Fiat CryptoCurrency

Cryptocurrency fans are often ranting about how fiat currencies are bad and unfair and controlled by the banks and government and that it all can be freed with crypto, made fair just because it is peer-to-peer and without the man.

It is mostly just wishful thinking, I have yet to see good theoretical model on how whole society could function just by using crypto tokens.

There are undoubtedly big upside of cryptocurrencies — mainly it’s peer to peer aspect.

  1. You can send your token far away and reasonably quickly, but only depending on your definition of quick
  2. And send it without too high fees, but again, your mileage might vary
  3. Also it used to be touted as anonymous — but is not really much so

Those were three big pros for bitcoin and all have not stood the test of time well. Of course, various altcoin technologies have implemented solutions for all the deficiencies of those three main advantages. So for the purpose of this article we can assume that they are solved.

But even with all of them solved, crypto token still acts at most like a coin from 12th century:

  1. It can exchange hands at will. Admittedly you had to have more physical contact
  2. It can be split into smaller pieces (not by using shears anymore, and it can have smaller fractions, but still)
  3. There was limited supply, as only real gold or silver could be used to create coin. New coins could be minted from gold dug up in goldmines, but some old ones also got lost, were made into jewelry or wore out over time
  4. It is used for only small fraction of overall economy — mainly among the rich and influential people. Little folk often did barter among themselves and paid their taxes in produce. And when not bartering, they often used cattle, sheep or other animals as a means of exchange.

It was very simple economy back then, very poor. And that is often what fans of pure peer to peer cryptocurrency, most often bitcoin, imagine as a bright future for humankind.

what is missing? First step is to go from coin to paper money. Not even full fiat currency, but paper money that is backed by gold. So what are things that made paper money so beneficial for economic success of last couple of centuries, industrial revolution and all the following breakthroughs of humankind?

Paper money was created and become more usable, when monarchies became less absolute, and kings could actually be held accountable to their debts. So treasuries of their kingdoms issued credit notes in return of gold by wealthy traders or nobles. As king could not so easily default on his debt anymore, due to being accountable to parliament (in the case of UK), those credit notes started to be used among traders as a simpler means of exchange, compared to gold that was relatively harder to transport quickly and securely. Ability to have debt let governments to survive bad times more easily, and kings probably were less prone to arbitrarily raise taxes whenever they felt a need. But most importantly — trade improved, and with trade came wealth for everybody involved.

Second big step for the paper money was rise of banks. They had existed previously of course, but now they could operate even more efficiently. They started issuing their own credit notes and started taking in deposits not only in gold but in credit notes as well. That led to fractional reserve banking, which in turn created explosion of economic growth.

So how does it work? Imagine bank, it has 100 gold coins in initial capital and deposits by savers. It gives out 10 credits each of 10 gold coins. 10 persons who get those credits promise to pay back 11 coins each after a year. But instead of giving actual heavy gold, they give paper notes saying ‘bank owes bearer of this note 10 coins’, and gold stays in banks vault.

Person who got the credit note, goes and buys something with it. Now somebody else has the credit note. As he is planning some expenses next year, he wants to save his note for future use. So he goes to bank and deposits the note. Bank promises to give it back to him with interest of half a coin year later. And with 9 out of 10 credit notes there is the same situation.

Bank now has 100 gold coins in the vault and 9 credit notes of worth 10 coins each. It has assets worth 190 gold coins, but only 100 actual coins. Now when somebody wants to take loan, bank gives them one of previous notes. And cycle continues — there is more money in the system than there are gold coins. That is called monetary multiplier.

Of course, it can lead to trouble — if 11 people with 10 coin notes come to get their gold at the same time, and bank only has 100 coins, then it goes bust. That is called a bank run and used to be a very scary possibility in 19th century.

Now however there are certain protections against it — for example banks are mandated to never give out more money than certain ratio against their own capital. That is set by central bank. Also banks can go and borrow extra money from central banks very quickly. And governments often insure bulk of smaller deposits, so ordinary people are reasonably safe.

But this is already world of real fiat currency. No more backed by gold, but just by trust in the system as a whole. Trust that central banks and governments will not do dumb stuff that could ruin the value of the currency. It has happened in the past and can happen again.

Unfortunately sometimes idiots are in charge.

odern society owes all of its wealth and success to fiat currencies, but that all comes with this inherent price of possible instability and ruin.

Because of that, good central bank that can influence supply of money in the system is essential. It can either increase or decrease bank capital reserve requirements, thus influencing multiplier. Or it can increase or decrease interest rate by which it lends money to banks. Or it can buy more or less government bonds, thus increasing amount of money in the system. Or sell them to decrease it. Or it can do stupid things with any of those methods and destroy the currency outright.

Government also can influence value of money by spending more or less than it can afford. If it spends more than it gets in as taxes (by borrowing), then more demand can push up prices, and create inflation. If it spends less, than it takes in as taxes, then overall demand decreases and and thus overall economy can slow down, in turn leading to some price decrease. But prices of course depend also on banking side of things, and on trade and on million other factors.

So balancing all this is tricky and there is no single right answer. Financial system is not pure math, it is total sum of wishes, feelings, needs and abilities of millions of people. Thus economics are more of a social science, not discipline of mathematics. And when you influence society, it can react in a ways that are hard to predict. Especially when accounting for countless other financial innovations on top of the basics described above.

nd all that complexity can not be superseded by bitcoin ‘just because’. Having peer to peer transactions do not solve this complexity in any way.

Of course, there is Etherium that expands on bitcoins initially simple built in smart contracts system. So you can have tokens that will do something automatically if certain conditions are met. Well, cool, that certainly has its uses and allows to innovate more in the ecosystem. And probably there are many more token technologies that expand the possibilities in different directions.

And there also crypto exchanges, that act as a rudimentary banks. Mostly matching buy and sale orders from different people, but also probably shortcutting some transactions by using their own accounts. Not sure how they work right now, but probably they could grow in that direction. Or go bust like MntGox, which even produced its own verb — ‘we got goxed’ meaning ‘we lost all our bitcoins because we trusted online wallet’.

And all the major features of cryptotokens are either controlled by single entity or by tally of votes from miners, amount depending on who has the most videocards piled up next to the cheapest possible power plant.

And if they disagree, they split and fork the community and technology, thus destroying the very trust they supposedly hold in such a high regard.

iven all that, what to do? What could be done to bring crypto tokens and currencies to mainstream financial system?

My answer is fiat cryptocurrency. Same ease of P2P transactions as bitcoin, no transaction fees, up to millions of transactions per second — as some alternative cryptocurrencies boast to have possible. Actual anonymity. Like cash.

But with actual monetary and fiscal controls on top of cryptocash, elevating it into modern financial world.

So how could monetary policy work with fiat crypto? In a very interesting ways — for example, banks would be able to create loans out of deposits by creating actual new crypto tokens, just as good as the original ones. No need of ‘bank notes’. But at the same time, main blockchain, would get this issuance registered and there would be smart contract created, that would enforce capital reserve rule set by central bank, controlling codebase of the fiat crypto.

Also other financial regulations, deposit insurance, etc, could be handled by central bank via smart contracts.

Infrastructure of the fiat crypto would be run by banks and other participants of the market. It would not require ‘proof of work’, thus not destroying our planet with tons of unneeded electricity use for performing one way math computation. There are plenty of alternatives already, and for sure many more in the works, given the late crypto craze.

Participants would run the infrastructure, central bank would own the codebase and would not let unauthorized code into the system. New regulations would be released as a software updates.

Government would run layer of software on top of base controlled by central bank. Using their layer government would enforce fiscal policy — calculate taxes on transactions, define types of transactions, provide accounting standards as a plug-in software as well as run any other numbers based laws and regulations as a software. Pensions, fees, tariffs, etc.

It would be extremely good for health of the financial system to have central bank software in the heart of the system. It is good to have something hard to change and mathematically predictable there. But for the government (fiscal) part of the equation it would probably be better to be little bit less strictly coupled. While many laws can be turned into formulas, many others can not, and need to be interpreted and executed by humans using human judgement. So taxes, fees and other government fiscal interruptions would be computed automatically, but there would always be a chance for a citizen or government official to override, appeal or otherwise interact with them. With each interaction safely and irrevocably recorded in the blockchain of course.

fter modern fiat currency has been replicated in crypto world, it would be possible to innovate on top of it. And instead of often dangerous financial innovations of the past, this time it would go down differently.

At first, innovations would be described as a smart contracts, basically in a strict programming language. Meaning, that they could be testable in simulated environments, controlling for both technical challenges as well as possible theoretical changes in the evolving society.

Besides that, both banks and governments would be able to create more personalized products and services. Many ideas that would have been unimplementable before, now would become possible, just because availability of programming language.

For example, while in the past it would be very hard to enforce extra 100 coin luxury property tax on male citizens, who have been caught speeding with cars worth more than 50000 coins, for more than 6 times in any given period of 4 months, now it would be just couple of lines of programming, and enforcement would be automatic and culprit would receive push notification of the applied tax roughly 5 seconds after his speedometer hit 95 kilometers per hour.

Same with financial products — it would not be a problem to issue targeted loan, meant to buy goods from particular supplier in the given time window, but only if company has at least 100k cash at hand at the time of transaction, with interest rate dependent on the price of the goods bought. It would be all coded in the smart contract attached to the loan.

lso government would be able to tackle problematic areas of the economy better. Making taxes of small companies more dynamic, supporting struggling parts of the country and population more directly. Instead of broad policy changes, that are easily abusable and often thought as unfair, making them more targeted. And, no, not simply helicopter money.

For example, if small city is suddenly hit with economic disaster, there is a flood and also big local company closes a factory, government can issue emergency monetary injection. And not just simply throwing money at the problem from high up, and then seeing how it never reaches actual people in need.

We have seen way too often, than it ends up in the construction companies or funds, that are somehow in the middle of things, while people get next to nothing, and also that comes way too late.

No, in this case it would be very targeted grant with attached smart contract — for all citizens who own property in this small town, or who have received salary from companies registered in this area, or who own businesses there. And grant would be in the form of tax rebate, that can be taken out immediately in cash. And it would automatically negate itself at end of the financial year, if recipient is doing extremely well.

And best of all, as it could be possible to calculate economic dip from the disaster, money to fix it could actually be created by central bank, instead of paid by the taxpayers. Targeted quantitative easing, in a small amounts, where risk of inflation is small — what can be better? It certainly beats just lowering interest rates to zero or playing with banking rules — any effect, positive or negative, must first go through large layer of bankers, before reaching actual people. In this way, if risk is minimal, quantitative easing could be a blessing than a curse.

And it itself could be regulated by a smart contract embedded in the core of the system.

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Martins Untals

Author of “The Invisible Complexity”, IT executive, and consultant, living and working in UAE, Dubai