In 2009, Bitcoin came out as a revolutionary financial system meant to replace the fiat currency system. Since then, the fiat vs. crypto debate has brought to the table several advantages and disadvantages to both.
Some crypto enthusiasts want to see the fiat currency system replaced. Some economists think the fiat can never be replaced by crypto. And some economists think we should reverse to the gold standard.
Every side has its arguments, but let’s see what the truth is about fiat vs. crypto.
What does fiat stand for?
The term “fiat” comes from Latin, and it means “Let it be done.” The term is used as “mandate” or “decree.” Right now, it denominates the current financial system we use, “The fiat currency.”
Commodity money, representative money, fiat money
When humans realized that barter no longer suits their needs, they invented money. And as societies grew, they came to accept gold, silver, and other metals (precious metals especially), as an adequate form of money.
Since antiquity, gold qualified as a great medium of exchange, a unit of account, and a store of value.
Even if not used as money, gold still had and has its value. That’s why it is called a commodity.
Therefore, we define commodity money as money made out of a commodity from whom it draws intrinsic value.
But moving large quantities of gold in order to complete transactions is impractical, even dreadful.
Because it was impractical to go around with a wagon full of golden coins to buy a house, people decided to use bank mandates to make large purchases. These mandates later evolved into paper money that was backed by gold or silver.
Money backed by a commodity is called representative money.
A representative currency, also known as commodity-based currency, was subjected to the gold standard or silver standard.
As the demand for currency grew exponentially along with the population, the gold standard was dropped, and the fiat money system was adopted.
What is fiat currency?
A fiat currency is a form of money declared by the government as a legal tender and is trusted that people will find it valuable.
A fiat currency is governed by a central bank, which establishes the monetary policy.
Some examples of fiat currencies are USD, Euro, Japanese Yen, or Renminbi.
How does fiat money differ from commodities like gold and silver that were used as money?
The first and most prominent difference between fiat money and commodity money or representative money is that fiat denominates a monetary system that is backed only by the guarantee of a government.
Secondly, commodities like silver and gold exist in a limited amount; therefore, you can’t get more currency than you can cover with the said commodity.
In the case of fiat currencies, you can print as much money as you want, but that comes together with inflation.
SIDENOTE. Inflation – The expansion of currency and an increase in the general price level of goods and services.
One of the greatest distrusts in the fiat system comes from the Quantitative Ease utilized by the governments. Launching a great amount of currency in the market in a short time leads to hyperinflation, which leads to a drastic drop in purchasing power.
SIDENOTE. Hyperinflation – a large expansion of a currency supply that comes together with a drastic devaluation.
What might cause a change in the value of fiat money?
Fiat money’s value is based on the country’s economic strength. Loss of trade power, embargo, international economic sanctions, disproportions between imports and exports, and financial policies can affect the value of a fiat currency.
Each of those may cause inflation or deflation, which will affect the purchasing power of a currency.
SIDENOTE. Deflation – The contraction of currency supply and a decrease in the general price level of goods and services.
Purchasing Power – The number of goods and services that can be purchased with a unit of currency.
At first glance, you may think inflation is bad and deflation is good. Actually, it’s nothing like that. Most economies around the world are based on spending, and that requires money to move around in the market. Saving must not exceed spending.
Inflation is healthy for the economy when it’s around 2% encouraging a growth cycle.
Theoretically, the cycle goes like this:
- People spend more in short amounts of time, and that leads to a consumer spending increase.
- Prices are encouraged to rise by the increase in spending.
- The rise in prices leads to company income raise.
- More income for the company will translate into more income for workers, and with more income, they will spend more.
And the cycle goes on.
Fiat is an inflationary currency and encourages spending, thus keeping the economy moving and evolving. But inadequate financial policies such as quantitative ease destabilize the economy.
Pros and Cons of Fiat Currency
For certain, Fiat money is a convention. It is real because we agree it is. Even if we may tend to see its cons first, it has some merits as well.
Advantages of Fiat money
- Changes in demand for money are more flexible.
- Fiat Currencies are granted by governments and central banks. And for better or worse, they are stable.
- Banks and governments offer assistance and protection for your fiat currency funds.
- Because they are centralized, fiat currencies reach consensus easily.
Disadvantages of Fiat money
- Fiat currency may not be an effective store of value for long periods of time due to inflation and value erosion.
- Hyperinflation may deem a fiat currency worthless.
- You have to go ask a bank to complete large transactions or to send money.
- You don’t control your own finances; the bank does.
- Banks may be vulnerable to mistakes, overwriting, and hacking, having a single point of failure.
What does cryptocurrency stand for?
Cryptocurrency is a compound word formed by crypto, from cryptography, and currency.
Digital currency, Virtual currency, Cryptocurrency
With the widespread use of the internet, the banking system made use of the digital world to manage its financial system.
In time, most of the money and financial services were moved to the internet.
Therefore, the money that is represented online and has no physical form is called Digital Currency.
In fact, all fiat currencies have a major digital currency side. There is not nearly enough printed cash to cover the actual demand. Only 8% of the entire money supply exists in physical form.
In time, a new kind of currency appeared. That is Virtual Currency, a type of unregulated digital currency issued by a developer and used by the members of a virtual community.
With the idea of virtual currency appeared the idea of a non-governmental digital currency.
In the context of economic distress and quantitative easing, Satoshi Nakamoto used blockchain technology and created Bitcoin, the first Cryptocurrency. Within his whitepaper, he argued for a new monetary system that won’t be controlled by the government, has a fixed amount that cannot be exceeded, and gives people absolute control over their funds.
So, cryptocurrency is a type of digital currency built on blockchain and uses cryptography to secure information.
It is considered that a true Cryptocurrency is decentralized, but, in fact, some of the top cryptocurrencies are centralized.
For example, while Bitcoin is a decentralized cryptocurrency, Ripple is a centralized cryptocurrency.
What is Fiat cryptocurrency?
The fiat-crypto terminology seems a little bit odd. However, nowadays, China is testing its own CBDC (Central Bank Digital Currency), a plan started in 2019.
Altough some argue that the Digital Yuan virtual currency can hardly be considered a cryptocurrency, the Chinese CBDC is currently the closest to being a fiat cryptocurrency.
How do cryptocurrencies differ from virtual currencies and digital currencies?
In a sense, cryptocurrencies are both virtual and digital currencies.
So in the debate “digital currency vs cryptocurrency”, we identify digital currency as a big category and cryptocurrency as a subcategory of it. But the cryptocurrency is unique in this category because it uses cryptography and blockchain.
What is Bitcoin backed by?
In the technological meaning, Bitcoin is backed by the blockchain ledger which stores data about transfers and transactions.
But financially, Bitcoin is backed by the belief of people that it’s worth something. In a sense, cryptocurrency is similar to fiat.
How do cryptocurrencies have value?
Cryptocurrencies gain value through the basic rule of supply and demand, and also through the technology behind them.
Various economic, political, and social factors also affect the price fluctuation of cryptocurrencies. Trade wars, people looking to store their funds in something safer than their national currencies, businesses that need to transfer money internationally, and many other factors have granted a need for cryptos.
As a financial system, Cryptocurrency is deflationary. Most cryptocurrency developers will encourage you to hold your crypto rather than spending it because it will be more valuable after a year. This philosophy may lead our spending based economy to collapse.
However, with the boom of stablecoins and DeFi services, the crypto world is starting to move funds around more often, and not just for trading.
Pros and Cons of Cryptocurrency
Cryptocurrency is meant to be a currency for the people, made by the people. And as much as we love it, we do have to admit its faults, not only see its strengths.
Advantages of cryptocurrency
1. A cryptocurrency is built on the blockchain using encryption techniques. All the information written in previous blocks are immutable, and because of the network of nodes, it’s also resilient to hacking.
2. Inflation, in the traditional sense, cannot affect a cryptocurrency. There already is a fixed amount of units in most project, and practices like quantitative easing are impossible.
SIDENOTE. Quantitative easing – monetary policy in which the central bank purchases securities from the market in order to increase the money supply and encourage lending and investment.
3. Because cryptocurrencies work through the internet, they give access to financial services to developing countries and countries with oppressive regimes. Common people can easily store their funds and send large amounts of money privately, with small fees, without asking for approval.
4. You don’t have to go to a bank to complete a transaction and have full control over your finances.
Disadvantages of cryptocurrency
1. The main disadvantage of cryptocurrencies these days is extreme volatility. The reality is that you may find yourself investing $10,000 in Bitcoin and see your funds going down to $5,000 just like that or suddenly raising to $50,000. The high fluctuations make crypto just as attractive to traders as it is scary for investors.
2. The volatility isn’t the only risk. Cryptos are very risky for many factors. While hackers may avoid attacking the network, they won’t hesitate to go after individuals. If you’re so unlucky to have your public and private key and all your funds stored in a wallet on your smartphone when a hacker targets you, then you can kiss your cryptos goodbye.
3. These, of course, can also happen to banks that operate with fiat. However, a bank will give you assistance, and you may even have insurance for your money. But with crypto, you’re on your own.
4. Aside from hacking, you may mistakenly write a number in an address when you send your funds. If that happens, your funds are also lost with no way of getting them back.
5. Cryptocurrencies are still largely unregulated; therefore, governments and banks are reluctant to use them. Anti-Money-Laundry and Know-Your-Customer regulations are rolled out in many countries to reduce the privacy of crypto users and to make these niches more transparent.
6. While the principle crypto appeared on is honorable, lots of bad people plagued the market. A lot of ICO’s prove themselves to be scams. And that only brings more doubts from governments and the general public.
7. Lots of new cryptocurrencies sound like getting rich quick schemes. And that lessens the credibility in the market. Also, the general message to the crypto holders is to save their assets for long periods of time.
8. A fixed amount of units with people focused on saving creates a deflationary system that may never support an economy.
9. Decentralization comes with a cost. It takes enormous resources to reach a consensus on decentralized cryptocurrencies. Also, performance and usability are significantly lower than traditional systems. However, this issue is looked to be solved through layer 2 solutions like the Lightning Network.
Fiat vs Crypto
| Fiat | Crypto |
|---|---|
| Centralized. | Decentralized |
| You have to go to a bank to complete a transaction | Transactions are permissionless |
| Prone to inflation and hyperinflation | Cannot be affected by inflation in the traditional way, but it’s inclined to deflation |
| General Low volatility | Very High volatility |
| Encourages spending | Encourages saving |
| Uses cryptography for storing information | Uses cryptography for storing information |
| Banks are discussing blockchain implementation. | Blockchain is the foundation of Cryptocurrency |
| A rather opaque system | Transparent |
| Most operations, especially through banks, need permission | Permissionless (Subjected to AML and KYC regulation depending on the area) |
| Fiat subjects people to political and economic pressure on their finances | Crypto helps people ease political and economic pressure on their finances |
