- Source: CVM
Much has been written about how cryptocurrencies are changing the way we use money, and how they are even changing our very idea of what money is. But to understand exactly how and why this is so, we need to go back to basics and ask ourselves: “what is money and how does it work?”
By its most basic dictionary definition, money is “something generally accepted as a medium of exchange, a measure of value, or a means of payment”. Economists expand on this definition and say that money is not only a medium of exchange, but also a unit of accounting and something that can be used as a store of value. Money is a medium of exchange in the sense that we all use it to pay for goods and services and accept it as payment for our labour and other ways we create value. Money functions as a unit of accounting, a simple and widely accepted way of identifying and communicating the value of a unit of item or service. When we place a price on something, it is easy to understand and compare that price, as we all agree value of a dollar, or a yen, or any other currency that is widely accepted where the transaction is taking place.
As a store of value, money provides a convenient, easily transportable, and easily divisible, physical object that directly represents an agreed upon value. So when we get paid, the value of our labour is represented and stored traditionally in the monetary form of coins and notes, as well as in the digital form where we can transfer between bank accounts for payment for goods and services. But before we start examining cryptocurrency, we also need to understand how money derives its value to enable everyone to accept and agree upon that value. In this sense there are three types of money which can be defined by how their value is derived: commodity money, representative money and fiat money.
- Source: Medium
Commodity money, perhaps the oldest form of money, is an actual good or commodity that has a practical use beyond simply representing value. For example, our word salary comes from the ancient Latin word for salt. It is often claimed that this is because Roman legionnaires were at times paid for their service in salt. Salt was a much sought after commodity in the ancient world with many different uses, so it could be readily exchanged for other goods. Even in the present day, many cultures use animals such as pigs or cows as a form of commodity money, exchanging them in return for other goods or services.
Next, there is representative money, which is a form of money that can be directly redeemed for a valuable commodity. Typically gold and silver were used to back the value of a currency in the form of paper money. Countries would store vast amounts of these precious metals commensurate to the value of paper money circulating in their currency system. In this system, paper money was valuable because it could be readily exchanged with the government that issued it for a commensurate amount of gold or silver.
The most common form of money, and the one which we use every day, is known as fiat money. It gains its value solely by a government decree (or “fiat”) saying that it has value and is “legal tender” within a particular country. It can be in the form of paper money or coins, or it can be represented electronically, such as with bank deposits and credit cards. The government controls the supply of fiat money. It can be used to pay your expenses and the global market determines its value in relation to other national currencies and commodities.
Now we get to cryptocurrencies, which have only been in existence for about a decade. Although cryptocurrencies can perform many of the same functions of money, the way they are created and assigned value is quite different to other forms of money that came before them. A cryptocurrency is a digital asset, with no physical existence other than lines of code, and designed to work as a medium of exchange. The prefix “crypto” arises from the use of cryptography as a means of securing financial transactions in which the currency is used. This complex cryptographic process also controls the creation of additional units of the currency, as well as accurately verifying all transactions, typically on an immutable public ledger known as a blockchain. Cryptocurrencies are also defined by their decentralized control, where many separate parties use a consensus model to determine the state of the currency, rather than being controlled by a central government or bank. For more detail about how cryptocurrencies are created and controlled, we recommend that you read our other articles on the topics of blockchain and cryptocurrency.
Cryptocurrency is not considered legal tender (with the exception of Japan, which recognises bitcoin as legal tender within its borders) and unlike fiat money, its supply is controlled by an algorithm instead of how much paper money is printed. Despite these differences, the way cryptocurrencies function is quite similar to fiat currencies and they often provide even more functionality than cash. They can be used to transfer value across international borders without regulation or conversion. They can be used to buy things and pay for services. Due to their decentralised nature, they can also be more resistant to manipulation, fraud and deflation.
Bitcoin is currently the most recognised cryptocurrency in the world. It may soon rise to becoming the global mainstream currency of choice, because of its increased functionality and its potential to improve international trade in goods and services to become easier and more efficient. Like fiat currency, bitcoin gets its value from confidence – in other words, from people agreeing on its value and willingness to use it as a medium of exchange. With rising adoption of cryptocurrencies all over the globe, it’s only a matter of time before they replicate or replace many traditional fiat currencies, creating a much more interconnected and dynamic global economic system.