cryptocurrencies have not yet achieved such scalability. However, it is highly likely that this scenario will change in the near future. Cryptocurrency's high valuation has given it every opportunity to enter the global arena. And the recent rise in the value of digital currencies along with the notion of decentralization has made people turn their attention to this alternative.