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The investor’s guide to cryptocurrency [part 1]

06-04-2022

The decline of traditional currencies

Welcome to our Investor’s guide to cryptocurrency. In this first post, we will learn how the evolution of money followed by the 2008 Global Financial Crisis led to the rising of a new digital revolution in our monetary system. Continue reading to find your way into cryptocurrency investing.

The evolution of money

Money has had many forms throughout history. When most of humankind practiced hunting-gathering, we used to exchange goods through a system of bartering. The local hunter could, for example, exchange his kill for pottery to store his valuables. Individuals would agree on the value of both goods to make a deal.

However, this system had its flaws. Goods are not easily divisible, and it is inconvenient if you need to pay one-and-a-half sheep for some new clothing. Later on, people used objects that rarely occur in nature and whose circulation they could control as units of value.

This included multiple natural resources as currency in different parts of the world, such as amber, beads, silver and gold. The first known form of money, the Mesopotamian Shekel, only dates back to around 3.000 B.C. Currency in the form of coinage had many advantages over other commodities as these coins were more portable, durable, transportable, and had intrinsic value.

The relation between politics and money

The switch to coinage created an intertwining of politics and money. Only authorities were allowed to create new coins through mining, smelting and minting. These authorities predetermined the number of coins in circulation and where people could spend them. The money transformed into an instrument of political control. Most importantly, the change to coinage would make it easier to tax the public due to its divisibility and portability. These taxes were usually beneficial for the higher layers of society, which influenced these monetary policies.

Coinage eventually co-existed with paper money, but it took some time. The first recorded case of paper money appeared in the 11th century in China. However, only government officials used this form of paper money; later, in the 16th century, the first form of paper money emerged in Europe.

Goldsmith bankers in England handed out receipts after people deposited money. People would later redeem these receipts for money. Eventually, this system evolved into the Bank of England issuing notes in return for deposits. These notes and receipts had developed into the paper money we know today.

The digitalization of currencies

In the latter half of the 20th century, the Western World experienced a digital revolution. The invention of the computer formed the foundation of this revolution as they were able to calculate incoming deposits and withdrawals faster than the cashiers, and it made it possible for banks to keep an updated ledger of balances. This evolution was the first step towards the digitalization of our money.

The first modern-day credit card emerged during the late 50s and early 60s. Individuals were enabled to spend money without handling the currency in physical form. Computers executed the transactions, updating the bank’s balances. Not much later, the debit card appeared, and, steadily, money became digital. People started paying bills, transferring money between accounts and sending money electronically.

Today, only 8% of the world’s currency exists as physical cash. The rest of these financial assets, such as saving accounts, checking accounts, stocks, bonds, investments, and derivatives exist on commercial banks’ balance sheets and central banks.

Due to this digitalization, economies from all over the world have become more intertwined than ever before. Now, we can exchange currencies with the click of a button and trade foreign obligations through an app on our mobile phones. While this helped the rapid growth of the global economy, it also brought up potential vulnerabilities.

Ever since the financial crisis, many have seen the flaws of our current monetary system. It is time to face these flaws and take the next step in economic evolution.

Currencies without the Gold Standard

Early in the evolution of money, commodities backed currencies. That is the case of gold, which people could redeem for an agreed amount. This Gold Standard kept governments accountable for having a gold reserve to back the current circulating money supply.

In 1971, the U.S. government decided to leave the Gold Standard behind. Since then, a gold reserve no longer backed the U.S. Dollar. This is when the Fiat Standard was born. This new system allowed nations to increase their national debt beyond their resources. The value of a modern fiat currency relies on trust in the issuing government. If the trust in the government decreases, the value will go along with this trend.

The 2008 Global Financial Crisis

In 2008, many of us saw the first clear evident cracks in our financial foundation. The 2008 Global Financial Crisis developed rapidly at a rapid pace and spread across the globe within a matter of days. The crisis was triggered after the collapse in the value of mortgage-backed securities and derivatives tied to American real estate.

Due to a lack of transparency banks could sell these low-quality bonds without the notice of regulators and authorities. A bank’s collapse could spread globally like a Domino-effect due to the intertwining of our financial systems. A good example of this is the bankruptcy of the American banks Lehman Brothers and Bear Stearns, which eventually led to the nationalization of several European banks.

“There is definitely going to be another financial crisis around the corner because we haven’t solved any of the things that caused the previous crisis” – Mark Mobius, Founder Mobius Capital Partners.

Central banks and quantitative easing

To limit the consequences of a financial crisis, governments and central banks have one important instrument: Quantitative Easing. This monetary policy allows central banks to buy long-term investments, for example, bonds, aiming to increase the federal reserve’s balance sheet.

A new one is created for every dollar added to the balance sheet, increasing the money supply. This monetary policy was made possible only when leaving the Gold Standard behind. The downside of continuous quantitative easing is the increase in the money supply. Therefore, it has led to rising inflation and a devaluation of modern currencies.

To limit the influence of the Corona Crisis, governments aggressively started applying Quantitative Easing. The extreme increase in the money supply raised the inflation rates to a 40-year-high.

Reshaping trust with new currencies

The cracks in our financial foundation are still here. Quantitative easing has relieved the direct pains of the financial crisis but didn’t resolve the actual damages that allowed the situation to occur.

Modern fiat currencies are as strong as the trust in the governments and banks issuing the currency. The lack of transparency from governments and (central) banks about mortgage-backed securities caused people to lose their houses. In contrast, others continue to lose their purchasing power due to the increasing inflation.

People are losing trust in our traditional financial system and are searching for a transparent, permissionless and trustless replacement. In other words, a system where there isn’t a single entity in control, a system without a single point of failure, and a system that provides a clear monetary policy.

In short…

In this first part of the Investor’s Guide to Cryptocurrency, we explored how money and the traditional financial system have transitioned, from using the Gold Standard to the digitalization of money. Now, only a minor percentage of the world’s currency exists as physical cash or in the form of paper money. After the 2008 Global Financial Crisis, banks applied quantitative easing to lower the inflation rate; however, the roots of the problems remain in place. In the next post, Investor’s guide to cryptocurrency [part 2], we will dive into the arrival of Bitcoin and cryptocurrency to respond to the breaches in our financial system.

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