Cryptocurrencies get value from actual use through blockchain activities, while fiat currencies lose value with time due to inflation. We dive into these currency worlds to see how they shape our financial scene.
Any currency or asset derives its value from one of two things: it provides exposure to economic activity (e.g. stocks, corporate bonds) or there is reliable demand for it (e.g. commodities).
There is growing demand for some cryptocurrencies as alternatives to fiat currencies or safe haven assets such as precious metals. But unlike fiat currencies, the native tokens of blockchain protocols, such as Bitcoin or Ethereum, also provide exposure to the economic activity of users and projects built on top of the blockchain. Users of the protocols pay transaction fees, and this transaction fee economy provides a baseline for the value of the token.
Tokenholders access this value either by being validators or by the protocol collecting some or all of the transaction fees and burning the corresponding amount of tokens. These mechanisms ensure that value accrues to tokenholders simply for owning the token – either because validators bid up the price up to the point that the transaction fee income still provides an attractive rate of return, or if the tokens are burnt by the protocol, then the reduced supply acts to lift the price per token.
No similar intrinsic value exists for fiat currencies: there is no activity using fiat currencies that the holders of the currency participate in or earn a share of. Quite the contrary, because of the inflationary spending on most governments, fiat currencies’ purchasing power tends to erode significantly over time: a de facto stealth tax that holders of the currency are charged.
One argument for what gives fiat currencies value is that they are backed by the economy that uses the currency and therefore there is reliable demand for it. The creation of the petrodollar was based on this concept: compelling a large part of the world economy to transact in dollars, thereby creating demand for the currency.
However, for a currency to derive its value from an economy, it has to add value to the economy. Economic activity pivots to the best money available – unless a currency’s use is enforced by law and the use of alternatives is banned. Even in those situations, if the “official” money poorly serves the needs, shadow economies using different forms of money can arise to get around this. Ultimately, when an economy is captive to an inferior currency, it is a fundamentally fragile situation.
In the past, currencies used to be backed by commodities (primarily gold), but the gold reserves of governments now only amount to a tiny fraction of the money supply. Without any intrinsic floor to the value of fiat currencies, their purchasing power has declined dramatically since.
Learn more about this topic in our Valuing crypto assets investment research report.
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