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June 12, 2016
An Everyman's Guide To Understanding Cryptocurrencies
Cryptocurrencies Are Digital Currencies That Are Not Issued by Governments
What’s a cryptocurrency? Wikipedia’s definition is “a medium of exchange using cryptography to secure the transactions and to control the creation of new units.” Cryptocurrencies exist only in the digital realm; there are no physical coins or paper notes.
Cryptocurrencies have no intrinsic value. They share this characteristic with fiat currencies issued by governments/central banks:
“Fiat money is currency that a government has declared to be legal tender, but is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith. Fiat is the Latin word for “it shall be.”(Source)
Though major central banks own gold, the currency they issue is not “backed by gold,” i.e. it cannot be converted into gold upon demand.
The value of fiat currency is a function of supply and demand. There are many sources of demand for currency: governments demand taxes be paid in their fiat currency, for example, and this creates demand for the currency.
There is however only two sources of supply: the central banks of nation-states (or regional unions like the Eurozone) and private banks in fractional reserve money systems that enable banks to create new money via issuing new loans.
In a fractional reserve banking system, if a bank has $10 in cash deposits (i.e. in reserve), it can issue a new loan of $100. This loan is new money that was created out of thin air. When the loan is paid in full, this new money disappears from the system.
When central banks or states issue new currency in excess of what the economy is actually producing, the supply overwhelms demand and the currency’s value (i.e. purchasing power) falls accordingly. Venezuela offers a present-day example: the official exchange rate of the Venezuelan bolivar is 10 to the U.S. dollar (USD), but the “street”/black market value is closer to 1,000 to 1 USD. (My correspondents in Venezuela report that it is illegal to post the black-market exchange rate on a website.)
Governments typically restrict alternative currencies to protect their monopoly on money issuance: residents must use the government-sanctified currency or face prosecution and prison.
The U.S. government has declared bitcoin is a commodity (i.e. property) rather than a currency. Other nations have banned bitcoin (presumably out of recognition that it is an alternative currency outside their control.)
Why does bitcoin have any value at all? There are two basic reasons:
The supply is limited. The design of bitcoin limits the total number of bitcoins to 21 million. (If you really want to know why this is so, you’ll need to understand the blockchain and bitcoin mining, topics that are beyond the scope of this article.) At present, there are over 15.5 million bitcoins in circulation, roughly three-quarters of the eventual issuance of 21 million.
There is demand for bitcoin precisely because it is outside the control of governments/central banks and cannot be devalued at will by governments/central banks.