Our ancestors started off with the barter system – something like “I will give you 2 buffaloes in return for 5 shiny new super-sharp axes”. Soon they realized that the barter system had too many limitations – everyone didn’t want buffaloes, buffaloes were neither divisible (not too many people would want 0.35 buffaloes) nor very portable (imagine having to carry a buffalo on your shoulders while going shopping).

So they moved on to more acceptable, divisible, homogeneous and portable forms of money – cowry shells, salt, gold, silver and lots more. The Chinese invention of paper eventually led to the birth of paper currency, which was initially backed by gold or other precious metals.

Then the world moved on to fiat money – currency that’s declared as legal tender by a government but not backed by a physical commodity.

This brings us to an essential question – what is money? Money’s a matter of functions four, a Medium, a Measure, a Standard, a Store. So goes the couplet based on William Stanley Jevons analysis of money in 1875. This meant that for something to be called as money, it must function as a medium of exchange, a measure of value, a standard of deferred payment and a store of value.

The birth of computers and the Internet brought in many electronic payment systems including debit cards, stored value cards, giro transfers, credit cards, net-banking, electronic bill payments, electronic cheques, mobile wallets, digital gold currencies, digital wallets, electronic funds transfer at point of sale, mobile banking, SMS banking, online banking, payment cards, real-time gross settlement systems, SWIFT, wire transfers and more.

And then came SatoshiNakamoto’s path breaking invention – Bitcoin. This brought the world its first truly peer-to-peer virtual currency.

Bitcoin earned a lot of notoriety primarily because of its use by members of the now shut-down Silk Road – an illegal online marketplace that facilitated the sale of almost a billion dollars worth of drugs, guns, stolen financial information, counterfeit documents and more. All Silk Road transactions were conducted exclusively in bitcoin.

A lot of virtual currencies piggybacked on Bitcoin’s underlying innovation – the blockchain. In fact we now have more than 650 virtual currencies being used around the world.

A virtual currency has all the features of money. Just as fiat currency is not backed by any asset (just the promise of the issuer), virtual currencies like bitcoin are also not backed by any asset. And there is no promise since technically there is no identifiable issuer.

The only difference is that fiat currency has legal tender status in at least one country while virtual currency is not recognized as legal tender by any country.

Now suppose someone deposits Rs. 1,000 crore of gold in the lockers of a very trusted bank in a very safe country. Against this gold, this person issues a virtual currency called GoldCoin.

Technically, GoldCoin would work just like bitcoin. But unlike bitcoin, GoldCoin would be 100% backed by real gold, which you can personally verify by visiting the lockers of the very trusted bank in the very safe country.

Track record of Government backed currencies

Would you use this virtual currency?

Before answering this question, consider the track record of Government issued currencies:

• In post World War I Germany, the Rentenmark was introduced to replace the existing currency at the exchange rate of 1 for 1 trillion!
• In 1983 Argentina issued the new peso to stabilize its currency. One new peso was equal to 100 billion of the original pesos (pre-1983)!
• In the 1990s, Peru replaced its currency at a conversion rate of one billion to one!
• In 2008, Zimbabwe introduced the new dollar that was equal to 10 billion of the old dollars!

The lesson in all this is that a nation’s currency is not exempt from the laws of supply and demand. The more currency that is printed, the less it is worth.

A completely gold-backed virtual currency would not face such fluctuation in value since its value would be linked to the value of gold. And gold is something the human civilization has cherished for centuries.

Now, think again. Would you use this virtual currency?

No matter what your answer, virtual currencies are going to grow and this will have implications for all of us – from Governments looking to clamp down on money laundering, tax evasion and terrorist funding to businesses looking for faster and cheaper ways to receive and pay money.