Fiat Money vs. Cryptocurrency

Crypto vs Banking System - Innovation & Technology Blog

From cowrie shells to crypto — the evolution of money and the upward push of cryptocurrencies.

Money is a requirement of any financial transaction and is a mutually accepted representation of value around the world. In the earliest eras of civilization, societies denominated money in livestock like cows, goats, and camels. Then, everything from cowrie shells to salt saw good use as a form of money, before giving way to the more familiar form of precious metal coinage. Today, fiat money — government-issued legal tender with no intrinsic fee — represents the most dominant iteration of money. For many, paper bills and coins are the solely form of money they have ever known.

However, as history has shown us, money evolves, and its subsequent stage is upon us. The emergence of blockchain technology and cryptocurrency over the last decade presents a foundational update to the world’s systems of money and value. Built on decentralized blockchain networks, digital currencies like bitcoin (BTC) and ether (ETH) are not controlled by a single governmental body and offer considerable opportunities for financial inclusion worldwide.

What determines whether or not cryptocurrency is, in fact, money? It all comes down to fulfilling three key criteria:

Using Money

All effective forms of money have to act as a shop of value, medium of exchange, and unit of account. Without fulfilling these requirements, cash can’t obtain scalable utility.

Store of value: All forms of cash need to act as a shop of value. As such, there need to be widespread confidence that money will retain its value. For instance, when a company issues a $100 invoice to a customer, it should be assured that the $100 has the same (or virtually the same) value 30 days out. Without value stability, there’s no incentive to use something as money, as the risk of devaluation is too high.

Although the majority of fiat currencies are reliable, there are many exceptions that are subject to currency inflation and ineffective monetary policy. And, whilst this early duration of evolution in the cryptocurrency and blockchain house has been marked by significant market volatility, the emergence of stablecoins (price-stable digital assets with underlying collateral structures) strengthens the use case of digital currency as a store of value. Pegging cryptocurrency value to an underlying asset (fiat money, crypto, or a commodity) has introduced a dependable store-of-value functionality to cryptocurrencies.

Medium of exchange: Money must be a generally accepted form of payment. Both sides in a transaction have to share the perception of value. For example, let’s say someone presents to pay their babysitter in Monopoly money. Because Monopoly money has no perceived value (outside the context of a Monopoly game), the babysitter would not accept it as a form of payment.

Similarly, many were hesitant to accept cryptocurrency as a form of payment when it was first introduced in 2009. However, the speedy growth and adoption of digital forex markets indicates a growing acceptance of cryptocurrency on both the individual and the institutional level. For example, in Fall 2020 PayPal started offering U.S. account holders the ability to trade some cryptocurrencies — Bitcoin, Ethereum, Bitcoin Cash, and Litecoin to begin — and it plans to lengthen this service to choose international markets in first-half 2021. While fiat currency remains the dominant medium of exchange, cryptocurrency is making up remarkable ground as more and more people start to recognise the value of digital assets.

Unit of account: To function as a unit of account, money should be able to price financial transactions via efficiently denominating the value of all products and services during the economy in relation to each other. For example, a $500 mattress is more valuable than a $20 hat.

With fiat currency, monetary policy via central banks is used to control the value of every currency in relation to others. By printing money or adjusting interest rates for borrowing, governments strive to increase or decrease the value of their fiat currency. The value of each crypto unit depends on prevailing crypto market prices.

To be a valid unit of account, each unit of cash must also be divisible. For example, a fiat dollar can be broken down into quarters, dimes, nickels, and pennies. Cryptocurrency is specially well suited towards divisibility because it is digital in nature. For example, BTC is divisible into units as small as one satoshi, which is one hundred millionth of a single bitcoin.

Beyond these requirements, money should additionally be durable, portable, uniform, limited in supply, and generally accepted. It’s obvious that the fiat money we use today meets all of these criteria, for this reason its universal use.

Issuance and Governance

A major criticism of fiat money is that it lacks intrinsic value, instead deriving perceivable worth from its status as legal tender. Fiat money’s price is inextricably linked to decisions made by central authorities, specifically governments and central banks, regarding their economic and fiscal policy. For fiat currency to be issued, a central bank simply incept the order.

Alternatively, cryptocurrency derives intrinsic value from its native blockchain, where monetary policies are transparent and written into the protocol’s codebase. While cryptocurrencies frequently have no fiscal policy, it is necessary to understand that their economic policies are subject to the governance and consensus mechanisms of the protocol itself, rather than a single, central authority.

Most blockchain networks these days count on consensus mechanisms known as Proof of Work or Proof of Stake to mint new coins and many, however not all, have a finite supply of coins programmed into the protocol. Once minted or printed, each cryptocurrency and fiat forex can be bought on exchanges and held as an investment, traded for other assets, or exchanged and spent in return for goods and services.

The Exchange of Value

Except for cash exchanges, transactions using fiat currency take place inside the normal banking infrastructure. In most cases, an intermediary is quintessential to facilitate the exchange of funds between two parties. People who use credit cards or financial services apps to buy groceries do so via payments technology companies like Visa or PayPal. People sending cash to relatives in another country engage wire services merchants like Western Union to facilitate the transfer.

Transactions using cryptocurrency, however, show up by blockchain except the need for a centralized intermediary, immediately giving the system’s customers more freedom. Transactions are validated and recorded by a distributed, decentralized network of participants by way of that blockchain protocol’s consensus mechanism.

Money Is Evolving

As records has proven, money and the structures that underpin it will continue to evolve. From cowrie shells to crypto, the form and technology may also change, however the requirements and utilization in regards to value, exchange, and accounting stay the same. While fiat currency is nevertheless the dominant form of money, cryptocurrencies and the blockchain technology that underpin them may very well represent the subsequent step in the evolution of money.