The difference between fiat and cryptocurrencies
If you read at least a little about cryptocurrency, you probably heard about its many advantages compared to paper money. But what is a fiat currency? In this article, we will look at the main differences between traditional currencies and new digital ones. What are the advantages and disadvantages of using Fiat compared to cryptocurrency? Let’s figure it out!
Types of money
As more and more transactions are 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 consequences of cryptocurrency scaling, it is important to understand the basic history of money. Before moving on to what fiat money is and how it differs from cryptocurrencies, we must first highlight the various types of money.
In economics, money is defined as a generally accepted way of exchanging goods and services. Almost everything can be considered money if it fulfills what we call the three basic functions of money (i.e., a medium of exchange, accumulation of value, unit of account). Given this, it is not surprising that throughout history there have been different types of money. To give you a brief overview, we will look at the four most important of them: commodity money, paper money, fiduciary money and commercial bank money.
This is the simplest and most likely the oldest type of money. It is based on limited natural resources that serve as a medium of exchange, a storehouse of value and a unit of account. Commodity money is closely related (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 that should be noted with respect to commodity money is that its value is determined by the intrinsic value of the product itself. In other words, the product itself becomes money. The most popular commodity money is gold, but over the centuries, even such products as spices or shells have acted in this capacity.
Fiat money is a form of money supported by the government. It is used as the main method of payment for goods and services, as well as taxes. Fiat money is money issued by the government as legal tender and not secured by gold or other physical goods.
The cost 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 today exists in every bank transaction or purchase with a credit card, this money is still tied to physical paper currency and is thus controlled by governments.
Unlike commodity money, paper money is not supported by any physical commodity. By definition, their intrinsic value is significantly lower than the 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 fiat money system.
The cost of fiduciary money depends on the belief that it will be accepted as a medium of exchange. Unlike paper money, the government does not declare it legal tender, which means that, by law, people are not required to accept it as a means of payment. Instead, the issuer of fiduciary money promises to exchange it for commodity or paper money at the request of the bearer.
As long as people are confident that this promise will not be broken, they can use fiduciary money, like ordinary paper or commodity money. Examples of fiduciary money include checks, banknotes or securities.
Commercial Banking Money
Money of a commercial bank can be described as claims against financial institutions that can be used to purchase goods or services. It is part of the currency, which consists of the debt of commercial banks. In particular, money from commercial banks is created through what we call partial reserve banking.
A fractional reserve bank describes a process in which commercial banks issue loans in excess of the value of the actual currency that they have. Here, we simply note that essentially the money of commercial banks is debt obligations of commercial banks that can be exchanged for “real” money or bought goods and services.
Fiat Money Benefits
Fiat money has some advantages. Without being tied to gold, they help control value and prevent economic crises. For example, the United States government can control the value of the US dollar to prevent catastrophic events, such as the 2008 recession, from falling currency values. Since the “redeemable” value of the US dollar is constant, it also facilitates trade and storage than a currency whose value is constantly growing and falling.
Fiat currency weaknesses
Paper money has its drawbacks. Despite the systemic checks introduced, inflation can greatly affect fiat money. There is also the problem of a corrupt government bringing the issued currency closer to zero.
This is not some dark future of science fiction novels, there really are countries with this problem, and this is a very real threat. Hyperinflation is a serious problem, and this can happen if the government is too zealous in its efforts to print new money.
How is cryptocurrency different from fiat currency
Like fiat currency, cryptocurrency can be used as a medium of exchange. The main difference is that, unlike the fiat currency issued by the central bank or the government, cryptocurrency is not issued and is not controlled by the central authority.
Governments and banks may decide to print new paper money when required. And, for example, the Bitcoin network has a limited number of coins that will be issued over time, and this policy will never change. Currencies and cryptocurrencies function differently.
Cryptocurrencies are more democratic in their approach, and although the system is not 100% reliable, it is much more difficult to destroy it, since all participants in power must agree on changes. Cryptocurrencies tend to resist inflation as they have limited reserves.
Unfortunately, crypto assets also have problems 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 lead to the disappearance of profit, leaving traders in the red.
Can cryptocurrency replace paper money
This seems like a real possibility, and in fact there are already governments working on the issue of their own cryptocurrencies. In order 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 tied asset that could perform tasks similar to the US dollar, and at the same time provide the advantages of crypto.
The strength of any fiat currency stems from the power of the government or the bank that issues it. While the intention to introduce fiat currency should be stable, during the recession and rapid inflation, we saw that this is not always the case. For example, in recent years, the country of Venezuela has been hit by hyperinflation, in which the annual inflation rate in 2018 was at least 60,000 percent. Compare this 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 is much higher, and the IMF estimates it at more than 1 million percent.
The reason for such sharp differences in estimates can be partly explained by the huge amount of inflation. With hyperinflation, the inflation rate is so great that when it is calculated, a small change in the calculation can lead to a huge difference in the estimate. The difference can also be explained by the opacity of governments when it comes to financial policy.
This does not apply to cryptocurrencies. One of the main value propositions of blockchains is their transparency. We know how many coins exist, and we have records about each transaction in the blockchain. In times of rapid inflation, people need the ability to convert their wealth into a more stable supply or risk losing huge amounts simply by leaving their fiat currency unattended.
This is another huge reason cryptocurrencies are valuable. Since there is no central bank or government that could change monetary policy, the digital currency serves as an escape from a centralized currency that may be subject to poor monetary policy.
- The fiat currency is the money that the government has set as legal tender. In contrast, cryptocurrency refers to a decentralized and digital medium of exchange that uses encryption techniques to facilitate transactions.
- While emissions and control of fiat currency are regulated by the country’s central bank, cryptocurrency operates independently of the central bank.
- One of the main features of cryptocurrency is that transactions between the parties are direct, as it eliminates intermediaries, such as banks, which is mandatory in the case of fiat currency.
- When it comes to delivery, paper currency has an unlimited supply, as it can be printed as required. Conversely, cryptocurrency has a limited supply.
- The Fiat currency is physical, that is, a common medium of exchange, while cryptocurrency allows digital exchange.
- Fiat currency is often represented by coins, paper bills and banknotes. Cryptocurrency is an open and closed part of the code.
- The cryptocurrency transaction cost is higher compared to fiat currency.
- If we are talking about storage, the salaries of individuals are stored by them in their bank accounts. On the contrary, 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 common on the market and offers unlimited consumption opportunities for its users, cryptocurrencies have not yet reached such scalability. However, it is highly likely that this scenario will change in the near future. The high appreciation of cryptocurrency provided her with all the opportunities to enter the world stage. And the recent rise in the value of digital currencies, along with the notion of decentralization, has led people to turn their attention to this alternative.