Money 101
To better understand or appreciate cryptocurrencies, it’s important to get a good grasp of the nature of money. This is because cryptocurrencies are a form of money and by understanding the true nature of money, especially what important characteristics it should possess, you’ll be able to better appreciate and understand the nature of cryptocurrencies. And in turn, you’ll be able to better understand the principle of hodling.
What is Money?
At its very core, money is something that is used to represent the value of other things. If you study history, you’ll see that the values of things have been expressed in different forms and money, the primary way by which values have been expressed has come in different shapes and materials. Case in point, things like gold, shells, wheat and salt have been used in the past to represent value and as a medium of exchange. But for something to be able to continue representing value, the people who are using it must continue trusting that a medium of exchange is indeed valuable and more importantly, its value will persist for a long time so that they will still be able to benefit from it in the future.
How People’s Trust in Money Has Evolved
Only until one or two centuries ago, societies had always placed their trust in something when it comes to the value or representation of money. But the way people trust in money has shifted from trusting something to trusting someone.
In the past, people would use - as I mentioned earlier - stuff like gold, wheat, salt and even seashells as a medium of exchange or money. But over time, people caught on to the fact that using such things as a measure of value and medium of exchange can be quite burdensome. Can you imagine buying your groceries with seashells or salt? What if inflation was very high the last several years and you want to buy a month’s worth of groceries? Can you imagine bringing that much salt to the supermarket? And if you’re the grocery owner, can you imagine having to weigh the salt being paid to you by your customers and needing a very large space and vehicle to store and transport all that salt? And what if it rains? Do you get the picture?
Because of such inconvenience, people were forced to improvise and come up with a more practical value storage and payment solution; paper money! So this was how it worked in the beginning.
When you take up a bank or the government’s offer to take physical possession of your gold bars for storage, they’d issue you certificates or bills for the amount or value of the gold you deposited with them. Say your gold bars were worth $500, the bank or the government taking possession of your gold bars would issue you a paper certificate or bills worth $500.
Because of the convenience and practicality it brings, paper money has grown so much in popularity and has become the primary means by which goods and services are bought and sold all over the world today.
Back in the day, the value of the United States dollar was linked or based on gold. The money of the United States of America was valued based on its gold holdings. This was referred to as the Gold Standard. But over time, the macro economy has changed and as a result, the link connecting the value of the United States dollar to the value of gold was cut. As a result, Americans - and the rest of the world, considering the US$ has become the world’s primary currency - had been conditioned to shift their trust from gold to the Federal government.
In other words, people have been conditioned to shift their trust when it comes to monetary value from something - gold - to someone who assumed responsibility for the value of the dollar, which is the Federal government. And the only reason this system continues to work is trust because let’s face it, there’s no real underlying asset of worth behind the value of the dollar or other currencies. This was how fiat or paper money was born.
Fiat Money
The word “fiat” is a Latin word that’s best interpreted as by decree. This means that any fiat currency, i.e., paper money, only has value because their respective governments say so. As a result of such legal decrees of value, paper or fiat currencies are also called “legal tender” which means they have to be accepted for payment of goods and services in their respective countries. That being said, you can now see that money as we know it today has value only because of its legal status, which is declared by governments. As I mentioned earlier, the trust in the value of money has shifted from something (gold) to someone (the government).
Now fiat money as we know it now has some pretty serious issues. These are being centralized and are practically unlimited in quantity.
Being centralized means that there’s a central or lone authority that has the power to issue and control its supply, which in the case of the United States dollar is the Federal Reserve. It’s also practically unlimited in quantity because the Federal Reserve has the power and capability to print or mint more units of the US dollar if it chooses to do so. Now, why is this a serious concern?
The reason is one of the most basic principles of economics; supply and demand. To be more specific, this means that when the supply of an object is increased, the value of that object will tend to decrease assuming demand for that thing remains constant. Conversely, when the supply of an item is decreased, assuming constant demand, the value will increase. So if the Federal Reserve or any monetary authority prints more money, it’ll flood markets with more of that currency, which can make it worth less, i.e., buy less of goods and services. So when you see the prices of goods and services rising substantially over the long term, it’s not necessarily because they became more expensive but because the value of the currency, e.g., the United States dollar, has dropped due to increased supply.
Digitizing Money
The establishment of fiat money has made it easy - even mandatory - to create digital ones. The advent of the Internet and establishment of monetary authorities that control and issue money have made the idea of digitizing money, i.e., making the most of digital or online currencies and letting such authorities keep tabs on who owns how much, a feasible and even necessary one. Proof of this is the evolution of alternative modes of payment to the point that they have become the main methods for transacting today.
For example, credit cards, fund transfers and PayPal have become standard forms of payment these days. And in the United States, in particular, paying in cash is looked upon as unconventional or even suspicious in some cases. The ramifications of this evolution are huge. One of them is the ever shrinking amount of physical money circulating in many of the world’s biggest economies and financial systems.
Becoming exceedingly digitized, how does money in its digital form work? And a more specific concern with the digitalization of money is this. What systems are in place to prevent doublespending of money, i.e., what’s to stop me from digitally reproducing my money so that I’d have so much more than what I actually have? You know, like creating duplicate copies of my favorite songs for listening on my different devices.
Most financial institutions today address this issue with centralization. What this means is there’s only one party responsible for keeping records of financial transactions under a particular system, i.e., keeping track of who owns what and how much. Everyone who transacts under such systems has an account, which has a specific ledger under which all transactions and balances are recorded and maintained. Everyone - including you and me - trust the systems of financial institutions to keep accurate records of our balances and these institutions, in turn, trust their computer systems. In short, the solution of centralization of records is based on a ledger that’s stored in one big-ass computer system or network.
Prior to the creation of the blockchain, there have been many attempts to create alternative digital forms of payment that have failed because of one very important issue; preventing double-spending sans a central authority. That’s why the centralized records keeping solution has persisted until this day - it generally works.
Challenges Posed By a Centralized Monetary System
Whenever we give someone or a group of people total authority over something, there will be serious challenges that will need to be addressed. When it comes to doing so over the monetary system, there are three specific challenges that need to be addressed and these are corruption, mismanagement, and control.
There’s a saying that absolute power corrupts absolutely. Central banks or monetary authorities such as the Federal Reserve, who have the legal mandates to print money and create value in the process, practically have the ability to control how value is created and destroyed in their respective countries and in the case of the Federal Reserve, in the whole world. And such legal mandates are akin to unlimited or absolute financial power. A very good example of this is the fiasco at Wells Fargo where its employees were ordered to clandestinely open fictitious bank and credit card accounts in an attempt to puff up the company’s revenues and consequently, its net profits, for several years. And compared to monetary authorities, Wells Fargo isn’t even an authority.
Mismanagement is simply when a manager or a steward acts in a way that is not consistent with how his or her boss - the owner - wants him or her to act. Mismanagement - in the case of monetary authorities - can happen when governments act against the interest of the people they govern. A very good example of this is the way the United States monetary authorities allowed major financial institutions to issue credit-linked notes or financial derivatives with mortgages that have very high default risks, which corrupt credit ratings agencies have rated as “investment grade.” This has resulted in the near collapse of the United States financial system, which the Federal Reserve rescued by acting against the interest of the public by using public money, which the public has objected to, to save the biggest financial institutions from collapsing in 2008.
Another issue of mismanagement is printing of new money without proper consideration of the deflationary effects of such an action. As mentioned earlier, printing more money floods the financial system with too much money, which in turn can cause a specific currency’s value to plunge or drop (law of supply and demand, remember?). A very good case of this is the Venezuelan government, who mismanaged the country’s financial system and official currency by printing too much money. The Venezuelan currency has become practically worthless to the point that people started to measure its value by weight instead of amount.
Lastly, a central monetary authority means surrendering all control over the people’s money to the government. Because governments have the legal mandate to control the money supply, they also have the authority to control your money in ways that can prove to be very unfavorable or unjust to you, e.g., freezing your bank accounts and keeping you from accessing your money. Keeping physical cash on hand doesn’t mean the government can’t keep you from beneficially using your money. Governments can still keep you from using your money for your benefit simply by revoking its legal tender status so you won’t be able to use it for transactions, such as what India did in the past.
Gold And Silver
Let’s talk about gold and silver. Why? Because of its connection to money. To be more specific, gold and silver aren’t just investments - they’re money! You might say “No, money is the US dollar or the British Pound!” Sorry to burst your bubble but those are merely currencies, as is the case with all fiat currencies in the world. But currency is different from money. First, currency is just a legal tender status, the value of which isn’t determined by the people but by governments.
Second, legit money has important characteristics that make it so and the United States dollar doesn’t have all of them and as such, money is more than just a medium of exchanging goods and services. Here are the seven characteristics of legit money:
- Durability, which is the reason why wheat and salt are no longer used as money;
- Divisibility, which is the reason why paintings and other pieces of art aren’t used as money;
- Convenience of use, which is why copper or lead isn’t used as money;
- Consistency in value, which is why real estate is hardly used - if ever - to pay for goods or services;
- It must have intrinsic value or value as it is, which is why paper isn’t really money;
- It must be limited in available quantity, which is the reason for not using iron or rocks as money; and
- And lastly, it should have a long track record of acceptability.
Upon close evaluation, you’ll find that only gold and silver actually meet these characteristics. If you look at financial assets like stocks, bonds, or even real estate, they don’t pass the consistency test because their prices tend to fluctuate. For others likes stocks, chances are that stocks of companies from 100 years ago - save for a few big and strong ones - have either deteriorated in value or are no longer worth anything because the companies whose ownerships such stocks represent no longer exist.
The only items whose purchasing powers have not only been maintained but have also increased over the long-term are gold and silver. If only for this characteristic alone, gold and silver have kicked the butts of many currencies that have failed over the last 5,000 years. And if you factor in the fact that gold and silver are the only items that continue to have high value since the early days of all civilizations on Earth, you’ll see why fiat currencies aren’t really money.
Gold And Silver: Can Their Values Be Manipulated?
To answer this question, I’ll focus the discussion more on gold. Gold price manipulation is defined as any intentional efforts to control the prices of this most precious metal. This supposedly happens in major financial markets when gold traders intentionally attempt to influence gold prices via certain financial instruments, particularly derivatives. These traders may have been able to successfully cause short-term deviations from the real values of gold, but over the long-term, it doesn’t appear to be so.
The United States’ Securities and Exchange Commission (SEC) defines manipulation in greater detail as any intentional act whose purpose is to trick investors by artificially affecting or controlling the market for a specific asset and includes activities like quote rigging, and voluminous trades or transactions that are meant to paint a deceptive impression of demand for a particular asset and sway market prices in their (traders’) favor. And when speaking of gold price manipulation, there’s one particular type of manipulation that is believed to be prevalent and that is price suppression, i.e., manipulating gold prices downward.
A really good question to ask then is this. Are the prices of gold - and consequently silver - manipulated? If you ask enough number of gold traders or investors, they’ll tell you that it can be. Even more, they’ll probably tell you that they are being systematically manipulated right this very moment. Are they right?
There are several iterations of this belief. One is that central bankers control the prices of precious metals. Another iteration of this belief is that greedy private commercial bankers are the ones manipulating gold prices downward through derivative instruments (short-selling and futures contracts) and high-volume trades meant to paint a scenario of low and decreasing demand for gold and silver.
When you look at theories like these, they seem plausible at first glance because of instances where gold prices were controlled in the past, such as when certain governments fixed the prices of gold for decades or when the London Gold Pool suppressed its prices. Add to the fact that very rarely do financial institutions get penalized for gold price manipulation and you have a very prevalent belief that indeed, gold and silver prices can be manipulated.
But if you look at the long-term price histories of gold and silver, it becomes exceedingly clear that the answer to our question is no, prices of these precious metals can’t be manipulated. Check out academic papers on the subject and you’ll find that no compelling evidence for the case of price suppression or manipulation exists. In fact, you’ll find very clear cyclical patterns if you check out the long-term price charts of these two precious metals. From a long-term view, particularly of the 2000s, you’ll probably start to wonder how the heck people believed that price suppression for these two precious metals existed. And when you think about crying wolf, you may start to wonder why manipulation is selective, i.e., manipulation is responsible when prices go down and when prices are going up, it’s the market that’s pushing it up.
And while we can’t disprove the belief that the world’s biggest players attempt to manipulate prices, their effects - if any - are very short-lived because it’s practically impossible to suppress the true market price of gold in the market. Those who want to suppress the price of gold and silver over the long-haul simply don’t have enough financial resources to do so. And any attempts to do so will only backfire soon because any significant drops in the prices of gold and silver will only increase demand for it and consequently, lead to an increase in their prices.
Naked Short-Selling
Many investors and traders of these 2 precious metals tend to certain financial institutions, particularly bullion banks, of naked short-selling in order to put downward pressure on prices. But does naked short-selling mean? Short-selling means selling something you don’t have. So if you talk about short-selling gold bullions, it means you’re selling gold bullions you don’t have yet.
Now, why would you sell something you don’t have yet and get into a whole lot of trouble for it? After all, isn’t selling something you don’t have considered fraud? Well, not really. You may not have the gold bullions yet, but you can borrow other people’s gold bullion to sell them. And when the price of gold bullions drops, you can buy the same amount of gold bullions you borrowed for short-selling and in the process, make money. This type of short-selling is called “covered” short-selling because you cover yourself by first borrowing enough gold bullions to sell.
Naked short-selling is uncovered short-selling, i.e., you sell the bullions you don’t have even when you haven’t borrowed any to sell yet. Naked short-selling also happens when you shortsell gold bullions without any guarantee from other people that you can borrow enough bullions for short-selling from them. Naked short-selling can put you or any trader who does it at high risk of not being able to deliver the gold bullions sold to the buyer. Thus, the potential impact of naked shorts can be very serious.
There are “rumors” or “urban legends” that accuse the Federal government of using bullion banks to execute tons of naked gold short sales on the Commodities Exchange on its behalf to suppress the price of gold, maintain the US dollar’s value, and gives these bullion banks the opportunity to make huge money by repurchasing the bullions at lower prices. Sounds so evil and believable, right?
But think about this: if the number of naked short-sellers and there naked-short positions were that significant, the drop in prices of gold would be so huge that it would generate a reciprocal spike in demand for it. And the huge spike in demand would just wipe out the price drop because of the law of supply and demand.
Another thing to consider is the practicality of executing huge amounts of naked short sales just to suppress or manipulate the price of gold or silver. To execute this strategy effectively to drop the price of these 2 precious metals, naked short selling institutions would have to purchase a huge number of futures contracts just to cover their naked short positions. And as the futures contracts mature, they’d either have to buy the actual amounts of huge metals per futures contracts bought or rollover their positions, buy contracts that will be expiring, and flip the next ones out.
In either case, the institutions involved in naked short-selling for price suppression will need to eventually unwind their positions, which will ultimately reverse or neutralize any price suppression effects of their attempted naked short sales. And this explains why naked shortselling for price suppression isn’t realistic and why you’ll see that based on long-term price charts for both gold and silver, their values follow cycles or patterns.
The main point of it all is this is that, despite the many conspiracy theories of price manipulation for gold and silver, proof of such is lacking. As for all financial assets whose values are marketdriven, there are bull and bearish markets over the long-term. Bear markets - or when prices are falling - don’t equate to price manipulation any more than bull markets - when prices are going up - do. It’s all about market demand, cycles, and the ability to time our transactions well.
