A term widely used in crypto is ‘fiat currency’, which is a type of currency that is not pegged to the price of any commodities, such as gold or silver. It does not have any intrinsic value nor is backed by tangible assets and, in fact, the value of a fiat money is largely based on the public’s faith in the currency’s issuer, normally being a country’s government or Central Bank. When applied to paper money, fiat currency refers to the notion that currencies, like dollars, only have value because the government says it does and because a collective belief agrees on this.

What Is Fiat Currency?

Every country’s economy is led primarily by the definition of its national currency (or currencies, depending on the nation). With that being said, the United States Dollar (USD), the Euro (EUR), Pound (GBP) and other major currencies are classified as fiat money.

The word “fiat” is Latin in origin and refers to an arbitrary order issued by a government or other authoritative figure. When applied to paper money, fiat currency refers to the notion that currencies, like dollars, only have value because the government says it does and because a collective belief agrees on this.

For many years, dollars were actually backed by reserves of valuable assets such as gold and silver. The U.S. went off the gold standard for domestic transactions in the 1930s and ended international conversions in 1971. Dollars have not been redeemable in silver since the 1960s. Today, the U.S. Federal Reserve is required to hold collateral equal to the value of the dollars in circulation, and it does so using government-issued debt. So essentially, the dollar has value for two reasons:

• Because the U.S. government says it does.
• Because investors and lenders around the world believe that the U.S. government will repay its debts.

Also, the same applies for every single fiat currency around the globe. Fiat currencies have value because they are backed by a government, and people who hold it agree to its worth. Since fiat money is not tied to valuable commodities like rare metals or oil, governments, or more accurately central banks, can limit the supply of their currencies to help protect their value.

Fiat money serves as a means of exchange for goods and services since it is generally accepted. Additionally, it acts as a unit of account and a store of value, enabling individuals to estimate the worth of goods and services as well as to save or invest money. Governments also use fiat currency as a way to control the economy by adjusting the money supply through monetary policy, such as setting interest rates or printing more money. Additionally, it is used as a means of payment for taxes and government services.

Fiat Currencies vs. Cryptocurrencies

The main difference between fiat currencies and cryptocurrencies is that cryptos do not require government backing, while fiat currencies depend on it.

Most cryptocurrencies are created using a cryptographic computer networking technology known -blockchain- which enables them to circulate without the need for a central authority such as the Federal Reserve.

Many proponents of cryptocurrencies argue this “decentralization,” in which currencies are governed by users instead of central authorities, will result in more efficient and less corrupt monetary systems.

However, there is nothing stopping governments from using cryptocurrencies or their associated technologies in national currency systems. El Salvador, in September 2021, became the first nation to adopt Bitcoin as legal tender, while China is developing a digital version of its national currency (yuan).

Because most cryptocurrencies are not backed by central banks, they derive their value from different sources. Bitcoin, the first and most valuable cryptocurrency, generally has its value determined by the market logic of supply and demand. There is a finite supply of Bitcoin that is governed by its underlying software, so when demand goes up, so do prices.

Pros and Cons of Fiat Currencies

Pros of Fiat Currencies

Since fiat money is not a scarce or fixed resource – like gold – a country’s central bank has greater control over its supply and value. This means that governments can manage the credit supply, liquidity and interest rates more reliably.

Unlike commodity currencies, which could be affected by the discovery of a new gold mine, the supply of fiat currencies is regulated and controlled by the respective currency’s government. There is less risk of an unexpected devaluation caused by the supply of fiat currencies, as any increase in supply is a preempted decision made by a fiat currency’s government.

Cons of Fiat Currencies

Since fiat money is not tied to a tangible asset, its value is dependent on responsible fiscal policy and regulation by the government. Irresponsible monetary policies can lead to inflation - and even hyperinflation - of a fiat currency.

There is also the greater chance of economic bubbles with fiat currencies – an economic cycle in which there is a rapid increase in price before an equally rapid decline in price.

The increased prevalence of bubbles is because fiat currencies have a virtually unlimited supply, which means that quantitative easing is an option for governments. While possibly providing stimulus to an economy, quantitative easing can also cause greater inflation rates. This could impact anything from housing prices to national debt levels, which in turn could impact the financial markets.

Conclusion

Fiat currency is the most widely accepted type of currency globally, with hundreds of currency exchanges and payment networks supporting this globally-accepted ecosystem in basically every country.

Fiat money has no intrinsic value and is determined by market forces, but still was the way that the society decided that the economy would move during the last centuries. Today, we have around 180 currencies on the globe, and financial transactions between countries are made using them.

Fiat currencies are also accepted when buying cryptocurrencies, and it is only a matter of time until we see a clearer merge between traditional finance - with fiat currencies - and open finance - with crypto.