Personal Finance

What Is Fiat Currency?

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Fiat currency is a term that describes the money you use every day. The U.S. dollar is a fiat currency, as are most other modern currencies circulating around the world.

Fiat currencies’ values are generally supported by the economic power of a government. This kind of money is different from an asset-backed currency, which derives its value from an underlying asset.

A currency based on the value of gold, for example, would be an asset-backed currency. Asset-backed currencies can also be legal tender, but since the Great Depression the international monetary system has emphasized fiat currency.

Today, the term fiat currency is commonly used as a way of distinguishing regular money from cryptocurrency. Cryptocurrency is a digitally created form of payment that can exist without the help of a central bank.

Why is it called fiat currency?

A “fiat” is an official order or decree. So if a currency is created by a government order, you could say it was created by fiat — making it a fiat currency.

An expression of such a fiat is written right there on the dollar bills in your wallet: “This note is legal tender for all debts, public and private.”

What gives fiat currency value?

For many years, dollars were actually backed by reserves of valuable assets such as gold and silver. The U.S. went off the gold standard for domestic transactions in the 1930s and ended international conversions in 1971. Dollars haven’t been redeemable in silver since the 1960s.

Today, the U.S. Federal Reserve is required to hold collateral equal to the value of the dollars in circulation, and it does so using government-issued debt.

So essentially, the dollar has value for two reasons:

  1. Because the U.S. government says it does.

  2. Because investors and lenders around the world believe that the U.S. government will repay its debts.

Fiat currency vs. cryptocurrency

The main difference between fiat currency and cryptocurrency is that cryptocurrencies don’t require government backing, while fiat currencies depend on it.

Most cryptocurrencies are created using a cryptographic computer networking technology known as blockchain, which enables them to circulate without the need for a central authority such as the Federal Reserve.

Many proponents of cryptocurrencies argue this “decentralization,” in which currencies are governed by users instead of central authorities, will result in more efficient and less corrupt monetary systems.

However, there’s nothing stopping governments from using cryptocurrencies or their associated technologies in national currency systems. El Salvador in September 2021 became the first nation to adopt Bitcoin as legal tender. And China is developing a digital version of its yuan national currency.

Because most cryptocurrencies aren’t backed by central banks, they derive their value from different sources.

Bitcoin, the first and most valuable cryptocurrency, generally has its value determined by the market logic of supply and demand. There’s a finite supply of Bitcoin that’s governed by its underlying software, so when demand goes up, so do prices.

And because many investors in cryptocurrencies are speculating on their future worth, prices relative to the dollar have been quite volatile.

On the other hand, certain “stablecoins” are backed by a reserve of cash or other commodities intended to keep their value stable.

The author held no positions in the aforementioned securities or cryptocurrencies at the time of publication. NerdWallet is not recommending or advising readers to buy or sell Bitcoin or any other cryptocurrency.

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