From IOUs to Crypto

“The internet is going to be one of the major forces for reducing the role of government. One thing that’s missing but will soon be developed, is a reliable e-cash.”

~Milton Friedman (1912-2006); American economist and statistician, 1976 Nobel Peace Prize recipient.

Question: Could you discuss the concept of money, digital currency, and cryptocurrency? 

Answer: Let’s start with an overview of money and civilization. Before the development of currency, people bartered by exchanging one type of good or service for another. Ledger systems came into being using IOUs or tokens like shells, beads, or whale teeth in exchange for credit, goods and services. Obviously, these systems were cumbersome and lacked centralized control and oversight. 

As civilization developed, metals such as bronze, copper or tin were exchanged and valued because they had an end use and could be used for cooking utensils or weapons. Eventually, coins were issued with valuations based on the metal used. Gold and silver, because of their relative scarcity were made into coins and helped improve commerce. 

Upon returning from China, Marco Polo reported that paper money was used and eventually caught on as the medium of exchange around the world. Paper money was backed by a physical commodity such as gold or silver with values changing depending on supply and demand. When gold and silver began arriving from the United States, or what was known as the New World, the enhanced supply caused prices to go up in Europe, otherwise known as inflation.  

In 1973, the U.S. and other countries abandoned the gold standard which meant that gold reserves no longer back paper money, leaving us with a fiat currency. There is no inherent value in the dollar; the worth is determined by confidence or a shared concept of what a dollar can buy. The dollar is legal tender and recognized by courts of law as satisfactory payment of monetary debt. 

With technology, we now have electronic forms of money. Most central banks are studying digital currencies as part of the money supply and a key factor in global development of society. These changes are here to stay, offering benefits as well as potential risks. Today, the concept of money includes more than hard currency, with paper and coins representing only a small percentage of transactions. 

Stablecoins are a type of cryptocurrency tied to hard currency. Stablecoins may improve payment efficiency, speed settlements, and reduce costs, but they don’t offer the same protections as conventional payment systems like your bank account. Banks are required to hold a certain percentage of deposits in reserve. The rest can be lent out, adding to the money supply. There are a number of money supply measures reflecting various degrees of liquidity. The monetary base includes currency in circulation and reserves of banks and other depository institutions held at the Federal Reserve (the Fed). 

The Fed creates money by buying Treasury securities from commercial banks using money it literally creates out of thin air then crediting the commercial banks with bank reserves which are multiplied through the fractional reserve banking system. Banks must hold a certain percentage of deposits in reserve to provide liquidity to depositors; the rest can be lent out. Loans are made with excess reserves and further expand the money supply. The Fed increases or lowers interest rates to influence and adjust bank reserves. 

Bitcoin, Ethereum, and Dogecoin are cryptocurrencies or digital assets using ledger technologies, such as blockchain, to secure transaction records and verify transfers. Cryptocurrencies are an elaborate and elegant yet limited medium of exchange. At the moment, digital currencies can only be used to buy a small number of goods and services and transaction fees tend to be high. They may store value, but as we see, the values change dramatically from day to day. At this time, cryptocurrencies are not a readily acceptable, recognizable or convenient way to make payments. 

Some critics compare cryptocurrencies to a pyramid scheme and highlight a number of negative points. Cryptocurrencies are widely used in money laundering, the illegal drug trade, and other criminal activity. This is no different than paper currency when it is used for evil rather than for good intentions. Another complaint is that a great deal of energy is used when mining new cryptocurrency, adding further concerns about the impact on the environment. Despite its convenience and value, digital currency is extremely controversial. People have love-hate relationship for it. 

The Fed is studying the risks and benefits of centralized bank digital coins and will issue a discussion paper summarizing its findings later this summer. In the meantime, stay focused and plan accordingly.

The opinions expressed are those of the writer as of July 11, 2021, but not necessarily those of Raymond James and Associates, and subject to change at any time. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed.  Past performance does not guarantee future results. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Bitcoin issuers are not registered with the SEC, and the bitcoin marketplace is currently unregulated. Bitcoin and other cryptocurrencies are a very speculative investment and involves a high degree of risk.

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This article provided by Darcie Guerin, CFP®, Vice President, Investments & Branch Manager of Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. She may be reached at (239)389-1041, email darcie.guerin@raymondjames.com Website: www.raymondjames.com/Darcie.