Cryptocurrencies are receiving a lot of publicity, including stories of ‘bitcoin millionaires’ and ‘mining operations’ raising images of a latter day gold rush. But cryptocurrencies probably remain a bit of a mystery to many.
This FlagPost provides a brief and simple explanation of why cryptocurrencies (cryptos) have both the form and function of money, but do not function as well as normal government-backed (fiat) money.
The FlagPost does not address the benefits and costs of a cashless economy, the technical aspects of the theory of money, the goals and mechanisms of monetary policy or how specific cryptocurrencies, such as Bitcoin, work.
The functions of money
In barter economies goods and services are traded directly—money is not used. However, direct barter becomes increasingly difficult as the number and quality of goods and services increases. Money is needed to better enable efficient transactions. For money to be useful it must serve three functions:
The forms of money
Money based on a commodity—such as gold, copper, tea or tobacco—is called commodity money. It faces two major problems as a form of money.
First, commodities have intrinsic value and thus command their own price. The price of the commodity interacts with, and impacts on, its ability to act as a consistent means of payment: a potentially volatile price creates a potentially volatile unit of value. This feature also results in commodity money being unstable as a unit and store of value.
Second, the physical supply of commodity money is restricted to a finite, or slowly increasing, quantity. This means that the price of commodity money will rise as the demand for money increases. This can occur when trade expands or when the demand for credit grows. In other words, the demand for commodity money may result in inflation, suppressed trade or restricted credit.
To overcome the problems inherent in commodity money, by the 1970s governments had almost universally replaced commodity money (represented by the gold standard) with fiat money. Fiat money is not linked to a commodity; it is a decreed legal tender by government fiat, or law. Unlike commodity money, fiat money has no intrinsic value and its supply is not limited. Governments can issue or withdraw money from the economy without being constrained by the price of a commodity (by buying and selling bonds, for example). This is useful for macroeconomic management.
Advanced computing technology has enabled the creation of digital or cryptocurrency, often represented as a virtual ‘token’ or ‘coin’. Cryptos are primarily used to buy and sell goods and services, but possess no intrinsic value. The word ‘cryptocurrency’ is derived from the encryption techniques used to secure the underlying networks. Unlike fiat money, issued by sovereign governments, cryptos are created and controlled by a dispersed user group.
The uniqueness and validity of each online transaction using fiat money is verified and cleared through a third-party payment system. The Australian Payments Network, for example, allows some degree of monitoring and control by government. By contrast, transactions using cryptos are verified by a dispersed user group and cannot easily be monitored and controlled by government.
When a crypto is bought or sold it must be verified as a unique transaction. For example, it should not be possible to sell the same crypto to two different users at the same time. The process usually involves two main steps:
- first, each transaction is sealed with a highly complex digital signature (a hash function). The digital signature must include details of the transaction and all previous transactions in a blockchain that is available to all users and potential users
- second, each transaction must then be verified as unique, and fraudulent transactions discarded. Specialised user groups verify digital signatures (and thus also the blockchain) as a true record of the transaction and are rewarded with a crypto (or a fraction of a crypto) for their efforts. In this way cryptos are created, or mined. Those involved in the verification process are called ‘miners’.
Because cryptos are in effect ‘mined,’ their supply increases slowly, often not keeping up with demand which can put upward pressure on the price of the crypto. In addition, the crypto market dynamic is influenced not only by demand and limited supply of one crypto—for example Bitcoin (of which there will only be 21 million)—but also by the price of other cryptos.
The future of cryptos
Cryptos strongly resemble—and suffer from many of the same problems as—commodity money. In particular:
- the limited supply of cryptos makes them unsuitable for large volume transactions—they cannot be regarded as universal ‘means of payment’
- the intrinsic value of cryptos along with the market dynamic between different cryptos could result in possible large price fluctuations making them unsuitable as a means of measuring and comparing prices of other goods and services—they are not a good ‘unit of account’
- potentially large price fluctuations mean that cryptos are not an ideal measure of wealth or long-term assets—they do not perform well as a ‘store of value’.
Holding crypto is similar in many respects to holding gold coins, but in a ‘virtual’ vault rather than a physical one. Cryptos, in their various forms, are just another traded commodity that can be converted into fiat money relatively easily. However, cryptos can be used for transactions outside government oversight.
Disillusionment with fee-collecting third parties, the fear of government control over the money supply, and the belief that the fiat money system will eventually collapse, have all been proffered as arguments in favour of cryptos.
However, faith in the crypto market is only as strong as the collective belief of the user base—comments made by large holders of cryptos can affect consumer expectations of their value, leading to significant spikes in the market.
It is unlikely that cryptos will entirely replace fiat money, even in a cashless economy.