In 2021, El Salvador passed a law that made Bitcoin legal tender, as the US dollar. Meanwhile, one of the world's biggest financial markets, China, has been cracking down on crypto mining companies while planning to launch its digital currency.
Moreover, the cryptocurrency market is now valued at more than $1.56 trillion at the time of writing.
Traditional financial institutions have been taking more notice of the cryptocurrency market now that its popularity has increased with different investor groups. In the United States, these include names Goldman Sachs, Barclays, USAA, and many other retail investors. The market for trading and payments is becoming more popular with a growing number of point-of-sale machines that can settle purchases using digital wallets and cryptocurrency. However, the popularity of cryptocurrency also leads to an essential question: what will happen to fiat currency? Why are more people shifting from fiat to cryptocurrency?
First, what is Fiat Currency?
What is fiat currency? Fiat refers to circulating monies issued by the Federal Reserve (US dollar), the European Central Bank (euro), and the Bank of England (British pound).
Fiat is a type of currency that is not backed by a commodity such as silver and gold. This means that its value doesn't depend on these metals (or any other type of commodity). It doesn't have any intrinsic or use the value at all.
Instead, its importance in economics relies significantly on two factors: the Central Bank's value and the agreed exchange value when people use it.
As an illustration, a Benjamin or a hundred dollars is equivalent to 100 dollars because the government maintains it as such. Buyers and sellers also consider it to be equal to $100. This won't change whether the demand for such money increases or not.
In the past, under the Bretton Woods Agreement of 1944, the US dollar’s value was pegged to the value of gold. However, it ended in the early 1970s when President Nixon axed the US dollar’s convertibility to gold.
This is where cryptocurrency differs and is turning traditional finance on its head. Where Fiat money supplies are controlled and issued by governments and banks and are usually opaque in nature, cryptocurrencies are run in a global decentralized manner will all participants considered equal. There is no central bank, chairman of the board, or agency that controls a cryptocurrency outright. Some less popular cryptocurrencies are considered centralized, but for the benefit of this article and examples, we’re focusing on Bitcoin and Ethereum.
Each blockchain and its corresponding token have rules written into its source code for people to see, audit, and understand in a decentralized manner. Communities and miners vote on changes to the code, and a 51% majority will effect a change or upgrade to a blockchains protocol.
Blockchain governance will dictate when new tokens are minted, when miners are paid their transaction fees and rewards, how many tokens are in circulation, and how the protocol should develop long term. These factors, as well as levels of trading and on-chain activity, will affect a coin's price through peaks and troughs, giving investors and traders reasons to invest in cryptocurrency.
So, at first glance, fiat money may be less volatile than crypto through government policy and intervention, not a decentralized free market like Bitcoin. Thus, why are people so interested in shifting from fiat to cryptocurrency? Answer: inflation.
Inflation: Its effect on Fiat Currency
Inflation is a term used to describe when the purchasing power of a currency decreases concerning goods and services. This purchasing power decreases when the circulating currency supply being issued or “printed” by a government or central bank is substantially increased and released into the banking system. The increased supply pushes up the price of products and services within an economy, affecting people's cost of living. Everything from the price of bread and the size of a chocolate bar to the fuel price is influenced by inflation. The most straightforward example of inflation is to think back to when you were young. Did you ever go to your local shop and buy ice cream or a can of cola? How much did it cost back then? What does it cost now?
Economic experts use tools such as consumer price indexes to determine the possible inflation rate for any given month or quarter of a year and where inflation can be expected to reach in the future when combined with other financial data such as country GBP output, importing, and exporting of goods and services as well as GBP of competing countries globally.
Inflation rates can fluctuate in many ways. Between April 2020 and April 2021, the consumer price index went up by over 4 percent, which means that, during this period, inflation also increased. The cost of goods and services is more expensive compared to the previous year.
How does inflation impacts Fiat Currencies?
Fiat currency carries its value because the parties involved in a transaction consent to its value. The two parties could be two people, a person and a merchant such as a store or a shop. All these parties "trust" the value of the British Pound, US Dollar, or Euro to facilitate a trade of goods and services and "trust" they can buy the things they need with that currency in the future for the same value. The problem with inflation is, that fiat’s perceived value can decrease.
According to Equitable, within two decades, an inflation of 4 percent a year has reduced the value of 1 dollar to around $0.44. This also means that the cost of $1 in 1977 now costs you $4.48 today to purchase the same item.
In some instances, a country can experience a fiat crisis like hyperinflation, suggesting that the inflation rate is 1,000 percent or more than fiat money becomes virtually worthless. Hyperinflation occurred in Germany in the 1920s after the First World War with high government debt and reappropriations owed to other countries. In recent years, the same thing is happening in Venezuela.
For this reason, cryptocurrency is becoming a more viable option to make payments and investments, which they view as a possible hedge against inflation. Why? Nearly every asset, stock, share, or commodity on the planet is valued against the US Dollar as a primary settlement currency. As more US Dollars are printed, the value of these assets goes up, but the buying power to acquire them decreases.
This article doesn’t imply trading and investing in crypto is better than investing in traditional markets. Crypto offers a different set of value propositions, financial instruments, and decentralization free from market tampering, some forms of regulation, and a level playing field for all participants. Crypto is currently a volatile and infant market. With regulation on the rise and new participants and institutions joining the market every day, cryptocurrency and tokenization have a real chance to replace every traditional need on the planet… Eventually.