What is backing Bitcoin?

What is a backed currency?

A backed currency comes with a guarantee that it can always be exchanged for a predetermined amount of another asset. For example, issuing a currency backed by gold, a government may guarantee that 100 units of the currency can be traded for an ounce.

Any asset can back a currency. The most common assets are gold and silver. The United States began to back dollars with gold in 1879, given its fungibility and scarcity.

Currencies can also peg other currencies. The issuer of a pegged currency guarantees that it will be worth a stable value against its currency pair. This arrangement thrives with confidence in the issuer’s ability to maintain a fixed exchange rate. However, backed currencies devalue if market participants lose faith in the issuer. Black markets for currency exchanges typically follow, and unveil the real exchange rate.

Government-issued currency without any backing is known as fiat “currency.” Fiat means “let it be done”, from the Latin translation of Genesis when God created light.

Why back currencies?

Currencies are backed to ensure that they maintain value. Currency is a necessary tool for governing, but many countries have issued unstable currencies. This makes it difficult for citizens to use the currency effectively and hurts economic growth. A government can print its currency indefinitely, but the more it prints, the less scarce the currency becomes. A government can protect its currency from inflation by acquiring more of the backed asset in order to maintain a credible exchange rate.

A government can back their currency with another asset to reassure citizens that it will retain its value. However, this method will only succeed if citizens trust the promise of the backing. If holders of the currency begin to doubt that the government has enough of the corresponding asset to ensure the promised exchange rate, then the currency may deteriorate rapidly as individuals attempt to exchange their currency for the scarce underlying asset.

What is backing Bitcoin?

Bitcoin is not backed by any asset, or controlled by any person or organization. Therefore, nobody is in a position to make this promise, and they would not gain anything by assuming the liability associated with ensuring the backing. The lack of backing does not mean Bitcoin does not have value. The majority of currencies do not have any backing. By definition, a fiat currency is not backed, and is what every major economy uses to transact.

However, a government-issued currency usually derives its stability from the central bank’s control of the quantity of money issued, and the faith its citizens and other nations place in the government’s stability. When this faith is eroded, a fiat currency can depreciate rapidly as citizens and foreign nations try to trade their currency for more stable assets.

For a better comparison to Bitcoin, consider assets that are not issued by a central authority. Precious metals that derive their value from scarcity are similar to Bitcoin in this sense.

Owners of gold are not entitled to exchange it for another valuable asset. Gold is valuable itself. Individuals are generally not worried about gold depreciating because the market has valued gold for millenia. Similarly, Bitcoin’s value comes from the demand for Bitcoin and does not require any backing to maintain this value. It is the first asset in history engineered to be scarce with a fixed supply cap.

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