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

Fiat currency is government-issued money used around the world, but what exactly is it? In this article, we delve into its origins, how it can be traded and the effect it has on money supply, foreign exchange and physical money through bank notes and coins.

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What is a fiat currency and how does it work?

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 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 stocks 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.

Pros and cons of fiat currency

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

Advantages of fiat currencies

  • A central bank can increase or decrease the supply of currency whenever needed, giving it control of an economy’s money supply by also setting interest rates, in turn giving it the ability to more easily control inflation and deflation.
  • A central bank can also devalue its currency to make its exports look more attractive to other countries, in turn potentially boosting international trade and the country’s GDP. This is typically achieved by increasing the supply of the currency and is sometimes referred to as a ‘race to the bottom’ since multiple countries may be doing it at the same time. The term debasement stems from when coins were primarily used. Gold and silver coins would be mixed with other less expensive “base” metals, which reduced the overall value of the metals in each coin.
  • The money supply of a fiat currency is controlled by a governing body that is put in place to maintain the interests of the nation. It is not controlled by the amount of gold there is in circulation or other commodities​, for example, that could be affected by new mines or changes in technology, which may affect the supply and demand for commodities (and therefore, unexpectedly effect the value of a currency).
  • 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 public’s value and faith in a fiat currency is based on its responsible handing by the governing body of that currency. Central banks and governments don’t always get it right. If they increase the money supply faster than the economy is growing, this will lead to inflation. If there is way too much money supply, this is called hyperinflation where interest rates, as well as prices, soar.
  • If there is not enough money supply or people are unwilling to spend the money they have, this will slow the economy down and cause deflation. A situation where prices of goods, and financial markets, tend to decline reducing wages and wealth for most people.
  • As the central bank overseeing the fiat currency tries to control the price of a currency, it may not be able to forecast the result of what has been implemented. Often a central bank solves a short-term problem, while creating a larger long-term problem. This can result in bigger swings in the business cycle and in the price of financial assets, such as the stock market. When there is too much money supply, stock prices rise, potentially forming a bubble in the stock market​, and then collapse, rapidly removing the amount of currency in circulation and causing financial hardship for many.

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 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 currency however they liked, except for basing it on gold, as that attempt has previously failed.

How well do fiat currencies hold their value over time?

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.

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What factors influence the price movement of fiat currencies?

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

Currency manipulation tactics used by governments and central banks

Governments and centrals banks hold large sway over how a currency is valued. Both authorities have several tools they use to affect or manipulate the price of their currency for a desired effect, including:

  • Quantitative easing​ (QE), which increases money supply by purchasing long-term fixed income securities. This pushes down inflation and pushes assets like fixed-income securities, bonds, and stock prices up. At the same time, it may also lead to a decline in the price of the currency.
  • Intervention in the open market is not as common for most countries, but certain countries, like Switzerland, do it more often. This is when the central bank goes into the foreign exchange market and directly buys or sells large amounts of currency to push a currency price up or down.
  • Countries may also peg their currency to another currency, creating currency correlations​. This may be beneficial for large importers or exporters since the real cost of goods stays the same. When currencies fluctuate, goods can become more expensive or cheaper when priced in another currency. For example, the Chinese yuan is pegged to the US dollar. Several other countries are also pegged to the US dollar.
  • A country’s government or central bank may also place a currency floor or ceiling. This is when they won’t let its currency rise or fall more than a certain amount against another currency.
  • Encouraging or discouraging the holding of a currency. For example, Switzerland imposed negative interest rates on large cash balances held in Swiss accounts to thwart buying, which was increasing the value of its currency.
  • Revaluation of a currency is when a country changes the exchange rate of its currency relative to a benchmark. As a result of runaway inflation, Venezuela, for example, issued new bills where one new bill was worth 100,000 of its old bills in 2018.

Economic impact

How an economy performs will affect its currency. If GDP, wages, and employment figures are on the rise, this points toward higher interest rates which may attract increased international buying of that currency for its relativity attractive yield. When an economy experiences surplus growth, a slowdown may be expected which would mean lower interest rates and therefore, more selling of the currency which pushes exchange rates back down. Learn about these types of economic indicators​.

One at the expense of another

Currencies are always traded relative to one another, not inside a vacuum. While one country may have a great economy, it may trade at a lower value relative to a country that has a stronger currency. Or a country that has a seemingly weak currency may have a higher value relative to other countries that are doing even worse. This is what causes foreign exchange rates to move and gives traders an opportunity to profit from these speculating on these price movements. Currencies are always a comparison.

Supply, demand, and speculation

Supply and demand are partially determined by the factors mentioned. Speculation can also play a role. As a currency rises, it attracts more buyers. When that trend starts to turn, those buyers turn into sellers. The more speculators there are, the bigger impact they can have. Intraday, technical analysis​ and traders placing trades based on technical levels may have an impact, while fundamental factors play a more significant role over longer-term movements.

How can I trade the price movements of fiat currencies?

  1. Open an account. We offer 330+ currency pairs to trade on, which is the highest offering in the forex industry*.
  2. Choose your derivative product between spread bets and CFDs. These allow you to speculate on the price movements of currency pairs, rather than investing directly in the underlying asset, allowing you to trade on both sides of the market whether you think the price will rise or fall.
  3. Learn forex trading strategies that capitalise on currency movements.
  4. To view forex prices, open our Next Generation trading platform and click on ‘Products’, then ‘Currencies’.
  5. Click on a forex pair to open a chart.
  6. Look at different chart time frames, add technical indicators and check the ‘News & Analysis’ tab for news that is driving the price.
  7. Click the bid or ask price to sell or buy (open a short or long position). These are in the right corner of a chart.
  8. You’ll now have an order window open. Choose whether to place stop-loss and take-profit prices and how much you want to risk on the trade. Place your order.
  9. Track your trade in the ‘Positions’ tab.

Fiat versus cryptocurrencies: what’s the difference?

Please note that CMC Markets doesn’t offer cryptocurrency trading; this information is for general purposes only.

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.

Fiat currencies versus commodity money: what’s the difference?

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.

What are some safe haven fiat currencies and why are they deemed safe havens?

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.

How much fiat currency is in supply?

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.

Country Circulating supply
China ¥230,220,000,000,000
United States $20,709,367,701,000
Eurozone €13,972,924,000,000
Japan ¥1,515,543,000,000,000
UK £3,373,025,000,000
Korea ₩4,693,468,000,000,000
India ₹193,119,000,000,000
Canada $2,989,239,000,000
Hong Kong $16,270,817,000,000
Taiwan $51,857,579,000,000

Source: FiatMarketCap

What are some other stores of value apart from fiat currency?

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.

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Is bitcoin a fiat currency?

Bitcoin is not a fiat currency. While it does not have any intrinsic value, there is a cap of 21 million bitcoins. Although bitcoin has forked and will likely continue to, resulting in different types of bitcoins – such as Bitcoin XT and Bitcoin Cash – with varying quantities in circulation.

Which are the biggest fiat currencies that I can trade?

EUR/USD is one of the most popularly traded currency pairs​ in the world. This is followed the USD/JPY, GBP/USD, USD/CHF, AUD/USD, and USD/CAD. Therefore, the US dollar, euro, British pound, Japanese yen, Swiss franc, Australian dollar, and Canadian dollar are some of the biggest fiat currencies to trade.

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