Fiat currency: what is it and how do you trade it?

The word ‘fiat’ means to be given authorisation, decree, or determination by authority. A fiat currency is issued by a government of a country or territory in the form banknotes, coins, or digital currencies and is backed by the country’s government that is issuing the currency. Its value and success are determined by the public’s faith in that particular currency, the governing body that issued it and the economic performance of the country. It has no value in and of itself and is not backed by a commodity – such as gold​ or silver – or any other store of value.

The value is also affected by money supply (M2) and the foreign exchange of each country. While M2 is a measure of money supply that includes cash, checking deposits and easily convertible near money, M1 is a narrower measure of money supply – it includes just cash and checking deposits.

A central bank with monetary authority issues currencies for use in a country’s general population. As both the population and the use of a currency grows or shrinks, the central bank issues more or reduces the amount of money in circulation through the banking system. Through this process it creates and tries to control inflation and deflation.

Nearly all national currencies in the world are fiat including currencies such as the US dollar, the British pound, euro, the Japanese yen, and the Canadian dollar – to name a few. The foreign exchange market​, also known as forex, is where currencies are exchanged or traded.

The foreign exchange market is by far the largest financial market in the world, dwarfing the size of stock exchanges and bond markets. More than $6.6trn was traded on global foreign exchange markets per day in April 2019, according to the 2019 Triennial Survey of turnover in OTC forex markets. The US dollar is the world’s most actively traded currency, followed by the euro. Forex trading is the process of speculating on these currency movements.

According to the Smithsonian, there is evidence of coins used as currency dating as far back as the sixth or seventh century BC, with paper money first introduced in China in the 11th century.

The oldest currency that is still in use today is the British pound, which is around 1,200 years old. Sterling silver coins were introduced in 775 and paper currency started appearing in 1694.The Bank of England was also formed in 1694 to raise money for King William III’s war with France, when people deposited funds to a bank, notes or paper currency were issued in exchange. The King then used the deposits for the war.

Fiat currencies have benefits and drawbacks. The main ones are listed below.

The Bretton Woods Agreement was an international agreement negotiated in 1944 by 44 allied countries at the United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire.

The agreement confirmed that the US dollar would be backed by the price of gold​. Under the agreement, US dollars could be exchanged for a set amount of gold. Other currencies were then pegged to the US dollar, which meant their value moved up and down with the US dollar at a set ratio.

Due to the complexity of the system, the agreement didn’t go into full effect until 1958. By the 1970s, there was concern from the then US President Richard Nixon that the US didn’t have enough gold reserves to back the currency, and so he enacted a plan that ended dollar convertibility to gold, while also implementing wage and price controls to stop the rising inflation. After this, the Bretton Woods Agreement ended in 1971. Since then, countries agreed that they could value their currencies however they liked, except for basing it on gold, as that attempt has previously failed.

Fiat currencies lose value since more currency is issued over time resulting in greater supply and inflation. Increasing money supply is often referred to as ‘printing money’ in the financial sector.

Prices of goods move in the direction of money supply. As money supply increases, prices rise. On the other hand, prices fall as money supply shrinks.

While prices may drop for a time, which is called deflation, the more common state for most economies is inflation. Deflation is typically viewed as more harmful than inflation, even though inflation erodes the paper money’s purchasing power over time.

During times of deflation, asset prices are dropping, which means business profits decline along with wages and the price of financial assets. Most businesses and consumers appreciate this less than an inflationary environment where prices, business profits and wages are more likely to rise.

The trade-off is that without inflation and an increasing money supply, there is no growth in an economy.

Fiat currency prices are affected by a wide range of factors, including political, economic, tactical, and technical, which are listed in more detail below.

Cryptocurrencies​, like fiat currencies, have no intrinsic value. Their value is based on supply and demand, and people’s faith that the cryptocurrencies can be readily used in exchange for products and services.

Since cryptocurrencies are relatively new, much of their value is from people buying and holding them hoping that they will appreciate in value, as opposed to using them to buy things.

With fiat currencies, transactions can be hard to track. With cryptocurrencies, every transaction is logged and verified. Some cryptocurrencies have a cap on how many are issued. Fiat currencies have no cap on how much money can be issued.

Major global fiat currencies tend to be quite stable, allowing for goods and services to be exchanged with little fear of the value changing substantially from day to day. On the other hand, cryptocurrencies tend to be quite volatile, which limits their use (if volatility remains) since the price of a good in a cryptocurrency could vary significantly from day to day.

Commodity money is currency that is backed by a commodity, such as gold or silver. Fiat currency is not backed by anything except faith in the central bank of the country and belief that the country will repay its debts.

Commodity money has intrinsic value in that it can be exchanged for an amount of some commodity. Like the pros and cons of fiat currencies discussed, commodity money can also have pros and cons.

On the positive side, when the price of the commodity is stable, inflation tends to be stable. On the downside, an increase or decrease in supply of the commodity, or even price changes, affect the value of the currency and can therefore cause inflation and deflation as well.

The Swiss franc is an example of a safe haven currency​​. This is partially due to its stable political and economic situation, but also because it tends to have low inflation. This makes it a ‘risk-off’ currency.

As discussed, rising interest rates tend to attract buyers that push the price of the exchange rate up, but then when panic hits or interest rates are heading for a drop, all those buyers head for the exits causing big price swings. That money usually flows into safe haven currencies, which tend to be more stable, although this influx can also cause them to have large price swings.

The Japanese yen is also a considered a safe haven currency, for the same reasons as the Swiss franc. In times of panic, people also tend to head toward the US dollar. Since it is an accepted currency in a number of places around the world – which is a testament to its stability and people’s faith in it – many people feel safe owning the US dollar in times of uncertainty.

There are hundreds of trillions of dollars (equivalent) in circulation. As of November 2021, below are estimates of the money supply in circulation for the 10 countries with most currency in circulation.

Fiat currencies may not be a great store of value, since they lose purchasing power over time.

Because stock market indices tend to rise over time, the stock market is considered a store of value. Gold, silver, and other commodities have value, and while these values fluctuate, they are considered a store of value.

Land is considered a store of value. A building may be a store of a value for a time, but like a car, buildings tend to need work/maintenance. Over many years, the building could be worthless, but the land tends to increase in value – assuming there is demand for it. Cars and vehicles are not considered stores of value, since they depreciate as they are used.