By Larry Wright
What is Inflation?
More and more people want to know more about cryptocurrencies like Bitcoin due to its claim of working as a solution for inflation. But first, it is important to understand what inflation is? Every country issues fiat currencies or paperback money for its citizens. Over time fiat currency keeps losing its value which is called inflation.
It means that a person who was able to purchase 100 grams of a product for one dollar some time ago can only purchase 50 grams for the same money now. For the most part, people do not like inflation and treat it as a destructive force. Understandably no one wants to lose the value of their savings. However, there are always two sides to every coin, and the same logic applies to inflation as well.
Why does Inflation Happen?
To understand inflation better, it is important to understand why it is a continuous process and how it happens. All fiat currencies are issued by a government institution such as Central Bank. The Central Government usually prints more money than its original requirement. Due to the economic principles of supply and demand, the increasing amount of money decreases its value. The direct result of money devaluation is the increase in consumer goods.
Many people listen to stories from their grandparents about how they were able to purchase one-cent chocolate candy that is now sold for one dollar. Kids from the 80s or 90s may remember purchasing one egg for ten pence, and after 2 or 3 decades, they saw the price of one egg increase by 100% or more. This continuous inflation of fiat currencies encourages people to invest in cryptocurrencies such as Bitcoin.
Is Inflation a Necessary Output of a Healthy Economy?
Many economists believe that inflation is sometimes a good and necessary force. A Cambridge university economist, John Maynard Keynes believed that there are certain scenarios where inflation is not a harmful thing. Investors like Ray Dalio once said that inflation and growth are the two main drivers for generating asset class returns.
Due to inflation, the government can create more job opportunities during economic recession periods. However, it is crucial to understand that good inflation is controlled and occurs in smaller percentages. With low inflation, people are inspired to spend more and acquire investment products like stocks, bonds, and cryptocurrencies.
Hyperinflation and its Disadvantages
It is clear that lower rates of inflation indicate the growth potential of an economy and are considered a healthy development. Nevertheless, inflation eventually runs out of the bounds of careful estimates and becomes a big issue such as hyperinflation. Hyperinflation is a period when the purchasing power of the masses decreases while the prices of goods and services increase drastically.
Under these circumstances, living costs rise by many folds, and the value of the regulated fiat currencies keeps decreasing. During the COVID pandemic, the Federal Reserve tried to control the economic crisis with stimulus checks and money printing. However, despite all the corrective measures, the Central bank still could not stop the massive amount of money devaluation due to the excessive supply of fiat currencies. Once again, people looked at cryptocurrencies to keep their savings from losing more value.
Cryptocurrencies as Deflationary Assets
Cryptocurrencies like Bitcoin are deflationary assets by default. A deflationary asset refers to a type of commodity that can resist the loss of value over time. It is important to understand that, like all other asset classes, cryptocurrencies also experience inflation to some degree. However, due to their inherent nature and the default design of blockchain, they have a higher tolerance against inflation.
People often buy Bitcoin to prevent loss of money due to devaluation and inflation. Between 2010 and 2020, Bitcoin prices traveled from 0 to $20,000 per unit. It is worth mentioning that Bitcoin is a digital ledger that allows people to record their transactions on a decentralized network that operates independently of any central government.
Here is why cryptocurrencies are deflationary:
Inflation Hedge
Bitcoin is often touted as a protection or hedge against inflation. When the citizens of a country want to find an alternative to store their money in an investment option, they pick Bitcoin. Since its introduction, Bitcoin has managed to keep increasing in value consistently. During the 2020 bear market, Bitcoin prices fell by 300% due to rising inflation. However year-to-date index showed. Bitcoin prices were still 2% up, which saved the investor’s interests.
Lack of Central Control
Cryptocurrencies like Bitcoin are decentralized, which means that they operate independently of any Central Banks or government influences. Every central bank is liable to conserve national reserve and manage the government securities. There are many instances where the monetary policies of the government, like money printing or change in the interest rates, can affect the fiat currencies negatively. Meanwhile, cryptocurrencies are safe from such external influences due to their decentralized nature.
Limited Supply
Before Bitcoin, physical gold was used as legal tender collateral and a national reserve option for many years. However, at any point, the discovery of new gold mines could increase supply and decrease the value of the gold reserves. Such a sudden entry of new gold reserves can also crash the price of the fiat currencies that were pegged to the shiny metal. Today, most central banks don’t rely on gold as a reserve option. However, crypto coins like Bitcoin are safe from such unexpected price fluctuations due to their limited supply i.e., 21 million.
Quarter Yearly Halving
Many people have claimed that fiat currencies are a Ponzi scheme because the government of a country can print money as much as they want without any accountability. On the other hand, cryptocurrencies like Bitcoin are safe from such risks. The total supply of Bitcoin is fixed at 21 million coins in total that can never increase. Furthermore, the supply of Bitcoin has halved every four years automatically. The process of 50% Bitcoin supply reduction every four years is called halving. Like fiat currencies, if too many Bitcoins enter the market at once, their price can crash. Therefore, halving diminishes the supply of the new token entry into the market that warrants its safety from sudden devaluation.
Institutional Interest
There are many corporations and financial institutions that have started to prefer Bitcoin as a portfolio diversifier. The presence of big players in the Bitcoin market generates better goodwill for the token as a reliable investment product. Over the years, the institutional interest in Bitcoin has shown a consistent increase due to its steady price appreciation in comparison to fiat or stocks.
Digital Gold
In olden times, investors used to purchase gold to secure their savings for the future. However, in recent times Bitcoin has managed to assert itself as a digital alternative to gold. While gold can be made into jewelry and items of adornment, it takes time and a lot of investment to keep it safe. Meanwhile, people can store Bitcoin on hardware and software digital wallets that are secured by encryption. Furthermore, anyone who holds Bitcoin can instantly transfer it online or convert it into hard cash for personal use.
International Currency of Exchange
The ongoing crisis in Ukraine has proved that Bitcoin is effective as a currency during emergencies such as war. During the war, the Ukrainians suffered from the failed banking system. However, the people were able to gain access to Bitcoin donations when the fiat currencies crashed and became scarce. Likewise, Russians and Turkish citizens were able to use Bitcoin when their local currencies were devaluated drastically.
Universal Banking Facility
El Salvador accepted Bitcoin as a legal tender last September. The president of the country claimed that while people lost faith in fiat currencies due to the unfathomable amount of inflation, Bitcoin arrived as an alternative. Furthermore, Bitcoin was able to provide financial services accessible to anyone who has a smartphone. There are other cryptocurrencies like Cardano native ADA that are trying to provide financial services in remote areas of Africa where local people are still largely unbanked.
Disadvantages of Crypto Volatility
Cryptocurrencies offer several merits and advantages over regular fiat currencies when it comes to combating inflation. However, one downside of tokens like Bitcoin is the high volatility. A 30% price loss for a stock is deemed as bad news. On the other hand, for cryptocurrencies, the margin of such losses is a fairly regular occurrence.
Veteran investor Mark Cuban once claimed that the high-risk factor of cryptocurrencies is the main reason that their profit margins are so massive. The general sentiment around Bitcoin dictates that the price of the crypto is going to rise during uncertain times. Sometimes, against all expectations, the price of the crypto market crashed alongside the stock market during the COVID restrictions.
Financial theorists postulate that inflation has a direct correlation with the price point of the cryptocurrencies like Bitcoin. During the July 2020 bear market, Bitcoin prices lost a significant chunk. However, in August of the same year, the year-to-date price of the token rise from 2% to 300%. Showing price volatility, Bitcoin prices crashed by 45% in May next year once again. Some crypto enthusiasts look towards stablecoin to counter the volatility risk of crypto.
What are Stablecoins?
Stablecoins are another byproduct of blockchain that have a fixed value. A stablecoin issuer needs to peg the token value to a reserve to ensure its price stability. There are three ways that the stablecoin issuers maintain their fixed value:
Capital Reserve
There are some stablecoins like Tether (USDT), where the issuer holds an equivalent reserve in the form of fiat currencies. Tether management claims that the company holds 1 USD to back every Tether token. When the price of the USD increases, more Tether tokens are printed. On the other hand, when the price of the USD is decreased, Tether or USDT tokens are removed from the main supply to maintain 1USD price per USDT token.
Cryptocurrency Reserves
Sometimes, the stablecoin issuers peg the price of the token to another cryptocurrency. MakerDAO stablecoin DAI is one such example. It is worth noting that such stablecoins are subject to high-risk factors due to the massive volatility of cryptocurrencies. Therefore, MakerDAO has primarily pegged its stablecoin with fiat reserves as well.
Gold Pegged Stablecoins
A new trend in the stablecoin market is to peg with gold reserves. There are some examples of such tokens, such as PAX gold and Tether Gold or XAUT coins. It is possible to back the stablecoins with other types of trade commodities as well, such as silver, etc.
Algorithmic Stablecoins
These types of stablecoins are not backed by any type of asset class or monetary collateral. Such stablecoins use smart contracts that monitor their prices and maintain a fixed price by controlling the demand and supply dynamics. DAI token is one of the best examples of algorithmic stablecoins that claim to be decentralized as well.
Can Stablecoins Offer Protection Against the Unpredictability of Cryptocurrencies?
The main use case for stablecoins is to allow the investors to convert their digital reserves from cryptocurrencies to stablecoins when the market is declining. This service is useful for cryptocurrency investors because many cryptocurrency exchanges do not provide the option of fiat conversion. With the help of stablecoins, investors can convert and save their cryptocurrency profits without needing third-party applications.
Another advantage of stablecoins is that they are backed by banking enterprises. For example, the BUSD stablecoin issued by Paxos is regulated by the NYC Department of Financial Services or NYDFS. Due to this feature, the investment risks associated with cryptocurrency trading reduce by a big margin. Recently, the Office of Comptroller of Currencies or OCC allowed stablecoins issuers to list tokens on all public blockchain ecosystems.
Many elected officials have criticized the price volatility of cryptocurrencies as a major concerning factor. Recently, more government officials have started to come around to the idea of making stablecoins more popular as a way to allow digital investors to mitigate the risks that are associated with cryptocurrency trading.
According to a 2021 article published in CNBC, US Treasury Secretary Janet Yellen claimed that stablecoins have the potential to transform the financial system. She was speaking at the Housing and Urban Affairs Committee in Washington, D.C. The politicians also proposed that US legislators should pass a bill in Congress that ensures that only banks with financial insurance can issue stablecoins.
In addition to the stock market, many investors like to make money from Forex Trading. Forex Trading is the process of making money by purchasing fiat currencies of different countries on account of their conversion rates. Some people compare stablecoins to Forex trading for the crypto market. Just like crypto, stablecoins are available on all major cryptocurrency exchanges.
Another advantage of stablecoins is that investors can also purchase these tokens directly with fiat currencies. Every digital currency trader that has a digital wallet and KYC verification can purchase stablecoins and exchange them for other stablecoins like USDT, BUSD, and TUSD without any transaction fee charges. Some selected platforms allow people to stake their stablecoin and earn yield against them.
Risks Involved with Stablecoins
Stablecoins are a great way to escape the high price volatility of digital tokens. However, the crypto product is not free from some shortcomings that everyone should be aware of.
- Stablecoins prices can lose all their value and crash immediately if the price of its collateral crashes down.
- Stablecoins are thought to become useless in the future when cryptocurrencies will evolve and become more universal.
- Stablecoins are centralized, and they require the sharing of personal financial history with a government organization which hinders privacy.
- There are some instances where the stablecoin issuers falsified or forged their collateral reserves which resulted in catastrophic results.
- Examples of big failures like TITAN and IRON stablecoins create doubt. Both these stablecoins crashed suddenly last year, leaving their investors in massive losses.
- There is still a lack of regulatory framework available for stablecoin issuers that grant them the freedom to keep their collateral records private.
Conclusion
Inflation is a real phenomenon. While a small percentage of inflation signals a healthy and growing economy, events such as hyperinflation can be detrimental. Cryptocurrencies such as Bitcoin allow the investors to convert their savings into a steady stream of income and provide them security against money devaluation. Every prospective investor needs to understand the market dynamics and risks before making any financial decisions.
Cryptocurrencies have proved to be more reliable in combating inflation in comparison to stocks, bonds, and forex trading, but they are not free from risks such as high price volatility. One great way to counter crypto price fluctuations is stablecoins. Stablecoins allow investors to safely reduce their investment risks when the crypto market is down. The government is trying to introduce policies to ensure that the investors have access to secure, transparent, regulated, and verified stablecoins so that they can effectively mitigate crypto trading risks.