What is fiat currency?

Many of us take the existence of our money for granted, but modern currencies are actually underpinned by a complex "fiat" system that is controlled by the government.

In cryptocurrency circles, the term "fiat" is used to distinguish these government-issued currencies from digital currencies like Bitcoin.

Where fiat currency is centralised and has no supply cap, cryptocurrencies are decentralised, open source and often have a fixed supply.

If that makes sense to you, great. If not, read on to learn more about how fiat currencies work, and how they compare to cryptocurrencies.

What is fiat currency in simple terms?

A fiat currency is simply any money that is issued by a central government and not backed by another asset or commodity (such as gold).

This includes all the major currencies in the world. The US dollar, the Euro, the British pound and the Japanese yen are all examples of fiat currencies.

In contrast to commodities, fiat currencies have no intrinsic value. Instead, their value comes from the faith that people have in the stability of the government that issues the currency.

The word "fiat" literally means "let it be done" in Latin, but in modern usage means an authoritative command or official decree.

As such, "fiat" currencies are those officially issued under a government's legal authority.

• A quick history lesson: Bretton Woods

  Fiat currencies have not been a constant throughout history.

  In fact, the modern fiat system came about after the end of the Bretton Woods System in 1971, which saw the major world governments move away from a gold-backed currency system that had been in place since the 1950s.

  Following World War 2, 44 countries agreed to a new monetary system that would promote international growth and cooperation and help restore prosperity in a post-war world.

  Under the Bretton Woods system, national currencies were pegged to the US dollar (which in turn was pegged to the price of gold). This was intended to prevent currency manipulation and bring a level of stability to global trade.

  In 1971, then-President Richard Nixon suspended the conversion of US dollars into gold, effectively putting an end to Bretton Woods and helping to usher in a new fiat system.

How are fiat currencies different to cryptocurrencies?

Here are some of the key intrinsic differences between fiat currencies and digital currencies like Bitcoin:

Unlimited supply. New fiat currency can be issued at any point, increasing the money supply over time. In contrast, there will only ever be 21 million Bitcoin.

Centralisation. Fiat currencies are issued and backed by a central bank or government, who have total control over the supply, liquidity and use of the currency. By comparison, Bitcoin is an decentralised, open source digital currency that is not controlled by any one central body or authority.

Trust. Fiat currencies are built on the trust instilled in the issuing government. if the government collapsed, so too could the currency. Bitcoin is considered "trustless" in the sense that it can continue to function without the support of a controlling body. The trust is instead place in the computer code that runs the Bitcoin network.

Of course, there are other practical differences between fiat currencies and digital currencies, including volatility, availability, legal status and the fact cryptocurrencies exist only in digital form.

Advantages of fiat currency

There are arguably 4 major advantages of fiat currencies, but even these are a matter of debate.

Many crypto advocates would consider the centralised nature of fiat currencies to be a significant flaw, and this was one of Satoshi Nakamoto's central motivations when creating Bitcoin.

Liquidity
The monetary supplies of fiat currencies are closely controlled by the central bank or issuing government, so there's no real risk of a supply crunch.

Government-backed currencies facilitate commerce and are part of the reason why modern economies function so efficiently.

Fiat currencies like AUD are also obviously accepted everywhere and can be easily traded for goods and services. The same can't be said for most cryptocurrencies or asset-backed currencies.

Stability
In comparison to cryptocurrencies and other assets such as stocks or commodities, fiat currencies are relatively stable.

While the value of fiat currencies can rise and fall against each other, they're not subject to the same level of volatility that has become a signature of the cryptocurrency markets.

Regulation
As government-issued currencies, fiat money is highly regulated. While counterfeit money does exist, fiat currencies are tightly-controlled and fairly immune to the type of manipulation you can find in the crypto markets.

What affects the price of fiat currencies?

There's plenty of factors that can impact the value of fiat currencies including political instability, inflation, interest rates, monetary supply, global trade and the national economy, to name just a few.

Written by

Thomas Stelzer

Publisher

Tom Stelzer is a publisher and writer for Finder, covering investing and cryptocurrency. He previously worked for Finder as a writer in Australia and the UK, covering things like personal finance, loans, investing, insurance as well as small business and business loans. He has a Master of Media Arts and Production and Bachelor of Communications in Journalism from the University of Technology Sydney. See full bio