What The Long History Of Currency Says About Cryptocalypse

Cryptocurrencies are digital assets that have value because people assume they have value. Fiat currency, on the other hand, has value because the government says it has value. Originally, banknotes were created by individual private banks to spare merchants the burden of having to carry huge loads of specie to settle large transactions. These notes could be carried around instead, used for transactions, and exchanged for noble metals later, if required. If the bank went bust in-between, it was bad luck, if not the wages of sin. To end this risk (and finance wars by sovereign will, independent of active concurrence by the nobility), the state took over monopoly powers to issue banknotes, in the late 17th to early 18th century decades.

The banknotes continued to be backed by precious metals, at least, in theory, till 1971 in the US, when President Richard Nixon broke the promise to exchange one ounce of gold for $35, effectively scuppering the Bretton Woods system of fixed exchange rates. It also ended the free ride Americans had had since the end of World War II on the global economy — for the cost of printing a one-hundred-dollar bill, America could procure $100 worth of goods and services from the rest of the world.

Today’s fiat currencies are not backed by any promise to convert them into things of intrinsic value. They can be used as a store of value, serve as a unit of account and used for exchange, the counterparties obliged to accept the currency as legal tender, because of fiat, or government order. These currencies are protected from disruptive changes in their value by regulation and monetary management.

Cryptocurrencies were created with the intention of creating money that is independent of governments. They have value because people perceive value in them. This is not all that unreasonable. Why does Mona Lisa have value, or even gold have value? Gold’s actual intrinsic value lies in its superior conductivity that makes it very useful in high-end audio equipment. Lenin spoke of using gold to build public urinals in his socialist paradise rid of false notions of value.

The trouble with beauty that lies in the eye of the beholder is that beauty might turn into its opposite if the beholder starts wearing glasses or vanish once the beholder winds up proving his mortality. Similarly, in a period of generalized loss of confidence in things economic, people might not have much confidence to spare for cryptocurrencies, and their value might just plunge, as has happened recently.

This is not supposed to happen to one sub-species of bitcoins, the stablecoins. Stablecoins are supposed to exchange for regular money at fixed exchange rates. Tether is supposed to be equal to one dollar. Tether’s issuers claim to have financial assets backing the currency to maintain that exchange value. Yet, thanks to lack of full transparency on the nature of such asset holding, even Tether suffered a loss of value, thanks to heavy selling pressure.

TerraUSD is another breed of stablecoin that maintains its value using an algorithm that calibrates it against the value of a paired cryptocurrency, Luna. When confidence shook violently, this arrangement all but crumbled. All cryptocurrencies lost significant value.

All this does not necessarily damn cryptocurrencies to the netherworld. These are useful additions to the instruments humankind has crafted to enable production, exchange, saving and investment. Cryptocurrencies, pieces of code on the blockchain, have unique benefits of leaving a transparent audit trail and triggering contracts automatically. The point is to regulate them, not to banish them.

The most direct form of regulation is for central banks to issue cryptocurrencies, the so-called central bank digital currencies, CBDCs. Central banks could allow regulated entities such as banks and non-banking finance companies to issue cryptocurrencies of their own, backed by real assets. After all, when a bank issues credit, it creates fresh purchasing power. How much credit a bank can issue is regulated by different kinds of reserves and prudential ratios the bank is required to maintain. A similar arrangement can be found for the issuance of cryptocurrencies, too.

In the absence of regulation, cryptocurrencies would form a Wild West. And, in shootouts at the OK Corral, people die.