The evolution of fiat money: From traditional currency to cryptocurrency

The history of money is a varied story of money’s evolution from simple barter systems that involved exchanging goods with a resource-scarce to that locality, for example, glass beads or seashells, to modern digital currencies today. Overall, the journey of money reflects our technological advancements and changing economic needs, including the historical transition from the gold standard to fiat money. In this article, we look at the stages of the development of money from traditional fiat money to cryptocurrencies.

Exploring what is fiat currency and its examples

The fiat money that forms the basis of today’s economies has no intrinsic value and is not backed by any tangible physical commodity. What is fiat money? It is a government-issued currency not backed by any physical commodity. Instead, fiat currency is supported by the government “fiat” – that is, by the authority of the state and the people’s confidence in that authority. The value of fiat money is determined by the dynamics of supply and demand, as well as the stability of the issuing government.

The US dollar (USD) is the best-known example of fiat currency and is a world reserve. The US dollar is the most potent currency in international business, trade, and finance. In particular, countries facing economic turmoil could opt to adopt the USD (or its pegged currency) as their medium of exchange. Using the currencies of countries with stable economies is a common way for people to hedge against local economic instability, such as in the case of Venezuela; because their currency experiences hyperinflation, people turn to using USD instead.

Similarly, following one of the highest rates in hyperinflation history across the globe, Zimbabwe eventually gave up on its local currency and turned to foreign currencies (primarily USD). Zimbabwe has recently begun using a gold-backed currency known as the ZIG—short for Zimbabwean gold.

Fiat money definition

The following are the critical characteristics of fiat money

1. Legal tender: Fiat money is created by government regulation and stipulated to be recognized by all in that country as the legal means of payment for goods or services
2. No intrinsic value: Fiat money is not supported by national physical material. Its value is derived entirely from supply and demand and driven by trust. Historically, paper money was originally redeemable for physical commodities, contrasting with today’s fiat system that operates without such backing.
3. Centralized: Fiat money is controlled by the central banks and monetary authorities that issue it.
4. Flexible supply: governments or central banks can increase the supply as they wish (according to monetary policy). Additionally, a commercial bank creates modern fiat through fractional reserve banking and lending.
5. Inflation risk: Fiat currencies, if not well managed, can be subject to inflation.

Examples of fiat money

While the US Dollar is perhaps the most well-known fiat currency, there are numerous other examples globally:

1. Major global currencies: The Euro, Japanese Yen, British Pound, and Chinese Yuan are some of the fiat money currencies used in the worldwide market and finance.
2. Digital representations: It is also important to point out that most of the fiat money in the current world is in the digital form in the banking sectors rather than the cash monetary form. For example, the balance of the money in the bank account is an example of fiat money in digital form. Government’s across the globe mandate using fiat money to pay taxes, for example,  creating a guaranteed demand for it.
3. Payment instruments: Credit and debit payment cards, as well as any other cards, are not fiat money but tools to transfer fiat money and, therefore, are part of the digitization process of the fiat system.

The role of representative money in the fiat system

Even though the modern world has adopted fiat money, discussing the idea of representative money and its link to fiat systems is necessary. Representative money is a type in which the money proper has no intrinsic value and is only a token of some other value object.

The significant difference between fiat and representative money is what backs it. Fiat money is supported by the government’s word and the public’s confidence in that word, while representative money is backed by an asset or a promise of value in the future.

Earlier, representative money played a crucial role in developing contemporary money systems. Some of the examples of representative money are gold and silver certificates. These certificates were evidence of the right to receive a specific quantity of precious metal held in the bank or government that issued the certificate.

In today’s economy, while pure representative money is less common, we can still find examples that share some characteristics:

1. Gift cards, prepaid cards, or tokens represent a right to goods or services from a particular retailer. One of the most well-known examples is MacCoin – issued by McDonald’s in 2018 as the world’s first food-backed currency that can be exchanged for BigMacs in more than 50 countries worldwide.
2. Gold/silver certificates: Although less common, some countries still issue certificates representing a claim on precious metals.
3. Certain bonds: Treasury bills and other bonds can be seen as representative money, representing a claim on future money.

Transition to the fiat money system

The transition from a currency entirely backed by commodities to one consisting purely of fiat money began in the 20th century, marking the end of the gold standard. The most notable incident was the Bretton Woods agreement, a system that came into being in 1944 due to the post-World War II economic and political order. Under this system, most of the world’s currencies were pegged to the US Dollar, which was convertible to gold. This was possible because, during World War II, the United States had amassed a huge percentage of the world’s gold stock.

But then, in 1971, President Nixon took a pivotal action in abolishing the dollar’s convertibility into gold internationally. This shocked the world. Its effects, however, have been limited mostly to the monetary and financial realms. When the American economy was performing well, this situation enabled the world to have a stable monetary regime. Now, without gold and using the dollar and American credit freely, the new regime must also be internationalized. Here, the United States provided information on how it could be brought about.

Several factors drove the transition to fiat money system:

1. Economic flexibility: Many countries were constrained by commodity-backed systems from using monetary policy to address economic issues.
2. International trade: Developing global trade then needed a more flexible monetary framework than commodities could offer.
3. Economic growth: Developing countries require more money than commodity-backed currencies would allow them to create.

Overall, the advantages of this transition include:

1. Increased monetary independence: Monetary tools came under the direct control of the government.
2. Economic management: Fiat systems provided better possibilities to counteract recessions and other financial obstacles.
3. International trade facilitation: The use of fiat currencies, due to increased trade and currency markets, also fostered globalization.
4. Currency manipulation: Some countries, such as Germany, could manipulate their currency to make their exports cheaper.

However, the transition also brought challenges:

1. Inflation risk: Commodity-based systems are naturally limited in the ways fiat currencies are not, but the downside is that fiat currencies are more prone to inflation if they are not regulated properly.
2. Dependence on trust: Fiat systems depend on the public’s confidence in the government and financial institutions.
3. Economic vulnerabilities: Fiat money is vulnerable to speculative attacks and economic disturbances, as evidenced in the George Soros attack on the British Pound in 1992.

The evolution of fiat currencies – from traditional fiat to digital

Over time, the way fiat currency has been managed and utilized for various transactions has evolved along with technology. The value of fiat money depends on the dynamics of supply and demand, as well as the stability of the issuing government, rather than being tied to a physical commodity like gold or silver. Important technological developments in managing fiat currency are as follows:

1. Banking infrastructure: The development of advanced banking systems, a real-time settlement system, and an automated clearinghouse has made financial transactions faster and more efficient.
2. Electronic payments: The proliferation of electronic payment systems and consumer online banking has meant that individuals and very small businesses often have many resources to help them manage cash flow and transact.
3. Security: In the same way, the physical currency has gone through transformation by integrating security threats like hidden holographic designs and color-switching ink, etc. to reduce counterfeit practices

Developments like these have laid the foundation for fiat currencies to become more digitized, with classic physical cash lines blurred by digital value versions.

The shift from fiat currencies to cryptocurrencies

The next step in the monetary journey is cryptocurrencies, which come in many types but ultimately use some version of blockchain technology.

Some of the key differences between fiat currencies and cryptocurrencies are;

1. Decentralization: All cryptocurrencies operate on some version of a decentralized network or blockchain
2. Supply: Most cryptocurrencies do not have a constant currency supply (like the fiat money system) but rather have a fixed amount of tokens
3. Transparency — Blockchain technology makes most cryptocurrency transactions easily traceable
4. Global accessibility: Cryptocurrencies can provide services of financial institutions to the world’s financially excluded populations.

The impact of cryptocurrencies on traditional financial systems could be profound:

1. Financial inclusion: Millions of unbanked people on earth could become part of the world economy by transacting using cryptocurrencies, bypassing the need for a bank’s infrastructure and services.
2. A monetary policy: Some cryptocurrencies, such as Bitcoin, have a limited number (even lower than the current global population), making deflation an issue that is not easy to handle by traditional monetary policy models.
3. Cross-border transactions: Cryptocurrencies have the potential to challenge international money transfers, making them faster and cheaper.
4. Store of value: Cryptocurrencies, particularly Bitcoin, for specific individuals might be used as ‘digital gold,’ which means they can be utilized as a store of value and safeguard against inflation and other economic activities.

Barriers to entry the world of cryptocurrencies

The world of cryptocurrencies poses several major challenges for the potential consumer. For starters, the industry is filled with a lot of technical terms and processes that are hard to comprehend, especially for new entrants into the crypto market. Some of the most common confusions may be related to wallet numbers, swaps, gas fees, the use of dApps or the irreversibility of blockchain-based transactions. 

Next, the fluctuation in the value of both major and minor cryptocurrencies is very high. This poses a lot of risk to the proposed everyday use of cryptocurrency as money or an asset with utility, which is the sales pitch in most cases.

Lastly, one of the most critical challenges that can be identified is the problem of on and off-ramping of crypto, that is, the conversion of fiat to crypto and vice versa. This is mainly due to the lack of widespread integration between TradFi and the crypto space, which presents a challenge to users trying to switch between these two financial domains. The most common consequence of this disconnect is an overwhelming amount of blocked withdrawal payments. You can read more about on and off-ramping crypto here.

Regulatory responses and the global dynamics of fiat currencies

The emergence of cryptocurrencies has provoked diverse reactions from governments and central banks worldwide. These responses include adopting the technology, setting strict guidelines, or banning it.

The Markets in Crypto-Assets (MiCA) regulation is the most extensive crypto policy in Europe. This framework is intended to give legal clarity to crypto-assets that are not covered by financial services legislation.

Another response to the crypto revolution is Central Bank Digital Currencies (CBDCs). Three nations have deployed their CBDCs, while 36 nations have commenced CBDC pilots, and 30 are in the experimentation phase. CBDCs are a central bank’s effort to retain power over monetary structures while using digital currency’s advantages.

In the United States, the regulatory landscape for cryptocurrencies remains complex: In the United States, the regulatory landscape for cryptocurrencies remains complex:

1. The recent decision in the Chevron case may have restricted the Securities and Exchange Commission (SEC) ‘s power to police cryptocurrencies as securities.
2. But the legal environment remains ambiguous, exemplified by President Biden recently rejecting the latest comprehensive crypto bill in Congress.

The development of CBDCs brings its own set of considerations:

1. CBDCs will be issued by central banks and thus may be more stable than private cryptocurrencies.
2. They might give governments more direct control over the money supply.
3. In more authoritarian countries, it can be an instrument of financial supervision and regulation, which is not excluded.
4. CBDCs could be helpful for interbank transactions and could revolutionize consumer and business banking. This may necessitate new economic models to replace fractional reserve banking.

Conclusion

The way that money has changed from fiat currency to digitalization and cryptocurrency is a clear indication of the progress of our financial systems. At present, we stand in the middle of the road, where fiat currencies represented digitally are widely used in people’s daily lives, cryptocurrencies are emerging, and governments are considering CBDCs. Read more about this crossroads in the article Partnership rather than conflict: Our future for crypto.

This evolution has its advantages and disadvantages. The advantages include higher speed and effectiveness of digital transactions, the possibility of expanding access to financial services through cryptocurrencies, and the improved monetary policy instruments provided by CBDCs, which are weighed against the privacy risks, stability of the economy, and shift in the position of traditional financial institutions.

As we proceed from here, one thing becomes evident: the future of money will be fashioned through the interaction of these several types of money. From the deepening of fiat currencies’ digitalization to the adaptation of cryptocurrencies by regular consumers to the emergence of CBDCs, the ways of money perception and utilization are to evolve in the following years. Read more about this in the article Why without Web 2.5, there’ll be no Web 3.0.

Both consumers and companies must keep abreast of these developments and their implications. Systems such as virtual accounts and instant settlement networks may be developed in the future, and they would present an opportunity to improve financial management and transaction conduct.

Money and its use are in a never-ending process of change. We are on the cusp of new and possibly transformative developments in managing our money, making it an excellent time to be involved in the intersections of finance and technology. The decisions that are made today at the personal and organizational levels, as well as at the national and international levels, will define the future of money and, therefore, the future of the world economy.

Frequently asked questions

What are some historical examples of fiat money?

Some examples of fiat money include flying cash, which was used in China around 800 AD by the Tang dynasty. Another example is the continental currency, issued in 1775 by the American Continental Congress during the American Revolutionary War. The French assignats were also circulated between 1789 and 1796 during the French Revolution and are also regarded as fiat money. Overall, history has many, many examples of fiat money.

Is Bitcoin a fiat currency?

Bitcoin is not a fiat currency. Fiat currencies are issued and regulated by a government or central bank, characteristics that do not define Bitcoin. Bitcoin’s value, on the other hand, is more grounded in the scarcity of the coins and the faith that people have in the currency, as well as the technology behind the currency.

What is currency backed by today?

Today’s most used currency is fiat money, which has no intrinsic value but is backed by the confidence people have in the government that issued it. They are based on the sound financial position of the government that issues them, the strength of the economy of the country of issue, and the confidence that the public has in the currency both as a medium of exchange and as a store of value.

What is the global-backed currency?

There is no backed currency in the traditional sense in the world today. The U.S. Dollar is the global reference currency and the most utilized currency for trading. It is a fiat currency, and it is not supported by any physical asset. Others have claimed that gold has a place as a ‘backed’ global currency, but it is not currently used as a currency in the contemporary sense.