It’s one of the inevitable questions from people not involved in the blockchain and cryptocurrency space – how can they, being entirely digital, have any value, in terms we generally understand (like the gold standard)?
The basic properties of any currency considered ‘sound’ include durability, divisibility, fungibility, portability, recognisability and scarcity. Most of these apply to digital currencies, but scarcity is hard thing to impose in the digital world.
It is, however, important, as value comes from scarcity – think gold and diamonds.
Creating scarcity for cryptocurrencies was a major challenge.
Money is a measurement of value and a medium of exchange. It has become like a universal language; we just use it and take it for granted.
That change is the result of money’s relative scarcity and the impact on money's value of the increase in its supply is called inflation.
When countries suffer from inflation, you see volatility in prices and monetary value. That’s why we shouldn’t take the stability of sound money for granted.
If the key to money holding value is scarcity, how does cryptocurrency achieve digital scarcity?
To be scarce, there must be a limited supply of the commodity, and it can’t be easy to replicate. This can be relatively easy to achieve and assess when we talk about a physical commodity, but digital is a different world.
Digital material can be copied easily and cheaply – just ask the entertainment industry – which is why cryptocurrency is not simply a file you keep on your hard drive. If it was, it could just be copied and copied and copied, reducing scarcity.
All forms of digital currency, whether crypto or fiat, rely on an accounting system based on digital ledgers, which are an organised record of debits and credits against account holders, providing a running balance.
This shouldn’t worry you. Almost all fiat money only exists digitally (ie, everything in your bank account), so it is a system you already trust.
As an example, bitcoin (BTC) as a cryptocurrency is also based on a digital ledger. The crucial difference is the rules around if/when/how much new money is added to the system and how the ledger is maintained. It is these differences that change everything.
We can only consider money useful if the ledgers can be trusted as accurate and honest and supply is controlled.
For fiat currencies this is dealt with by the relevant government managing the ledger for its currency, controlling the physical creation of the money and allowing credit and debit relationships between itself, the banks and the people.
It achieves this by having a central bank with allows select institutions, like banks, to keep their own ledgers. When you add up all the credit in all the records of all the institutions, including the central bank, you know the total supply of that currency.
There is then a consensus that the only books we trust are those kept by these institutions, and that they will be maintained properly. We collectively agree they will meet their obligations and the rule of law.
The traditional money systems are held together by this authority-based trust, and we can use our money online because we trust that banks won’t let people cheat and spend more money than they have.
We have even trusted them to ‘create’ money, lending out more than the deposits they hold, and assuming risks for complex investment strategies.
Obviously, this is an oversimplification, but the general principles rely on trust. While it generally works, there are weaknesses – for example, money in a bank may be yours, but isn’t strictly in your control.
In addition, a single central point of failure is more vulnerable to corruption, manipulation and external pressure, opening the door to abuse, mismanagement, and economic exclusion.
The most worrying feature of fiat, though, is how it undermines scarcity.
Economic activity creates value, and that means new money must be introduced to allow the economy to grow. To oversimplify again, new fiat money is created by commercial banks, overseen by the central bank.
Common ways of this happening are:
- Providing credit, like loans, to new customers that become deposits
- Buying existing assets, which become deposits
- Providing overdraft facilities, which are deposits that can be spent
Getting the rationing right is a delicate balance; create too little money and spending slows, create too much and the value is diluted, putting prices up. This, in effect, is inflation.
This means human institutions are ultimately in charge of money supply, which in turn means there’s no real scarcity. To many, this means fiat currencies, by definition, cannot be considered sound money.
Centralised systems can be vulnerable, but, had been, arguably, the only way to make a secure digital money, but not a sound one. Then along came bitcoin, using this approach from the very beginning.