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What Is Cryptocurrency Backed By?

July 1, 2022
6
min

Learn how cryptocurrencies share some of the same properties as traditional, or fiat, currencies and why other digital tokens are highly resistant to counterfeiting.

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When it comes to money, there is one fundamental question that eclipses all others: What is it backed by? For ages, the answer was simple. Major civilizations minted coins of gold and silver, which were accepted as legal tender across the ancient world thanks to the universal value of precious metals. Even after the widespread adoption of paper money during the Industrial Revolution, consumers could still walk into banks and exchange their bills for gold. 

That all changed in the latter half of the 20th century as governments ended their reliance on the gold standard. A new era dawned in which currencies were backed primarily by the credit and economic fortunes of the countries that issued them.  

Then came Bitcoin. Unlike traditional currencies, Bitcoin wasn’t the product of a nation-state and wasn’t governed by central-bank policies, government regulation, or economics. So what is Bitcoin backed by? 

In a word, belief.

How is regular currency backed?

State-backed currencies are tightly controlled by governments and central banks. Cryptocurrency supporters call them fiat money or currencies because they are managed by government decree, or fiat. Governors at the U.S. Federal Reserve, the European Central Bank, and similar authorities analyze economic conditions and adjust the supply and value of their respective currencies accordingly. 

For instance, the Fed may lower interest rates to stimulate borrowing and spur commercial activity if the economy is struggling. The Fed may also increase the money supply to lower the dollar’s value and stimulate the growth of exports. Conversely, the Fed may raise interest rates and tighten the supply of new currency when the economy is booming; this may help keep inflation under control and set a sustainable rate of growth. 

In this way, central banks play a vital role in determining the value of a currency, which is in turn a barometer of a nation’s economic condition. Elected officials can also affect the value of currencies by passing laws on trade policy, taxes, and other fiscal measures. Ultimately, fiat currency such as the U.S. dollar are backed by the financial decisions made by central bankers and lawmakers, as well as the state of the economy. 

How are Bitcoin and other cryptocurrencies supported? 

Introduced in 2009 as the first cryptocurrency, Bitcoin was designed to be the opposite of fiat-backed currencies. Instead of being controlled by a central authority, Bitcoin and other types of digital currency were created by computer programming and maintained on a distributed database known as a blockchain that is accessible to anyone with an internet connection. 

So what is Bitcoin backed by? On one level, it’s software code. The blockchain is designed to prevent “double-spending” and ensure every digital token is unique. That ensures integrity. The blockchain’s proof-of-work consensus mechanism also records every transaction and cannot be altered or deleted unless a group of hackers mount a so-called 51% attack and take control of a majority of the system. With millions of computers involved in the blockchain, that’s unlikely. The resilience of Bitcoin’s design instills confidence that tokens are secure and usable as legal tender.

On another level, Bitcoin is also backed by supporters who believe it’s a useful form of money that eventually will be adopted by the mass market. This belief is often spurred by doubts that the U.S. dollar and other fiat currencies will maintain their value over the long term due to mismanagement. In other words, cryptocurrency supporters are betting digital currencies will benefit as confidence wanes in traditional money. 

Critics say Bitcoin and other cryptos are flawed because they lack the hard support of central banks and are disconnected from the ebb and flow of national economies. Crypto advocates counter that this is a “fiat myth” because traditional currencies, which are no longer supported by gold, are also predicated on psychological forces such as confidence and what economists call the “animal spirits” of investors.

6 key attributes that make a currency useful

All currencies—fiat or crypto—need the following six attributes to be viable. 

  1. Scarcity. Maintaining equilibrium between supply and demand is crucial to a currency’s viability. With fiat currencies, central banks use interest rates and their ability to mint new money or remove it from circulation to strike the right balance. Bitcoin uses a program called halving to enforce scarcity: The Bitcoin blockchain will automatically stop making new tokens when 21 million are in circulation, which is expected to happen in 2140. Many other cryptocurrencies do not have this cap and can make tokens at will,  their credibility and diluting their value.
  2. Divisibility. Divvying up currencies into smaller denominations makes them easier to spend and bolsters their utility. That’s why we have $20 bills, quarters, and the rest. Cryptocurrencies are also available in bite-sized fractions. That’s how many investors buy and sell tokens and how users can purchase items ranging from a cup of coffee to a Tesla for the appropriate amount of Bitcoin.
  3. Acceptability. If banks, businesses, and individuals do not recognize the viability of a currency, it’s finished. A central bank, for example, could seriously err if it printed too much money and devalued its currency so much that no one wanted it anymore. Most cryptocurrencies, including Bitcoin, have yet to gain widespread acceptability and truly become legitimate forms of money.
  4. Portability. Currencies must be seamlessly transferable across borders and between accounts. The rollout of digital-payment systems has made it easier to send fiat currencies around the world, but it can still be a clunky, expensive process. Thanks to their digital nature and presence on decentralized blockchain networks, cryptocurrencies are highly portable. Plus the technology’s ability to record transactions instantaneously on shared databases makes them super-efficient. 
  5. Durability. This property is becoming less important as payments shift from bills and coins to digital formats. Still, currencies must withstand wear and tear to remain viable. Cryptocurrencies are inherently durable because they are software code, though the computers that manage tokens must be maintained and upgraded.
  6. Counterfeiting. Governments employ many security devices to prevent criminals from fabricating fake fiat currencies, including watermarks and polymer-based bills. For cryptocurrencies, software developers must stop hackers from replicating their code and manufacturing bogus tokens. Blockchain technology’s ability to make immutable datasets that record tokens and transactions has proven effective in preventing crypto counterfeiting.

How is cryptocurrency different from U.S. dollars?

The biggest difference between the greenback and cryptocurrencies is that the former supports the $23 trillion U.S. economy. And that’s just the gross domestic product of the U.S. The dollar is also the No. 1 currency in global trade, and the biggest reserve currency in the coffers of central banks in scores of other countries. That means other nations use the dollar to back their own currencies. 

Cryptocurrencies, in contrast, only support their respective blockchain networks. Moreover, cryptocurrencies are generally not accepted as a legitimate form of payment for goods and services. Even Bitcoin has yet to be widely adopted as a proper substitute for dollars in most of the world.

The bottom line

Cryptocurrencies share some of the same properties as traditional, or fiat, currencies. Bitcoin and other digital tokens are highly portable, durable, divisible, and resistant to counterfeiting. But they have yet to be accepted by the mass market as legal tender, and, with the notable exception of Bitcoin, many do little to manage their scarcity.

The biggest contrast between cryptocurrencies and fiat currencies lies in the forces that back each category. Central banks support currencies such as the U.S. dollar and the euro, which are bellwethers of their respective economies. Cryptocurrencies are backed by the rigor of their software and blockchain networks. 

But the main pillar supporting Bitcoin and other tokens is the belief that they will change the way the world uses money. That is much harder to measure than interest rates or changes by central banks in the money supply.

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