The Evolving Financial System

For the modern-day generation of finance experts, the idea of fixed exchange rates for national currencies based on a peg to the U.S. dollar (or gold itself) is completely foreign. These rates have been permitted to ‘float’ since the 1970’s; that is, they are determined in the global foreign exchange markets based on supply and demand, relative to different fiat currencies. This new system had several major implications for global finance.

First, the global supply of money was no longer pegged in any way to the global supply of gold. This led to sharply rising gold prices and high levels of inflation within many domestic economies. With these new, fiat money supplies being wholly unpegged from gold, the scarcity of money became only artificially ensured. Trust in the physical scarcity of gold, and of its existence within vaults, was replaced by trust in the economic stewardship of national monetary authorities.

Second, and relatedly, was the emergence of global forex markets. With rates no longer fixed, market mechanisms were required to discover the relative prices of foreign currency. Whereas the fixed exchange rates under the gold-based system largely precluded speculation, freely-floating rates transformed the forex markets into a global arena for speculative activity, fully separate from the production of goods and services. The Bank of International Settlements has reported that since 1992, forex turnover has clearly increased more than the underlying economic activity, whether measured by GDP, equity turnover, or gross trade flows. [2]

These and other issues associated with physically unconstrained fiat monies are what has perpetuated the economic function of gold. Despite its lesser monetary role, gold remains a universally popular ‘safe-haven’ asset, and is still held by many central banks. The estimated amount of physical gold above ground is 6.1 billion ounces, of which about half are connected to financial markets, implying a market cap of approximately $4.7 trillion USD. [3]With over $200 billion combined daily trading volume, gold markets are among the most liquid in the world. One major reason that gold continues to be held in many investment portfolios is as a hedge against financial instability.

i. Fiat Money & Financial Instability

The post-Bretton Woods period of unbacked fiat money, has coincided with numerous periods of currency-related financial instability around the world. The Latin American debt crisis of the early 1980s, the 1997 Asian financial crisis, and many other smaller-scale emergency situations all had their roots in this relatively new global monetary system. More recently, the Global Financial Crisis has shed light on the financial turbulence associated with debt-based fiat money. Its aftermath, an unprecedented global monetary expansion coordinated by leading central banks, has raised concerns about these monetary authorities’ economic stewardship.

ii. Bitcoin & Digital Tokens

The Bitcoin network was created as “an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. This description speaks to Bitcoin’s financial aspect (payments), but there is also a fully internal, decentrally secured monetary unit: bitcoins. Massively enhanced global payments efficiency is a major financial innovation, but the invention of digital scarcity – e.g. a hard cap of 21 million bitcoins – is a landmark monetary innovation; it is why some call bitcoin “digital gold”.

Embedded within the first bitcoin ‘block’ was the following text: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”. This British headline was a reference to the fallout from the Global Financial Crisis, hinting at the motivation of Bitcoin’s pseudonymous creator, ‘Satoshi Nakamoto’. Bitcoin and its underlying technologies seem intended to address problems and moral hazards associated with fiat money and the implied concentration of economic power in the hands of monetary authorities and major banks.

With truly humble origins, bitcoins were first used in May 2010 to purchase a real-world item, when Laszlo Hanyecz agreed to pay 10,000 bitcoins for two delivered Papa John’s pizzas in Jacksonville, Florida. The bitcoin’s market value has since experienced a tumultuous rise, regularly expanding by multiples and then contracting by over 50%. For example, in 2011, the price first reached $1 USD, surged to $31, and then fell back to $2. In 2013, bitcoin reached $1000, peaked at $19,500 in 2017 before falling back to $3,500, and is exactly $11,727.74 as of evening GMT on August 31st, 2020 ( Though generally trending upwards, bitcoin’s meteoric rise has been accompanied by extreme volatility.

These massive price movements caused media coverage of bitcoin to soar, particularly during the latter half of 2017. With value and popularity continuing to rise, politicians and financial regulators began paying attention. Amidst the frenzy surrounding this still-nascent technology, many around the world began to ask: is bitcoin money? For its biggest proponents, bitcoin was undoubtedly money, and of an entirely superior form. However, for its detractors, bitcoin could never be money; it was associated with nefarious activities, was not “backed” by any government, and its price was far too volatile.

These debates raised the question: what is money? With dictionary definitions lacking consensus on its meaning, one popular way to conceptualize this English term is by considering the following three functions: ‘medium-of-exchange’, ‘store-of-value’, and ‘unit-of-account’. For bitcoin’s detractors, the regularity of major price movements prevented bitcoin from being a store-of-value, meaning it could not be money. The purchasing-power uncertainty associated with holding this volatile asset would prevent its widespread use as a medium-of-exchange.

iii. ‘Stablecoins’

With bitcoin’s price volatility seemingly holding back a ground-breaking enhancement to the transactional utility of money (i.e. medium-of-exchange functionality, cheap and fast global value transfers, etc.), attempts were made to create digital tokens with stable values. This was done by pegging the value of a digital token to a fiat monetary unit, to achieve the best of both worlds: the transactional utility of a decentralized digital token, but the price stability of fiat money. These projects came to be known as ‘stablecoins’.