Fiat Currency: Meaning and Trading
Fiat currencies are government-issued money used worldwide. But how exactly are fiat currencies defined? In this article, we explore their origins, their impact on money supply, foreign exchange trading, and physical money in the form of banknotes and coins, and how they can be traded.
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Fiat Currency: Definition and Function
The word "fiat" means that an authority has granted permission, issued a decree, or made a resolution. A fiat currency is issued by the government of a country or territory in the form of banknotes, coins, or digital currencies and is backed by it. The value and success of this currency depend on public trust in it, in the government, and on the country's economic performance. It has no intrinsic value and is not backed by a commodity - such as gold or silver - or any other store of value.
The value is also influenced by the money supply (M2) and the foreign exchange reserves of the respective country. While M2 is a measure of the money supply that includes cash, checking deposits, and easily convertible cash, M1 is a narrower measure of the money supply - it only includes cash and checking deposits.
A central bank with monetary policy authority issues currencies for use by a country's population. As both the population and the use of a currency grow or shrink, the central bank issues more money or reduces the money supply circulating through the banking system. Through this process, it creates inflation and deflation and tries to control them.
Almost all national currencies in the world are fiat currencies, including currencies such as the US dollar, British pound, euro, Japanese yen, and Canadian dollar - to name just a few. Currencies are exchanged or traded on the foreign exchange market, also known as Forex.
The foreign exchange market is by far the largest financial market in the world, far surpassing the size of the stock and bond markets. According to the 2019 Triennial Survey on turnover in OTC foreign exchange markets, more than $6.6 trillion was traded daily on global foreign exchange markets in April 2019. The US dollar is the world's most actively traded currency, followed by the euro. Forex trading involves speculating on price movements.
According to the Smithsonian Institution, there is evidence of the use of coins as a means of payment dating back to the sixth or seventh century BC. Paper money was first introduced in China in the 11th century.
The oldest currency still in use today is the British pound, which is about 1,200 years old. Sterling silver coins were introduced in 775, and paper money has been around since 1694. The Bank of England was also founded in 1694 to raise money for King William III's war against France. At that time, people deposited money in a bank, and in return, banknotes or paper money were issued. The king then used the deposits for the war.
Advantages and Disadvantages of Fiat Currencies
Fiat currencies have advantages and disadvantages. The main ones are listed below.
Advantages of Fiat Currencies
A central bank can increase or decrease the money supply as needed and thus has control over an economy's money supply by also setting interest rates, making it easier to control inflation and deflation.
A central bank can also devalue its currency to make its exports more attractive to other countries, which in turn can boost the country's international trade and GDP. This is usually achieved by increasing the currency supply and is sometimes referred to as a "race to the bottom" as several countries can do this simultaneously. The term devaluation dates back to when coins were primarily used. Gold and silver coins were mixed with other, less expensive "base" metals, lowering the overall value of the metals in each coin.
The money supply of a fiat currency is controlled by a government body that safeguards the nation's interests. It is not controlled by the amount of gold in circulation or other commodities that could be affected by new mines or technological changes, for example. This, in turn, can affect the supply and demand of commodities (and thus unexpectedly the value of a currency).
The fiat currencies of major nations are easy to use and exchange for other fiat currencies as well as goods and services. Without them, transactions would be more difficult.
Disadvantages of Fiat Currencies
The value and public confidence in a fiat currency are based on the responsible management of that currency by its governing body. Central banks and governments don't always get it right. When they increase the money supply faster than the economy grows, it leads to inflation. When the money supply is too large, it's called hyperinflation, where both interest rates and prices soar.
If the money supply is insufficient or people are unwilling to spend the money they have, it slows down the economy and leads to deflation. A situation where prices for goods and financial markets tend to fall, and most people's wages and wealth decline.
Although the central bank overseeing the fiat currency tries to control the price of a currency, it may not be able to predict the outcome of its actions. Often, a central bank solves a short-term problem but simultaneously creates a larger long-term problem. This can lead to greater fluctuations in the business cycle and in the prices of financial assets, such as the stock market. If the money supply is too large, stock prices rise, which can lead to a bubble in the stock market. When the bubble then bursts, the money supply in circulation disappears quickly, and many fall into financial distress.
What is the Bretton Woods Agreement?
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 decided that the US dollar was backed by the gold price. Under the agreement, the US dollar could be exchanged for a specific amount of gold. Other currencies were then pegged to the US dollar, meaning their value moved up or down in a certain ratio to the US dollar.
Due to the complexity of the system, the agreement did not come into full effect until 1958. In the 1970s, then-US President Richard Nixon feared that the US did not have enough gold reserves to back the currency. So he enacted a plan that ended the dollar's convertibility into gold while simultaneously introducing wage and price controls to stop rising inflation. As a result, the Bretton Woods Agreement ended in 1971. Since then, countries have been able to value their currency as they see fit, except for pegging to gold, as this attempt had failed.
How Well Do Fiat Currencies Hold Their Value Over Time?
Fiat currencies lose value as more money is issued over time, leading to a larger supply and inflation. The increase in the money supply is often referred to as "money printing" in the financial sector.
The prices of goods move in the direction of the money supply. When the money supply increases, prices rise. Conversely, prices fall when the money supply shrinks.
While prices can fall for a period, which is called deflation, the more common state in most economies is inflation. Deflation is generally considered more harmful than inflation, even though inflation weakens the purchasing power of paper money over time.
In times of deflation, asset prices fall, meaning corporate profits decline along with wages and the prices of financial assets. Most businesses and consumers appreciate this less than an inflationary environment where prices, corporate profits, and wages tend to rise.
The trade-off is that without inflation and a rising money supply, there is no growth in an economy.
What factors influence the price development of fiat currencies?
The prices of fiat currencies are influenced by a variety of factors, including political, economic, tactical, and technical factors, which are explained in more detail below.
Currency manipulation: Tactics of governments and central banks
Governments and central banks have a significant influence on how a currency is valued. Both authorities have several instruments at their disposal to influence or manipulate the price of their currency to achieve a desired effect:
Quantitative easing, which increases the money supply by purchasing long-term fixed-income securities. This pushes inflation and causes asset values such as fixed-income securities, bonds, and stock prices to rise. At the same time, this can also lead to a decline in the price of the currency.
Open market interventions are not as common in most countries, but occur more frequently in some countries like Switzerland. In this case, the central bank intervenes in the foreign exchange market and directly buys or sells large amounts of foreign currency to push the price of a currency up or down.
Countries can also peg their currency to another currency, creating currency relationships. This can be advantageous for large importers or exporters as the real costs for goods remain the same. When currencies fluctuate, goods can become more expensive or cheaper when the price is quoted in a different currency. For example, the Chinese Yuan is pegged to the US dollar, as are the currencies of several other countries.
The government or central bank of a country can also set a lower or upper limit for the currency. This means that a country's currency is only allowed to rise or fall up to a certain amount against another currency.
Holding a currency is encouraged or discouraged. For example, Switzerland has introduced negative interest rates on large cash balances in Swiss accounts to prevent purchases, which increased the value of their currency.
A revaluation of a currency occurs when a country changes the exchange rate of its currency in relation to a benchmark. As a result of galloping inflation, Venezuela, for example, issued new banknotes, with one new banknote being worth 100,000 of the old banknotes in 2018.
Economic impacts
As an economy develops, so often does its respective currency. When GDP, wages, and employment figures rise, this indicates higher interest rates, which can lead to increased international buying of this currency due to its relatively attractive yield. When an economy shows surplus growth, a slowdown is expected, meaning lower interest rates and thus more sales of the currency. This, in turn, pushes exchange rates down. Learn more about the respective economic data in our economic calendar.
One currency at the expense of another
Currencies are always traded in relation to each other, not in a vacuum. While one country may have a great economy, it may be traded at a lower value compared to a country with a stronger currency. Or a country that seems to have a weak currency may have a higher value compared to other countries that are doing even worse. This causes foreign exchange rates to move and provides traders with the opportunity to profit by speculating on these price movements. Currencies are always a comparison.
Supply, demand, and speculation
Supply and demand are partly determined by the factors mentioned. Speculation can also play a role. When a currency rises, it attracts more buyers. When the trend reverses, these buyers become sellers. The more speculators there are, the greater the influence they can have. In the short term, technical analysis and traders (e.g., day traders or scalpers) who trade based on technical levels can have an influence, while fundamental factors play a greater role in longer-term movements.
How can I trade the price movements of fiat currencies?
The traditional method of foreign exchange trading involves buying a currency and holding it over a desired period, hoping that its value will increase and generate a profit.
Alternatively, you can bet on the underlying price movements of currencies through CFD trades. CFDs are a way to speculate on price movements without acquiring ownership of the underlying asset. Traders can buy or sell a number of units for an instrument. With CFDs on over 330 FX pairs CMC Markets offers you the largest selection in the industry*.
Fiat versus cryptocurrencies: What's the difference?
Cryptocurrencies , like fiat currencies, have no intrinsic value. Their value is based on supply and demand and people's belief that cryptocurrencies can be readily used in exchange for products and services.
Since cryptocurrencies are relatively new, much of their value is based on people buying and holding them in the hope that they will gain value, rather than using them to buy things.
With fiat currencies, transactions can be difficult to track. With cryptocurrencies, every transaction is logged and verified. Some cryptocurrencies have a cap on the amount issued, while fiat currencies have no such cap.
The major fiat currencies are typically quite stable and allow for the exchange of goods and services without fear that their value will change significantly from day to day. In contrast, cryptocurrencies are typically quite volatile, which limits their use (if the volatility persists).
Fiat currencies versus cash: What's the difference?
Cash (commodity money) is money backed by a commodity such as gold or silver. Fiat money is not backed by anything except faith in the country's central bank and belief that the country will repay its debts.
Cash has intrinsic value as it can be exchanged for a certain amount of a commodity. As with the advantages and disadvantages of fiat currencies, there are also advantages and disadvantages to cash.
On the positive side, inflation typically remains stable when the price of the commodity is stable. The downside is that an increase or decrease in the supply of the commodity or even price changes can affect the value of the money, thus causing both inflation and deflation.
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Which fiat currencies are "safe havens" and why are they considered "safe havens"?
The Swiss Franc is an example of a "safe-haven currency". This is partly due to its stable political and economic situation, but also due to its tendency towards low inflation. This makes it a relatively low-risk currency.
As mentioned earlier, rising interest rates typically attract buyers, driving up the exchange rate. However, when panic breaks out or interest rates threaten to fall, all these buyers flee, causing large price fluctuations. The withdrawn money typically flows into currencies believed to be safe, which are generally more stable, although this influx can also lead to large price fluctuations in them.
The Japanese Yen is considered a "safe" currency for the same reasons as the Swiss Franc. In times of panic, people also tend to turn to the US Dollar. Since it is accepted as currency in many parts of the world - a testament to its stability and people's confidence in it - many people feel secure holding US Dollars in times of uncertainty.
How much cash is in circulation?
There are hundreds of trillions of dollars (equivalent) in circulation. Below are estimates of the circulating money supply for the 10 countries with the largest cash circulation (as of September 2021).
What other stores of value are there?
Fiat currencies are not necessarily suitable as a store of value, as they lose purchasing power over time.
As 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 although these values fluctuate, they are regarded as valuable assets.
Real estate is considered a store of value. A building can be a store of value for a time, but like a car, buildings typically require investments in maintenance. Over many years, the building could become worthless, but the value of land tends to increase - provided there is demand for it. Cars and vehicles are not considered stores of value as they depreciate through use.
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