Will Cryptocurrencies Replace Fiat?

Money has evolved from primitive forms (seashells, salt, copper, gold) to its most recent form — as cryptographic bits in the internet. The advent of Bitcoin has introduced the idea of friction-less money, money that has absolutely no intrinsic value, not even value founded on trust in a third party. This form of money is threatening to make the currently most prevalent form of money (fiat money, exemplified by the U.S. dollar) obsolete. Most intellectuals in the cryptocurrency world believe that cryptocurrencies will eventually replace fiat money. I don’t believe it.

I believe that cryptocurrencies, in its current form, cannot replace fiat money. The issue is about monetary policy: deflationary (keeping quantity constant) versus inflationary (allowing quantity to increase).

Since 2011, I have written several thoughtful articles about Bitcoin in my blog (see samples here, here, and here). It has been my opinion, even back in 2013, that hard-limiting the quantity of bitcoins is not good for its use as medium of exchange. I tried to convince the Bitcoin community about this, and it fell on deaf ears. Most recently, I tried to convince the Ethereum community about ethers as medium of exchange, and almost nobody listened. I can understand why current holders of both bitcoins and ethers would resist any inflationary monetary policy: they want their holdings to continue increasing in market value.

This is my position with regards to the issue of inflation: no cryptocurrency can replace fiat money as medium of exchange if there is no inflation. Inflation is a requirement for stability of value, and stability of value is one of the most important requirements for a medium of exchange.

I believe I understand Vitalik Buterin’s concern about inflation with respect to security when mining is phased out in Ethereum: there won’t be enough incentive for people to freeze their holdings (even for a moment) in a Proof of Stake system in order to keep the network secure, if an inflationary monetary policy is adopted. This is debatable, but may be I don’t understand it fully enough. So for now let’s go along with Vitalik — security is most important. Ether is not meant to be a medium of exchange anyway: it is meant to be used as currency for paying gas. (In the Ethereum universe, transactions are not free. It’s not free so nobody can clog the network with useless transactions, thereby rendering it useless. Transactions consume gas, and gas is paid for using ethers.)


From the standpoint of decentralization, the merit of a simple monetary policy is obvious: if you simply limit the quantity, nobody has to decide when and how much to increase/decrease the quantity. However, decentralization does not necessarily mean losing flexibility. In fact, the most successful decentralized systems are those that are most flexible. Decentralization purists negate the importance of ceding control of some aspects of a system to the center, and in fact there are things that need to remain at the center.

Decentralization in a trustless automaton network is crucial: you eliminate the single point of failure, and anybody can put up a node, as long as that node is running an unmodified version of the network program. The network itself is decentralized, but the network program has to comply with a centrally determined set of rules. In fact, in most cases, such program is written by the same group of people (about one central team per network).

Central Banks

I understand the cryptocurrency intellectual’s hatred of central banks. Central banks exist as socialist centers of control in an otherwise capitalist, decentralized world. Each central bank is fundamentally a dictatorship ruling over its captive fiefdom. There is an unholy alliance between a central bank and the government that sponsors it: the government allows the central bank to control the local currency, in return the central bank allows the government easy access to money. In this arrangement, the people are the suckers. Witness how the people of Venezuela are suffering because of hyper-inflation — the Venezuelan government and its central bank blame the merchants for overpricing, and most people believe them. Even in highly open societies like the U.S., whenever the Fed buys government bonds, inflation is used to fund an overspending government. Inflation in this case is a controlled increase in the quantity of money; but even this periodic, precise increase can cause a mild and slow decrease in the value of money, which is still harmful. In short, the common thinking is that, because central banks engage in inflation, inflation must be bad.

Before the Fed

There is such a thing as good inflation. In the absence of a monopoly such as a central bank, banks can be allowed to issue their own bank notes. In the past, prior to monopolization by a central bank sanctioned by government, local banks were allowed to issue bank notes that people used as money. Such bank notes were backed by either gold or government bonds. A bank was safe and sound as a business only insofar as it managed the inflation of these bank notes with an eye to both safety and profits. If it increased the quantity of these bank notes beyond the margin of safety, it exposed itself to a catastrophic bank run which could wipe it out of existence. If it managed the quantity of its bank notes in circulation well, relative to its gold and government bond holdings, then it could grow in profits, size, and prestige, just like any business would. Also, just as one can exchange bitcoins for ethers, back then people could exchange bank A’s notes for bank B’s notes and vice-versa.

Well, you ask, if it were that good, why did bank notes cease to exist to be replaced by a single currency in any one country? The story is a little complicated, and rather than relate the full story here, I highly recommend a book by Prof George Selgin “Money: Free and Unfree”.

Briefly, the advent of central banks is a result of misdiagnosed ailment. Very simply summarized, the problem was that there were rules that prevented banks from branching, which then caused the seasonal shortage of notes, which became severe each time it happened, and each time the catastrophic shortage occurred, the blame was put anywhere else other than the rules, and so more rules were introduced, which naturally made things worse. Until finally the leaders introduced the mother of all rules, a law meant to rid the world of bank problems: they decided to start a monopoly (a central bank) in order to fix the problem. The details of the story are much more complicated, but Prof Selgin’s book relates the whole story well. The bottom line is this: central banks are not a market phenomenon — the central bank in any one country exists for one reason only: it’s there by law and not by Adam Smith’s “invisible hand”.


The good news is that it is possible to introduce cryptocurrencies that are designed to be stable from the start (so-called stablecoins), and in fact several are now in existence. Cryptocurrency intellectuals, including Vitalik himself, pooh-pooh these stablecoins because these are not totally decentralized. At the moment, the most popular of these currencies is called “Tether”.

Tether exists in the Bitcoin network, as a ledger separate from bitcoins. The company behind it claims that every Tether unit is backed by a USD deposited in either one of two Taiwanese banks. If this is true, then there can be no “bank run”: even if all Tether holders claim their USD at the same time, the company would certainly be able to meet the demand. Having a USD for every Tether is not even necessary, just as the local banks of old did not have a USD for every unit of bank note they released (before central banks came into existence). There are rumors that Tether does not have a hundred percent backing all the time, and I wouldn’t be surprised. Your money would still be safe.

Tether is widely used in exchanges and has become the most popular stablecoin in existence.

USDT (Tether) exchange rate graph from 2015 to present (bottom graph is volume)

Another stablecoin is BitUSD which is more interesting because it is based on puts and calls. A BitUSD is not created out of thin air; instead it is created as a loan against a cryptocurrency collateral. The collateral can be twice as valuable as a BitUSD at the instant of time that the BitUSD comes into existence. If the price of that collateral drops to say, 1.5 times the value of the original loan measured in USD, then the collateral is automatically sold, and the USD proceeds distributed to the BitUSD company and the owner of the collateral. In this way, each BitUSD is backed by its collateral. Of course, it’s meant to be used as currency, so the original owner (who loaned the cryptocurrency in exchange for BitUSD) can pass it on as payment to anybody who has an account in the Bitshares network.

BitUSD exchange rate graph from 2015 to present (bottom graph is volume)

A third stablecoin is Dai which is relatively new, and exists on the Ethereum network. The company behind this stablecoin (MakerDAO) has devised an elaborate mechanism for keeping Dai stable, similar to BitUSD. I won’t go into the details of this stablecoin, but suffice it to say that, if you look at the historical price graphs of all three stablecoins, you will find that these have been fairly stable. BitUSD has been subject to the most volatility (notice that very tall spike in 2015), but has recently been fairly stable. In general the stability is still not ideal, but nothing that would render these currencies useless.

A couple more stablecoins will be available soon: Stably and Basecoin. There will be more.

Dai exchange rate graph, from January of this year (bottom graph is volume)

A Most Interesting Situation

A cryptocurrency is not bound by any national boundary. Central bank fiefdoms are limited in scope and territory. People know about slow inflation in the fiat universe, and the market will surely choose currencies that are most stable. I think we have a situation in which central banks with their fiat currencies will be competing directly against cryptocurrency companies with their stablecoins. Who will win?

People who are intellectually invested in and who are comfortable with central banks will surely defend the status quo, and even demand that the government ban cryptocurrencies altogether. This is the ONLY way that central banks can win, by government edict.

However, as long as it can collect taxes, the U.S. government will not necessarily be threatened by cryptocurrencies. Besides, name a U.S. politician who has vocally been against cryptocurrencies? We can’t predict the future, but we know for sure that the U.S. government owes the Fed and bond-holders something to the tune of 22 Trillion USD. It cannot possibly pay for this borrowed money, but there is a way out, and cryptocurrencies can only help. How? By allowing the USD to decrease in value. This has happened before, in fact a number of times. Besides, it’s not just the U.S. who will be doing this: Japan, China, and the European countries all have huge debt, and so we can expect the Yen, the Yuan, and the Euro to devalue also.

Here is where cryptocurrencies can win, by basically having no boundaries, and having no government behind it. For example, MakerDAO, the company behind Dai, could have been based in the U.S.; instead, it chose to place itself in Singapore. Why? It really doesn’t matter where the physical company resides. If it were based in the U.S., it could be hampered by U.S. laws.

Citizens of a country or state whose government has chosen to ban cryptocurrencies will find themselves at a big disadvantage. It would limit their freedoms, and would see the economy of their chosen residence stagnate. The fiat currency they use everyday will plunge in value because the demand for such fiat currencies will be much reduced compared to quantity in circulation; and because, as explained above, governments will be better off allowing their currencies to devalue. At some point, people would not be able to avoid using cryptocurrencies, especially stablecoins. People would start disregarding unreasonable finance laws, and they would find ways to use stablecoins by stealth means, like using Virtual Private Networks.

It was relatively easy to get rid of banks of old and their bank notes, and impose a central bank. This time, it won’t be so easy to tame the wild world of cryptocurrencies. Who will win? I think this time the people will finally win.

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