A fiat currency is money that is issued and backed by a government, whereas cryptocurrencies are digital and are not issued by a government, bank, or other central authority. Examples of fiat currencies include the U.S. dollar, the euro, the yen, and most internationally traded currencies.
Fiat currency is considered centralized, because these traditional types of currency are typically governed by a single authority. Cryptocurrencies are generally decentralized, meaning they rely on blockchain technology and are overseen and managed by a distributed network of computers.
These days, it’s important for investors to understand how fiat money works, why it matters, and how it relates to different types of cryptocurrencies.
What Is Fiat Currency?
Fiat money evolved from asset-backed currencies, when governments would mint or print money that was either made from a physical commodity, i.e. precious metals like gold or silver — or could be redeemed for the equivalent amount of that commodity. Over time, though, it became impossible for governments to hold enough of a precious metal to back every coin or piece of paper currency, and so-called fiat currencies became common.
For example, the current fiat money system came about in the U.S. during the 20th century when many countries moved away from the gold standard, where currencies were directly tied to gold. Fiat money cannot be redeemed for an underlying asset, so its value is based on government policy and foreign currency markets.
There are currently some 180 fiat currencies in the world today. The value of fiat currencies is driven by the forces of supply and demand. Central banks like the Federal Reserve set monetary policy to control the supply, gauging how much money is needed in the economy and printing accordingly. The biggest risk is that they could print too much, triggering a bout of hyperinflation — rapid, out-of-control price increases that can lead to economic devastation.
Faith in a fiat currency hinges on the stability of the government that issues it, as well as trust in the central bank that manages its supply. Here’s a deeper dive into the fiat-currency systems that are fixtures of modern economies.
How Do Fiat Currencies Work?
Fiat comes from the Latin and generally means “a formal authorization; a decree.” So fiat money refers to an order by the government that gives these currencies value and makes them legal tender.
There is no underlying store of gold or silver to give fiat currencies material value.
Instead, fiat money is backed by the authority of each government. For example, the U.S. dollar is backed by the “full faith and credit of the U.S. government.” According to the Federal Reserve:
“(Dollars) are not redeemable in gold, silver or any other commodity, and receive no backing by anything. The notes have no value for themselves, but for what they will buy. In another sense, because they are legal tender, Federal Reserve notes are ‘backed’ by all the goods and services in the economy.”
Fiat money may be more susceptible to inflation and deflation because a government can print as much money as it wants. Also the value of these currencies rides on the confidence of consumers and the currency markets.
The Background of Fiat Money
Needless to say, the history of money is long and complicated. But the history of fiat currency is less so.
Essentially, for thousands of years goods were paid for by trading other goods (e.g. trading livestock for grain). During certain periods in the Roman Empire, salt was considered so valuable that people used that to purchase goods and pay people (that’s where the word “salary” comes from). Over time precious metals like gold and silver became a form of payment as well.
Asset-backed coins and paper money may have first emerged centuries ago in China. This representative money caught on because people could use it to pay for goods and services — and also redeem it for an underlying commodity. For example, currency in the United States was historically based on — and redeemable for — gold or silver. That ended in the Great Depression, when the Emergency Banking Act of 1933 stopped allowing citizens to redeem dollars.
The U.S. moved off the gold standard completely in 1971 for international transactions. And the dollar became a fiat currency. However, the Federal Reserve holds collateral that’s equal to the value of U.S. dollars in circulation in the form of government-issued debt.
Today, the Federal Reserve is required to hold collateral equal to the value of the dollars in circulation, and it does so using government-issued debt.
Alternatives to Fiat Currency
There are many alternatives to traditional fiat currencies, including something called “hyper-local currencies”, cryptocurrencies, and other tender created as a means of payment or exchange. Anyone, whether a company or individual, can create a form of tender (or payment) that can be used as an alternative to traditional currencies.
Alternative currencies don’t have to be regulated in order to function — all that’s required is for a group of people to agree to accept the alternate form of money as a store of value. For example, many businesses (e.g. airlines, credit cards) use systems of rewards and points that enable people to “earn” a kind of currency with that company that can be spent on other products.
What Are Hyper-Local Currencies?
Some areas of the world have independent forms of currency. In the Berkshires region, for example, there is a form of money called BerkShares, which is a way to stimulate the local economy. Similar examples exist in communities around the world, including in parts of England and Europe, where an alt currency was introduced to help support the local area.
Is Crypto an Alternative Currency?
Because most forms of crypto are highly volatile and can’t be used as actual payment for goods, services and other transactions, it’s an open question whether crypto can be considered a currency at all. Some forms of crypto are gaining traction as a form of payment, but the use cases are still somewhat rare.
Fiat vs Crypto: What’s the Difference?
Currencies basically serve two main purposes: as a medium of exchange and as a store of value. The rapid rise of investing in cryptocurrency has raised questions about whether fiat currencies will continue as the dominant medium of exchange.
Cryptocurrencies emerged almost a decade into the 2000s, with the launch of Bitcoin in 2009, the first and still the largest form of crypto. Cryptocurrencies are in essence virtual currencies that are part of the new DeFi, or decentralized finance, movement. They’re managed by a decentralized network rather than by a single authority, like government-issued fiat currencies.
Transactions made with cryptocurrencies are permanently logged on a ledger known as a blockchain. This ledger is viewable to anyone, therefore functioning as a public database. Because crypto transactions can be expensive, time-consuming, and complicated (to do business using crypto, you need a crypto wallet, for example) crypto may not be suited to real-world behaviors.
Fiat vs Crypto for Payment
Some proponents of cryptocurrencies argue that one day digital currencies will take over fiat money as the main mode of payment, because of their ability to deliver near-instantaneous transactions in some cases. They argue that if trust vested in a fiat currency is in the government backing it, trust vested in crypto is in the power of blockchain technology.
So far, though, cryptocurrencies haven’t really taken off as a medium of exchange. While some vendors and businesses accept crypto as payment, most transactions around the world are made with fiat currencies.
Critics argue that the volatility of cryptocurrencies like Bitcoin make them less ideal as a mode of payment. Imagine getting a paycheck in Bitcoin — such market fluctuations could dramatically magnify or shrink a person’s income in a matter of days.
Fiat vs Crypto as Store of Value
Cryptocurrencies like Bitcoin have arguably functioned more as a store of value, similar to how people have historically invested in precious metals.
Like precious metals, cryptocurrencies like Bitcoin need to be “mined,” which limits its supply. In fact, Bitcoin was designed with a cap on the number of coins that could be mined: 21 million.
Meanwhile, with fiat currencies like the U.S. dollar, the supply is potentially limitless. As of December 2020, there’s about $2 trillion or so of U.S. paper currency outstanding in the world. The Federal Reserve’s balance sheet— a proxy for the amount of money in the system — has grown by a staggering amount since 2007, as the central bank fought off recessions during the financial crisis of 2008 and the Covid-19 pandemic of 2020.
Meanwhile, speculators and investors have put money into the crypto market with the hope that their coins will maintain their worth or, ideally, increase significantly in value.
However, many others cite volatility as a reason why digital coins are not a reliable store of value.
What Are Central Bank Digital Currencies (CBDC)?
One potentially interesting development could be the advent of central bank digital currencies (CBDC) — virtual currencies that are created and backed by a nation’s central bank.
CBDCs sounds to some people like an oxymoron because cryptocurrencies by definition are decentralized and don’t have an authority backing them, but a January 2020 survey by the Bank of International Settlements found that 80% of central banks were researching and experimenting with CBDCs.
|Physical currency that’s issued and overseen by a central bank
|Digital currency that’s created by a decentralized system
|Can be used as a store of value
|Too volatile to be a reliable store of value
|Primarily used for real-world payments
|Rarely used for real-world payments
Could Crypto Take Over Fiat Money?
Could cryptocurrencies become so ubiquitous that crypto would replace fiat currency? It’s hard to imagine, given the current state of crypto. Cryptocurrencies are still highly volatile and risky investments. In order for the vast majority of people to use crypto to pay for goods and services, there would have to be more stability in the crypto market.
Pros and Cons of Fiat Money
Pros of Fiat Money
A major convenience of paper currencies is that they are easy to produce, carry around, and consequently, good at facilitating exchange.
Another plus is not being reliant on a physical commodity market like gold. This means the money system isn’t as susceptible to the risk of outside players manipulating a metal’s supply and demand in order to distort currency prices.
Arguably, the most important advantage of fiat currencies is that they allow central banks to control money supply. Deciding how much currency to print is a valuable tool when trying to manage economic cycles.
For instance, the Federal Reserve has a dual mandate of keeping both unemployment and inflation low. In order to keep unemployment low, the central bank can boost currency supply, and when that starts to spark inflation, the Fed can raise interest rates to tame price increases.
Cons of Fiat Money
The biggest risk to a fiat-currency system is that the central bank miscalculates or mismanages and prints too much money — a situation that could result in hyperinflation, when the rate of inflation grows at more than 50% a month.
Fiat Currencies and Hyper Inflation
A 2012 study by the Cato Institute found that some of the worst cases of hyperinflation include Germany after World War I, from which there are photographs of German children playing with bundles of money as building blocks, and Zimbabwe from 2007 to 2008, when prices of bread skyrocketed and people carried cash in wheelbarrows.
Most recently, in 2019, hyperinflation in Venezuela reached 1,300,000%, pushing the government to issue 50,000 bolivar notes, which equaled $8.13 in U.S. dollars at the time.
Investing in Cryptocurrencies
A fiat currency is issued by a government, while cryptocurrencies are digital and rely on blockchain technology. Examples of fiat currencies include the U.S. dollar, the euro, the yen, and most internationally traded currencies. While there are fewer than 200 fiat currencies in the world, there are thousands of types of crypto: e.g. Bitcoin, Ethereum, Polkadot, Dogecoin, Litecoin, and more.
Fiat currencies by themselves have no intrinsic value. Instead, it is up to a government and its central bank to preserve their value, while also ensuring that there’s a healthy supply for an economy to grow. In a way, cryptocurrencies are similar in that they don’t possess inherent value, but investor demand means that some forms of crypto do have value and some are even used as payments.
While people argue that cryptocurrencies could challenge fiat as a store of value and medium of exchange, that possibility is a long way off. Cryptocurrencies like Bitcoin have seen their prices and popularity jump. However, they haven’t yet become a common way for people to pay for goods. Volatility in the market has also made some investors believe that digital coins aren’t a good store of value, although many investors have faith that crypto will grow.
What are some examples of fiat currencies?
Most internationally traded currencies are fiat currencies: e.g. the U.S. dollar, the Japanese yen, the British pound, the EU’s euro, and so on.
Is Bitcoin considered a fiat currency?
No. Bitcoin is the oldest and still the largest form of cryptocurrency.
Why do they call it fiat money?
Because it’s backed by the authority of a governmental system (fiat means by an order or decree). It’s not tied to an underlying commodity such as gold or silver.
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