What are Fiat currencies and how do they work?

As the crypto industry has grown exponentially over the past few years, new terms have emerged, including “fiat”. Some currencies can be called fiat, but fiat does not mean crypto. So what exactly is fiat money and what is its role in our modern times?

What is Fiat currency?

Simply put, a fiat currency is issued by a government but is not backed by a physical asset. In the past, national bidding was tied to collateral such as gold, silver or oil. But as economies grow and inflation rises, the ability to use physical collateral diminishes. This is one of the reasons why fiat currencies came into being.

The term “fiat” is used because it describes a kind of formal fiat. Therefore, when a government issues any type of currency, it does so via fiat. The great thing about fiat currency is that it essentially gives governments more economic control. This is because governments can decide how much of a given fiat currency they wish to print or mint.

Today, many currencies that you are probably familiar with can be considered fiat currencies. The British Pound, US Dollar and Euro are all issued by the government and considered national rates, but have no tangible guarantees.

close up of an american dollar bill

Unlike precious metals and other valuable resources, fiat currency is valued by the government that issues it. After all, a dollar bill is just a piece of paper if its subjective economic value is stripped away. Try paying for a taxi with a US twenty dollar bill in Spain, and you will also see how fiat currency depends on its economy of origin.

But fiat money has not always been so dominant. The US dollar, for example, was once backed by gold. This was called the “gold standard”. Between 1879 and 1933, the United States directly tied the price of the dollar to a certain amount of gold. But the Great Depression of 1929 made it impossible to maintain the gold standard and the system quickly collapsed. Since then, the US dollar has not been directly backed by gold or any physical collateral, for that matter.

The term “fiat” has been around for over 150 years, although fiat currency has been around since the Song dynasty of 11th-century China, when notes began to represent financial value. It was only centuries later that this form of currency began to become central to national economies.

But with the rise of cryptocurrency in the 2010s and 2020s, the term “fiat” has become more widely known around the world. So why is this the case?

Fiat and Crypto

bitcoins on our bills

In recent years, you may have heard the term “fiat” mixed up in the realm of crypto. But that doesn’t mean that all cryptocurrencies are fiat. In fact, most are not. A fiat currency must be issued by a government, while most cryptocurrencies are created by non-governmental individuals or groups.

Bitcoin, Ethereum, Litecoin, Dogecoin, and hundreds of other crypto assets are considered non-fiat, although there is now debate over whether Bitcoin should be given this title.

Indeed, in 2021, the South American nation of El Salvador adopted Bitcoin as legal tender. Although the Salvadoran government did not create Bitcoin, the decision to adopt this asset as legal tender brings into question whether Bitcoin can be considered fiat in this specific country, and it certainly is. . The Salvadoran government has declared Bitcoin its main fiat currency, along with the US dollar.

But El Salvador is not the only country with a vested interest in digital currency. Amid a wave of hyperinflation starting in 2016, the Venezuelan government struggled to find an alternative to its national currency, the bolivar. To cover this drastic drop in the value of the bolivar, the government issued a new currency, a cryptocurrency known as petro (₽).

Bitcoin representation in front of a screen

While oil was initially thought to be backed by oil, this turned out not to be the case. In fact, petro is not backed by any physical assets, making it another example of digital fiat currency. While Venezuela still uses the bolivar, the petro is now another form of legal tender that residents can use in the country.

The reason crypto and fiat currency have become so intertwined is that the two are very often compared or mentioned together. For example, an exchange may state that you can trade on its platform in both crypto and fiat.

There is also a lot of controversy surrounding these two types of financial assets. Some believe cryptocurrency is doomed, while others view government-issued fiat currency as bad news due to public distrust of legal authorities.

The confusion of stablecoins

But not all cryptocurrencies are backed by anything. While this is the case for standard cryptos like Bitcoin and Ethereum, another breed of cryptocurrency uses physical collateral.

USDT Representation

These assets are often referred to as stablecoins. However, it is important to note that not all stablecoins are backed by warranties. There are different types of stablecoins, some of which have no type of tangible backing. But let’s talk about a stablecoin backed by physical collateral: Tether Gold.

You may have heard of Tether (USDT) before. It is an incredibly popular stablecoin pegged to (but not backed by) the US dollar and backed by reserves from Tether Limited Inc. But to keep things simple here we are going to discuss Tether Gold, a stablecoin backed by, you guessed it, gold.

Each Tether Gold token, or XAUT, is worth the same amount of money as one troy ounce of gold. The currency is backed and pegged to gold, which means that Tether Limited Inc. has its own gold reserves, which are currently held in Switzerland.

But although Tether Gold is backed by a physical asset, it is not issued by the government, which means it is not considered fiat currency.

How Fiat currency is used

two laptops facilitating the purchase transaction

Unlike most cryptocurrencies, fiat currencies can be spent in different ways. As mentioned earlier, many countries now use fiat currency as legal tender, so its use is somewhat endless. The British pound, for example, can be used to buy anything in the UK. It is also used in loans, mortgages, gifts and insurance.

In short, if a fiat currency is nationally tender, it can be used in countless ways within its legal region.

But, as we already know, fiat currency is not very versatile internationally. So it’s nothing less than crucial in the economy (or economies) that legalized it, but its value fluctuates wildly depending on the issuing country and where it’s spent. Therefore, most fiat currencies are subjective and their value depends on where you are.

Fiat currencies dominate the economy

Today, it is undeniable that fiat currencies are inherently crucial for most countries. Although no type of valuable physical asset backs this currency, it still claims to dominate the global economy and plays an important role in each of our lives.

About Shirley Hudson

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