What Is Cryptocurrency Backed By?

Cryptocurrencies have a total market cap of over two trillion US dollars and on a daily basis, millions of dollars worth of crypto transactions are exchanged between people, startups, and companies from all over the world.

The majority of transactions are done with Bitcoin (BTC) and Ethereum (ETH) as the two most popular cryptos with the highest market capitalization. Even so, there are thousands of other digital currencies, including many popular altcoins like Litecoin (LTC) or Ripple (XRP) that are also traded on cryptocurrency exchange platforms in large volumes.

Given the fact that cryptocurrencies are a very young form of financial tools, active only since 2009 and the launch of Bitcoin, many people and companies have doubts regarding how these digital assets work and what actually gives them value.

Cryptos are totally different in terms of what they are backed by and how they obtain value compared to traditional fiat money like USD or EUR.

Let’s take a look at how fiat and digital currencies work and what are the factors that determine the value of a cryptocurrency.

Fiat Currencies

Fiat currencies are all traditional currencies in circulation that are backed by government institutions and central banks. These currencies exist in their paper form or on bank accounts and credit cards as figures that can be paid out physically if need be. For a currency to be usable in a society or internationally, it needs to be a valid store of value that people can rely on and know its value won’t just vanish overnight.

Throughout human history, precious metals like gold, silver, or precious gems were all used as a store of value and payment methods because they were regarded as objects that can maintain a stable value. Gold has positioned itself especially as a scarce and valued metal that can guarantee a hard, concrete value which won’t decrease quickly. Raw commodities such as fish, wood, and similar necessary raw materials were also used as payment.

However, it was far more practical to create a currency that wouldn’t require people to carry around large amounts of various commodities. Instead, minted currencies were invented. These currencies were often backed by gold as a metal of high value.

Nowadays, the most popular forms of currency are all basically paper money that doesn’t physically have the same intrinsic value as gold or silver. Instead, these currencies rely on the value they represent in the monetary system. Every amount of, let’s say, USD can be exchanged for a certain amount of goods or different products, depending on how much money you want to exchange by buying some product.

Modern fiat currencies aren’t backed by gold like in the beginning of the 20th century in America, but rather, they are backed by the faith that millions of people put in the exchange value of the currency, accepting it as a store of value and method of payment.

Factors That Contribute to the Success of a Currency

The most popular and globally accepted currencies today are fiat currencies. There are several factors that are considered as key characteristics of a currency, and they contribute to its acceptance and widespread use in a financial system.

Currency Scarcity

One of the basic characteristics of a currency is the circulating money supply available for use. If a currency has a supply that is lower than the demand for it, numerous economic problems can be caused, since the currency isn’t available to people for use. On the other hand, if there is too much of some currency circulating, the prices of products and other commodities could rise dramatically, which could lead to an economic collapse of the monetary system that is using that currency.

It is of utmost importance that the circulating supply of a currency fits the exact needs of the population that is using it and that is why regulators such as central banks along with the state financial agencies regulate the supply of money according to the market demand. Countries can’t just print more money without a reason. New cash is printed by governments when the current supply doesn’t meet the public demands.

The rate of inflation is usually controlled by state financial institutions by maintaining a preset inflation level that controls the value of the local currency. This is done in order to prevent the creation of an economic price bubble that could explode and drive prices sky high.

Governments usually tend to keep the inflation rate of the country’s fiat currency at a rate of a couple percent, which is totally different when compared to cryptocurrencies because a lot of them have issuance rates that change over time.

Bitcoin, for example, gets more difficult to mine over time, making it harder to produce new coins, in order to control the scarcity level of the crypto coin.

Durability of a Currency

Money changes hands on a daily basis, so it needs to be made out of durable materials. If a currency is made of low-quality paper or metals that can get damaged real quick or lose their primary shape over time, then the currency is quite useless.

This is why fiat money is usually made out of special paper that is both firm and flexible, making it a durable physical asset. In some countries, money is even made with polymer plastic as a more durable alternative to classic paper money.

Coins have low value in modern societies, unlike gold or silver coins in the earlier periods of human history, but even these modern coins are made to last despite their low value.

Measures Against Counterfeiting

A currency has to be hard to counterfeit and make illegal copies of. If a certain currency can be easily counterfeited, that means that government institutions don’t have effective control over the supply of the currency and that inflation can happen at any time, depending on how many bills are in circulation.

Especially if counterfeiting a currency becomes widespread practice, numerous economic problems can occur and drive up prices without the government being able to do anything about it.

This is why fiat money is made with special techniques, like engraving micro drawings and symbols in the circulating bills with machines that are unavailable to any members of the public. That makes the circulating bills easy to differentiate from fake ones. Counterfeiting is also a serious crime all around the world and it can land you a serious prison term.

Currency Utility

The first reason behind the development of currencies, historically, was to create a means of trade without bartering products and services between traders. Currency was created in order to replace barter agreements with the value behind money. This is why every currency has to have a high level of utility and reliability.

When a currency is widely trusted as a means of storing value and trading, it is considered effective, such as USD or EUR.

Transportability Between Users

Money has to be easily transportable between people, companies, and institutions. This doesn’t mean just physical transportability, but also the convertibility and exchangeability through exchange offices and financial services that make it possible to send currency internationally through businesses like Paypal and Western Union, or through bank transfers.

A widely accepted fiat currency has no problems with transportability between parties all over the world, since exchanges accept its value. This is why the US dollar is accepted in most countries around the world as an exchangeable currency.

Degree of Divisibility

Currency has to be divisible into smaller units, in order to be flexible and able to work as an exchange medium for all types of products and services. Especially with stronger currencies such as the US dollar, smaller units are needed (such as cents) to precisely define the prices and values of goods.

Cryptocurrencies and Blockchain Technology

Unlike fiat currencies, cryptocurrencies don’t exist physically. They exist only as part of their networks, which are most often blockchains, even though there are cryptocurrencies that use different types of closed networks.

The most popular digital assets such as BTC and ETH use blockchain technology with advanced cryptography, and they account for the majority of daily crypto trading volumes and market cap. Since cryptocurrencies don’t exist physically beyond their networks, the only way someone can prove ownership over certain assets is through the private keys of those assets found within the owner’s crypto wallet.

Crypto wallets don’t actually keep currency in them, but rather the keys necessary to access your funds and do what you wish with them.

These private keys let people access their funds and move them using the native blockchains of those currencies without the meddling of any central authority, government agency, or bank. This is a huge advantage of cryptos over fiat currency since all the paperwork and legal regulations that are part of bank transfers can be avoided.

Cryptocurrencies transactions are also far faster than fiat money transfers.

Depending on the crypto used, a transfer can take anywhere between just a few seconds (like ETH), or a couple of minutes (on the BTC blockchain, for instance).

Blockchain technology is also very secure and extremely resilient to scams, money laundering, and fraudulent transactions since each transfer has to be verified by several independent system nodes before it gets processed. This is known as a trustless system.

All of these characteristics contribute to the immense popularity of cryptocurrencies as a medium of exchange, especially Bitcoin, giving it a high trust rate and, subsequently, real financial value.

How Is the Value of BTC and Other Cryptos Determined?

Of course, the value of Bitcoin and other virtual currencies isn’t backed by gold like the US dollar was at the beginning of the 20th century, nor are they backed by the agreed-upon value based on a country’s monetary system.

Cryptocurrencies are backed by the willingness of people to use them and accept them as payment and a store of value.

When Bitcoin was launched in 2009 by Satoshi Nakamoto with a whitepaper that declared Bitcoin as the first decentralized, digital cash in the world, the coin wasn’t popular straight away – far from it.

It took a couple of years for the crypto community to develop, largely thanks to crypto enthusiasts who believed in the future of digital currencies and contributed to the ecosystem by mining Bitcoin and acting as system nodes that verify each transaction on the BTC blockchain.

When BTC started being accepted more widely as a form of digital money in the 2010s, hundreds of altcoins were also launched one after another, bringing various new features to their users, promising quick transfers, the privacy of funds, and a safe storage of value.

The pricing behind a cryptocurrency is entirely determined by how many people are prepared to use the digital coin as a financial tool for storing value or making payments. If there weren’t millions of people worldwide that accept, let’s say, Bitcoin as a legitimate currency, then the coin wouldn’t have any real value.

This is why developer teams behind cryptocurrency projects tend to carefully construct blockchains that offer people attractive benefits, such as the total transfer privacy offered by Monero or the ability to create smart contracts on the Ethereum blockchain.

Bitcoin vs Fiat Currencies

Compared to fiat currencies, BTC’s scarcity is regulated by the initial whitepaper from 2009, which capped the total amount of Bitcoin that would circulate on the market at 21 million coins. This amount wasn’t available from the very launch of BTC, though. Instead, miners are responsible for creating new blocks of the BTC blockchain by verifying transactions and receiving Bitcoin rewards for each mined block.

The BTC mining rate is halved approximately every four years, making the coin more scarce by producing new bitcoins at a slower rate.

Every Bitcoin is divisible into 8 decimals, making it really easy to give precise value or a price for every possible product or service.

The utility of blockchain technology has made Bitcoin immensely popular since the network doesn’t require establishing trustworthy relationships between participants because the system nodes act as a security layer for every transaction.

Transportability is no issue for Bitcoin, unlike fiat money, because a transfer between two parties, no matter where they are in the world, takes only a couple of minutes, either directly or through a Bitcoin exchange.

Regarding durability, BTC is literally indestructible because it can’t be physically torn or damaged. All bitcoins exist on the BTC blockchain and can’t be lost unless the whole blockchain gets damaged or shut down. This can’t happen because there is no central server or authority that can pull the plug on the network – it’s decentralized.

Finally, counterfeit ability is out of the question when it comes to Bitcoin since the blockchain makes sure no batch of coins can get spent twice.

When you look at all these characteristics of BTC compared to fiat money, the numerous advantages become clear, so it isn’t hard to understand why such a cryptocurrency can achieve enormous value based on popularity and widespread use. In reality, it’s as backed by trust as are most well-established fiat currencies.

A Few Words Before You Go…

Cryptocurrencies apparently work quite differently from fiat money, since they don’t exist physically and aren’t backed by any material value that can be regulated by governments and central banks. Some people can find this fact troublesome because of the uncertainty of the future of a cryptocurrency, as it depends on its popularity among users. However, this is exactly the strength of digital assets.

Every developer team behind a cryptocurrency wants to create an asset that will become widely accepted and thus monetized through exchanges and transactions. This competition among developers is one of the key factors that guarantee the constant innovation and improvement of cryptos, subsequently granting them popularity and true value, which ensures that cryptos won’t just disappear into thin air.

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