What Are Fiat Currencies and How Do They Work

As the crypto industry has grown rapidly over the past few years, new terms have arisen, including “fiat”. Some currencies may be referred to as fiat, but fiat does not necessarily mean crypto. So, what exactly is fiat currency, and what role does it play in our modern times?

What is fiat currency?

Simply put, a fiat currency is issued by a government but not backed by physical assets. In the past, national tender was linked to collateral, such as gold, silver or oil. But as the economy grows and inflation increases, the ability to access physical collateral decreases. This is one of the reasons why fiat currency came about.

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

Today, many of the currencies you are familiar with can be considered fiat currency. The British pound, US dollar and euro are all issued by governments and are considered national tender but have no tangible collateral.

Unlike precious metals and other valuable resources, fiat money is given value by the government that issues it. After all, a dollar bill is just a piece of paper if stripped of its subjective economic value. Try paying for a cab in Spain with a twenty US dollar bill, and you’ll also see how dependent fiat money is on its core economy.

But fiat money was not always so influential. The US dollar, for example, was once backed by gold. This was known as the “gold standard”. Between 1879 and 1933, the United States directly linked the value 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 soon collapsed. Since then, the US dollar is not backed directly by gold or any physical collateral, for that matter.

The term “fiat” has been around for more than 150 years, although fiat money has been around since the Song Dynasty of China in the 11th century, when notes began to represent financial value. It was not until 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” became more prominent around the world. So, why is it so?

Fiat and crypto

In recent years, you may have heard the term “fiat” associated with the crypto realm. But this does not mean that all cryptocurrencies are fiat. In fact, most are not. Fiat currency must be issued by a government, whereas most cryptocurrencies are created by non-governmental individuals or groups.

Bitcoin, Ethereum, Litecoin, Dogecoin, and hundreds of other crypto assets are not considered fiat, although there is now some debate as to whether Bitcoin should receive that title.

This is because, in 2021, the South American nation of El Salvador adopted bitcoin as legal tender. Although the government of El Salvador did not create bitcoin, its decision to adopt this asset as legal tender raises the question of whether bitcoin can be considered fiat in this specific country – and it certainly is. The El Salvadorian government has declared bitcoin as its main fiat currency, alongside the US dollar.

But El Salvador isn’t the only country that has a vested interest in digital currency. Amid a wave of hyperinflation that began in 2016, the Venezuelan government was working to find an alternative to its national currency, the Bolivar. To prevent this drastic reduction in the value of the Bolivar, the government issued a new currency – a cryptocurrency known as the Petro (₽).

While it was initially thought that the Petro was backed by oil, this turned out not to be the case. In fact, the Petro is not backed by any physical asset, making it another example of a digital fiat currency. While Venezuela still uses the bolivar, the Petro now stands as another form of legal tender that can be used by residents within the country.

The reason why cryptocurrencies and fiat money get mixed up so much is that the two are often compared or mentioned together. For example, an exchange may say that you can trade both crypto and fiat on its platform.

There is also a lot of controversy regarding these two types of financial assets. Some think the cryptocurrency is set to fail, while others see government-issued fiat money as bad news due to public distrust of legal authorities.

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