What is Bitcoin Backed By?

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Last updated on August 25th, 2016 at 03:18 pm

Wondering what bitcoin is backed by? The answer is nothing at all, but that’s actually not a bad thing. Like most modern currencies bitcoin is not backed by gold or other precious commodities. In a sense, bitcoin’s value is derived from our common belief that bitcoin has value. The same is true of the American dollar, the British pound, and the European Union’s euro, as well as nearly every other modern currency.

Historically speaking, up until August 15th 1971 most currencies were backed by a commodity, usually gold or silver. In fact, before the invention of paper money, most currencies were coins fashioned from precious metals. Further, following World War II and up until 1971, most of the world’s countries operated under the Bretton Woods agreement, currencies were backed by gold.

The Bretton Woods Agreement and the End of Commodity Backed Currencies

In order to understand the current system, it’s important to understand the old system. Under the Bretton Woods system, central banks would be able to trade gold amongst one another, and currencies would be tied to the value of gold, and pegged against one another. When an exchange rate is pegged, this means its value is set. So if the American dollar buys .75 British pounds, that is the value that it is set at. Most peg rates are actually adjustable peg rates, meaning that policy makers can adjust the value when needed.

The Bretton Woods system was designed to reduce the currency fluctuations seen in the 1920’s and 1930’s. During this period currencies were moving rapidly and uncontrollably, which caused international instability, and helped to worsen the Great Depression, and create the conditions that led to the outbreak of World War II. While the Bretton Woods system worked well for awhile, it eventually caused disruptions of its own.

The End of Bretton Woods and the Rise of Fiat Currencies

The Bretton Woods succeeded in creating stability in the years immediately following the second World War. By the end of the 1960’s, however, serious faults in the system were beginning to emerge. Among the biggest faults was that the U.S. dollar was too strong, which caused disruptions in international trade. For this reason, among others, governments decided to abandon the agreement, and to use “fiat” currencies instead.

Basically, a fiat currency is a free floating currency that is not backed by any sort of commodity. In the past, your dollars or other currencies would have been worth a certain amount of gold or another commodity. In practice, trading in dollars for gold was often highly restricted, still dollars were at least hypothetically worth a certain amount of gold.

Now, the dollar is no longer tied to gold. Of course, you can still buy gold with your dollars, but their values are independent from one another. Most major currencies are also not pegged to one another, but instead are allowed to float. Exchange rates can thus vary between different currencies. A few years ago, a euro could have bought about $1.4 American dollars. Now? A euro will buy only about $1.13 dollars.

Bitcoin is sort of a Fiat Currency, but So What?

Like the dollar and the euro, bitcoin and most other digital currencies are somewhat fiat. They are allowed to float in the market, and their value is determined by the market. In sense, you could even say that digital currencies and their value are determined by consensus.

Unlike traditional fiat currencies, however, there are several key factors that make bitcoin’s value potentially more reliable. First, bitcoins must be mined through computers, which requires an investment of time and money. As it becomes more expensive to mine bitcoins, it is likely that the value of the bitcoins themselves will slowly increase.

Second, while governments can increase their money supply at any given time, thus depreciating the value of individual currency units, bitcoin’s supply is tightly regulated, and the number of new bitcoins entering the market is slowing decreasing. Bitcoin is not subject to the whims of government officials or anyone else for that matter. It is a free and independent currency.

What “Backs” a Currency is Irrelevant, Perception is What Matters

Since the end of the Bretton Woods agreement, the idea that commodities are needed to back currencies has become irrelevant. Instead, public perception and economic policies are what matter. Money has value because we believe it has value. This is true of the dollar, the euro, the pound, and yes even bitcoin.

We can trade our money for goods. Many retailers now accept bitcoin as payment. In fact, when evaluating new “exotic” currencies like bitcoin, adoption rates, the ability to buy goods and services, established history, and community size are arguably the best indicators of a currency’s value. Are people using it to buy goods? Is the community itself large, sustainable, and established? For bitcoin, the answer to these questions is yes.

Many people think of bitcoin as more of an investment asset than a true currency. Part of the reason for is because bitcoin prices tend to swing somewhat dramatically. The value of all fiat currencies can swing also dramatically, however. This is true even for government-backed currencies, which are subject to the whim of government policies. The British pound, for example, has lost much of its value over the past few weeks following the Brexit vote.

In some cases, hyper inflation can even strike with money becoming nearly worthless. Consider Zimbabwe, where inflation got so bad a few years ago that the government started printing up 100 billion dollar bills. When the currency was phased out, 35 trillion Zimbabwean dollars equaled 1 American dollar. More recently, in April the IMF reported that Venezuela would suffer inflation of approximately 500% this year, and 1,800% next year. As this inflation unfolds, Venezuelan money will quickly lose its value.

More often than not, the rapid onset of inflation is caused by government mismanagement and the over-printing of money. This is why bitcoin aims to be government free. People create their own money through mining. Then, bitcoin is allowed to be freely traded in the market. Further, since the money supply itself is limited and already set, policy negotiations are no longer possible. So while it’s true that bitcoin isn’t tied to any commodity, and that it is dependent on our collection perception, like most modern currencies, the P2P currency is arguably a more reliable currency than government-backed fiat currencies.

 

Brian Booker

An international financial analyst and writer. He has consulted for the Malaysian government, various MNC's, and other organisations. He focuses on currencies, commodities, and emerging South East Asian markets.
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19 Comments on "What is Bitcoin Backed By?"

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Dominic
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Dominic
I think a lot of people don’t understand how our current financial system works, much less what a fiat currency is. Nixon took us off the gold standard in 1971 to the chagrin of the world and the delight of the bankers and FED. Many of you are saying if you can’t hold it in your hands its not real. What you probably mean to say is it’s not tangible. The dollar bills we hold in our pockets are nothing more than bond certificates or IOU’s. A promise to pay said amount on the paper by the government, and nothing… Read more »
Rick M
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Rick M

Bitcoin seems to be gamers currency.
How does mining on the computer add to the value?
May as well sell your cyber character from your favorite game, it’s about the same value.
If you don’t get out, the ride will stop and you’ll be stranded.
Governments are responsible for currency values, With Bitcoin, you own stardust.

Zsofia Elek
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Zsofia Elek

Hi Rick, you can read more about Bitcoin mining in this article: https://99bitcoins.com/bitcoin-mining-profitable-beginners-explanation/

mc
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mc

You people are retarded. Bitcoin is a pyramid scheme designed to steal your money. Good luck comparing it to gold which has industrial uses.

mc
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mc

Bitcoin is a scam. Backed by nothing. Created out of thin air, it can vaporize in a millisecond. If you can’t hold it in your hand, you don’t own it. This stupid sh!t will be worthless before it’s over.

Ofir Beigel
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Ofir Beigel

I suggest to also take a look here:
https://99bitcoins.com/bitcoinobituaries/

Zsofia Elek
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Zsofia Elek

Bitcoin is not a scam, it is a decentralized cryptocurrency. I suggest read a bit more around the site, get familiar with the concept of Bitcoin before drawing such conclusions.

Woojae
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Woojae

you see people collect lots of currency and horde it and try to find labor at their price it’s like i have 100000000000$ and you can work for me 10$ an hour. the currency must have it’s own usefulness like gold can be use in teeth filling but then again it is easily replace by amalgam and other materials.

sensei
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sensei
To me, bitcoin is more like gold. Though gold is used in industry, as an investment asset class it has hardly any utility. It doesn’t pay dividends. If I possess physical gold, there is no use in it for me but a perception that It is valuable, because others would be willing to accept it in exchange for something that I want. As opposed to gold, bitcoin has little physical storage and transportation cost. Crypto currency is volatile now, since trading in it is rather speculative. However, If crypto currency becomes mainstream, be accepted as payments, as it is attempted… Read more »
M?
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M?

Good luck

Adam
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Adam
If a currency doesn’t back up by anything only perception, without weighing, availability, convenience in transaction, the age of objects etc, then how come it become precious same like our item that we have? example if i wanna buy your house then i just tell to you, “Hey dude i wanna buy your house heres the money (i gave you a ton of bread). Then you accept it cause your perception is bread value is equal or more than your house. But you forgot not counting other value on that item. If only perception that make a value on item… Read more »
George
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George

I don’t feel that bitcoin is a fiat currency. The high value of bitcoin is due to the difference in the currency value of countries. Its feasting on the currency values of different currencies. This is not the case with dollar or other currencies. However, I believe that as technology progresses new ways will emerge to have a stable e money.

Aleksandr
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Aleksandr

Unlike fiatnyh cash, the Bitcoin is not backed by gold or stocks, or any other material values. National Bank fund or share does not support cryptocurrency course. Pricing is entirely dependent on the supply and demand law. The interest of consumers provides a high market value of Bitcoins, and especially of mining provide an exponential increase in the deficit.

Anonymous
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Anonymous

Backed by energy. How much energy did it take to create a coin?

Ofir Beigel
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Ofir Beigel
“It is not correct to say that Bitcoin is “backed by” processing power. A currency being “backed” means that it is pegged to something else via a central party at a certain exchange rate yet you cannot exchange bitcoins for the computing power that was used to create them. Bitcoin is in this sense not backed by anything. It is a currency in its own right. Just as gold is not backed by anything, the same applies to Bitcoin. The Bitcoin currency is created via processing power, and the integrity of the block chain is protected by the existence of… Read more »
Anonymous
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Anonymous

yah agree

Professor
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Professor

Correct.

Willy Woo
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Willy Woo

Government fiat is by decree. Gold and Bitcoin has value by common consensus.

Bitcoin has utility as a supercomputing network that provides secure immutable and provable records. So you can say it’s backed by something physical and useful.

BILL
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BILL

I WILL TAKE GOLD ANY DAY ,BITCOIN IS AS WORTHLESS AS THE US DOLLAR!!!

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