Cryptocurrency as a Medium of Exchange
A medium of exchange is an intermediary asset that allows people to trade without directly trading goods and services. Currency is the paradigmatic medium of exchange. You can go to the store to exchange your dollars for a coffee or a book or practically anything that is sold in the U.S.
Before currencies were developed, people bartered: I might have bartered with you to swap my goose for your bushel of corn. But barter is inefficient. It’s hard to predict the cost of products and services because participants negotiate the price at the time of the transaction. Plus, you might not have a bushel of corn when my goose is for sale.
Currencies developed in response to the economic inefficiency of barter; first commodity currencies, then representative currencies, and on to today’s fiat money. But every step along that timeline increased centralization and reliance on a trusted authority. Fiat money exists only because it is backed by a stable government and managed by a central bank.
Nakamoto intended cryptocurrency to be money’s next evolution, but instead of increasing centralization, it would be decentralized and distributed. He achieved that goal with an ingenious peer-to-peer network sharing a data store based on a blockchain digital ledger.
You might be asking whether cryptocurrencies are, in fact, useful as a medium of exchange. After all, few of us pay our bills and buy our morning coffee with Bitcoin or Ether. We could, if the systems were in place, but we usually don’t for various reasons: lack of opportunity, price volatility, and transaction costs.
But that doesn’t mean cryptocurrencies are not useful as a medium of exchange. A medium of exchange allows anyone who possesses it to participate equally in markets. There are many Web3 markets where cryptocurrency functions in just that way, including crypto games, NFTs, and DeFi. In some parts of the world, decentralized cryptocurrencies are the only way to access markets, and many workers in the global economy take payment in crypto.
Cryptocurrency as a Store of Value
A store of value is an asset that tends to maintain or increase its value over time. Gold is a classic store of value. Its value tends to hold or appreciate, although it can drop in response to supply and demand. Gold also lasts forever; it doesn’t rot, tarnish, or rust. A fiat currency may also be used as a store of value in a stable economy with a healthy government. Treasury bonds are used as a store of value, too.
In some circumstances, cryptocurrencies are a store of value, prompting owners to hold on to them over the long term—known as hodling. It’s often said that Bitcoin is a better store of value than a medium of exchange. Bitcoin has a fixed supply. There will never be more than 21 million bitcoins and the rate at which new coins are added is carefully controlled. That makes them scarce, which may help to maintain their value relative to other currencies that have no such controls—excessive money supply often results in inflation.
Since its inception, Bitcoin’s value has multiplied, making it a useful store of value over that period. Of course, past performance is no indication of future performance, and whether any cryptocurrency is acceptable as a long-term store of value is a judgment call for each individual.
Fast, Low-Cost Currency Transfers
Currency transfers are one of the key uses of cryptocurrency. A currency transfer is a process of sending money internationally, but many of the benefits we’re about to discuss apply just as well to transactions within borders.
Cryptocurrency transactions are faster than wire transfers and other international transfer mechanisms. They are typically settled within minutes, instead of hours or days.
Crypto transaction fees are usually lower.
Decentralized cryptocurrencies preserve privacy. Transfers use blockchain addresses associated with cryptographic key pairs, not an individual’s identity.
Cryptocurrencies are more transparent than other methods of transferring currency. Anyone can look at the transactions on a public blockchain.
Cryptocurrency transfers are irreversible. Once the currency is transferred, it can’t be reclaimed by the sender. For many cryptocurrency users, this is an advantage. However, if you use cryptocurrencies for currency transfers, check and double-check before initiating the transaction—there’s no going back.
Stablecoins
Cryptocurrencies like Bitcoin and Ethereum’s Ether gain value through the market dynamics of supply and demand. Their value changes over time. But some uses of cryptocurrency call for a coin with a predictable value. For example, when trading in coins with volatile prices, it may be useful to move your holdings to a non-volatile coin for a time. Stablecoins can also act as a medium of exchange because of their predictable value.
How a stablecoin’s stability is accomplished differs depending on the currency. Many of the most popular stablecoins are pegged to fiat money or other assets used as collateral. In one popular model, every coin minted is matched by a dollar the operator holds in reserve. To buy coins, the buyer must deposit dollars. They can return their coins to redeem the dollars, at which point the stablecoins are destroyed.
Stablecoins tend to hold their value because they are—in theory—backed by a reserve and exchangeable for an asset with a relatively stable value. Because once issued, stablecoins can be bought and sold on cryptocurrency exchanges, their value may fluctuate somewhat as supply and demand change. However, they will tend to return to their stated value provided the market has confidence in the coin’s operator and its reserves.
Stablecoins are often traded on cryptocurrency exchanges. A trader may exchange fiat money for a stablecoin, and use it to buy other coins. This technique allows traders to hold a non-volatile balance on an exchange while still being able to trade quickly.
Utility Tokens
Narrowly defined, a cryptocurrency is a blockchain-based asset that can, with varying practicality, be used as a medium of exchange and a store of value. But there is another class of blockchain assets that serves a different purpose. Utility tokens are blockchain assets that are not primarily intended to be currencies but to serve a function within a blockchain network.
One use of utility tokens is to confer or delegate voting rights. That’s often the case with decentralized autonomous organizations (DAOs), which use the Ethereum blockchain and smart contracts to create a token, the ownership of which allows the holder to take part in the organization’s governance.
Web3 games also use utility tokens to allow players to buy items like NFTs or to reward gameplay. Another use is paying fees to a blockchain network to make use of its functionality. In fact, Ether, the Ethereum blockchain’s native cryptocurrency, was created as a utility token.
Ethereum is a distributed computing platform with smart contracts that run computations on the Ethereum Virtual Machine (EVM). The EVM’s computational resources would quickly be overwhelmed if there was no cost to using it, so users have to pay ‘gas fees’ proportional to the resources their smart contracts use. Ether is the token in which those gas fees are paid. Ether’s status as a utility token stands in contrast to Bitcoin, which Satoshi Nakamoto created solely as a digital currency.
However, as Ether’s story shows, utility tokens can become cryptocurrencies in the narrow sense. They are listed on cryptocurrency exchanges. Traders can buy and sell them. There’s a market for utility tokens that gives them value beyond their utility within an ecosystem.
Crypto Trading
Two factors impact the value of a cryptocurrency. The first is its usefulness as a medium of exchange, store of value, or some other purpose. The second is supply and demand on cryptocurrency markets. While it is possible for cryptocurrency holders to trade directly with each other, cryptocurrency exchanges make the process easier and less expensive. That is, they increase liquidity in the cryptocurrency market.
Cryptocurrency traders use exchanges to buy cryptocurrencies in exchange for fiat currency and other cryptocurrencies.
There are many reasons traders choose to trade cryptocurrencies. The primary reason is to take advantage of price volatility. Just like shares and other assets, cryptocurrency prices rise and fall over time. A trader can take advantage of volatility by buying and selling according to their belief in a coin’s future value. It should be emphasized that trading in this way is risky and you can lose money as well as gain it.
Other reasons traders choose to trade crypto include accessibility and diversification. Crypto exchanges make it easy to open an account and start trading; anyone can buy or sell crypto on the open market. Traders often keep crypto as part of diverse holdings that include other asset classes.
Crypto Staking
All decentralized cryptocurrencies need a way for distributed nodes to agree on the state of the blockchain. There is no centralized authority to determine which transactions are genuine, so they use a consensus mechanism. Bitcoin and others use a Proof of Work (PoW) consensus mechanism, which we explored in What is Crypto Mining and How Does It Work?
The Ethereum and Cardano blockchains use a Proof of Stake (PoS) consensus mechanism. PoS helps to secure the network and ensures network nodes eventually agree on the contents of the blockchain. It does so, in part, by asking block-proposing nodes to lock away a quantity of crypto as collateral.
If the nodes behave maliciously, they lose their collateral. But if they behave positively, they stand a chance of gaining cryptocurrency rewards. Crypto staking is not without risk, but it is a useful, low-friction way to generate passive income from crypto holdings.
Decentralized Finance (DeFi)
DeFi uses blockchain and related technologies to provide financial services similar to those provided by traditional financial institutions. As cryptocurrencies evolved, people realized that the technology could support not just decentralized currencies, but related services such as decentralized insurance and lending.
Decentralized credit services are particularly interesting. Let’s say you have a quantity of cryptocurrency you would like to hold on to, but you’d also like to access a more liquid digital asset to invest. DeFi services, which typically operate via smart contracts and decentralized autonomous organizations, will take your crypto as collateral and lend you a different asset, which you pay back at a pre-determined rate. It’s comparable to taking out a mortgage on your illiquid real estate to access liquid cash.
Every borrower must have a matching lender, so DeFi also gives crypto holders the opportunity to loan their assets in exchange for interest. The DeFi service is responsible for matching borrower funds with lender funds in much the same way a cryptocurrency exchange matches buyers with sellers. As with any credit, using DeFi to borrow and lend money is inherently risky, and you should be sure you understand the risks before committing your cryptocurrency to a DeFi platform.
How to Get Started With Cryptocurrency
The Bittrex cryptocurrency exchange makes buying and selling cryptocurrencies including Bitcoin and Ethereum as straightforward as possible. Simply register and create an account, deposit U.S. dollars or crypto, and you’re good to go—visit our cryptocurrency marketplaces or Instant Buy & Sell to get started.
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