Learn what cryptocurrencies are backed by and how its prices are defined
Cryptocurrencies, being relatively new to the market, is received with a mix of reactions by the general public. To technology enthusiasts, the inception of Bitcoin and other cryptocurrencies are the beginning of a new era in the financial industry. To everybody else, it’s laden with questions and resistance, mainly because it deviates a great deal from what we’ve been used to for years: having a centralized entity acting as a custodian to bring forth stability and security for our hard-earned money.
But history has proven that having a centralized authority also has its disadvantages, such as stifling regulations and sluggish transaction times. The lurking problems of centralization are the very reason why cryptocurrencies came to be.
One of the long-standing questions about cryptocurrencies, other than how they work, is what are they backed by? How is the value, or price, of cryptocurrencies defined?
What does it mean to be backed?
Before discussing about what backs cryptocurrencies, the first question that needs to be answered is, what does it really mean to be backed? Long ago, gold was considered the universal backing of any financial transaction. Backing with gold was a necessary measure to control inflation and deflation.
Termed as the Gold Standard, it was the widely accepted monetary system where the value of a country’s currency was based on the fixed price set for gold. The Gold Standard has been in place for many years, until the time of the Great Depression when the system was abandoned. In the 1970s, the Gold Standard was completely replaced by the current Fiat System, where fiat money is regulated by the government; in other words, without gold to back money, our current monetary system is backed by virtually nothing but debt.
Circling back to gold, the next question pertinent is, what backs gold? Simply put, gold is essentially backed by our faith in its history; we’re so used to trusting gold for so many years now that we don’t question its reliability anymore—it just is, given its history.
What backs cryptocurrencies?
Cryptocurrencies are simply backed by pure trust in its underlying technology: cryptography. Bitcoin, Litecoin, Ethereum, and the majority of the cryptocurrencies in existence today are not backed by anything but faith in their algorithm and the blockchain—just as gold is backed by our faith in its history.
The current problem is that cryptocurrency and blockchain technology are fairly new concepts in today’s digital world. Therefore, not everyone trusts cryptocurrencies given how short its history is; there just isn’t enough viable evidence for people to trust the system yet.
What defines the price of cryptocurrencies?
If cryptocurrencies are not backed by any tangible asset, then how is its value defined? How can cryptocurrencies be a store of value or a unit of exchange if it’s not backed by anything?
During the Gold Standard times, the value of money was backed by gold. With our current Fiat System, without anything backing it but debt (which is still money itself), money has value simply because everyone thinks it has value. The same principle applies to cryptocurrencies: it has value because its underlying technology and the people behind it (miners, traders, and investors) believe it has value.
Cryptocurrency was designed to store assets without relying on a central entity to control it, which is why its main value proposition is decentralization. The value of cryptocurrency is dictated largely by its limited supply and the demand of its coins, and fueled mainly by speculation and belief in the idea(s) of its creator. The value of a single digital coin is also defined by the difficulty level in which its mining algorithm needs to be solved.
What are asset-based cryptocurrencies?
With blockchain technology still being fairly new, it’s far from perfect—yet it’s getting there. As its value is based entirely on speculation and trust, cryptocurrencies are vulnerable to wild fluctuations in value, oftentimes plunging and rising to as much as 10% to 20% in a single day.
This high volatility has prompted some cryptocurrency enthusiasts to create a type of cryptocurrency that’s more or less stable and less volatile: stablecoins. For a coin to be stable, it must be backed by something tangible and of stable value, usually in US dollars or a physical asset.
Asset-based cryptocurrencies, as the term suggests, are the types of cryptocurrencies that are backed by an asset so that its value remains almost always constant. Its value is defined by the price of the asset it is backed by. Some examples include the following:
– US dollar-backed: Tether (USDT)
– Gold-backed: DigixDAO (DGD)
– Oil asset-backed: Petro (PTR)
– Diamond-backed: Cedex (CEDEX)
– Real estate-backed: ATLANT (ATL)
The issue with asset-based cryptocurrencies, however, is that they require a certain degree of centralization because there has to be a centralized custodian to keep the assets they are backed by. This, in effect, defeats the very purpose of blockchain technology, which is to offer decentralization.
Both cryptocurrencies and fiat money are, in essence, backed by faith and absolute trust in their respective underlying systems. While asset-backed cryptocurrencies are on the rise in an effort to respond to the weakness of current blockchain technology, there is still room for improvement. It was deemed possible for traditional money to move away from relying on the Gold Standard; thus, with the amount of technological advancements we have today, it’s more than possible for cryptocurrencies to exist in a purely decentralized economy where the value of digital money may not need backing by any tangible assets whatsoever.
– Article written by Tinny