Various factors can affect the value of bitcoins and other cryptocurrencies.
You may wonder what makes cryptocurrency so valuable, given its well-known volatility. Bitcoin ( CRYPTO: BTC ) often goes up or down in value by 5% or even 10% on any given day. Smaller cryptocurrencies can have even wider price swings.
After reading this article, you will better understand what makes cryptocurrency so valuable and why the price can fluctuate a lot in a single day.
Understanding the value of cryptocurrency
Cryptocurrencies are not usually governed or supported by any central authority. Government support can build faith in the value of the currency among consumers, and it provides large sponsors and collectors of the currency. (Try paying taxes in bitcoins.) But because cryptocurrencies tend to be decentralized, they derive their value from other sources, including:
- Supply and Demand
- The cost of production
- Availability on exchanges
- Regulatory documents
Demand and supply of cryptocurrency
The cost of something is determined by supply and demand. If demand rises faster than supply, the price goes up. For example, when there is a drought, the price of grain and food goes up if demand does not change. The same principle of supply and demand applies to cryptocurrencies.
The supply of cryptocurrency is always known. Some, such as Bitcoin, have a fixed maximum supply. Others, such as Ether ( CRYPTO: ETH ) , have no supply limit. Some cryptocurrencies have mechanisms that “burn” existing tokens to prevent too much circulating supply and slow inflation. Burning a token means sending it to an unrecoverable address in the blockchain .
The monetary policy of each cryptocurrency is different. Bitcoin supply increases by a fixed amount with each new block mined in the blockchain. Ethereum offers a fixed reward per block mined, but it also pays for the inclusion of “uncle blocks” in a new block, which helps improve blockchain efficiency. As a result, the increase in supply is not as fixed. Some cryptocurrency supply is entirely dictated by the team in charge of the project, which can choose to issue more tokens to the public or burn tokens to manage the money supply.
Demand can increase as awareness of the project grows or utility increases. Greater adoption of cryptocurrency as an investment also increases demand, effectively limiting the circulating supply. For example, when institutional investors began buying and storing bitcoins in early 2021, the price rose significantly as demand outpaced the rate of new coin creation, effectively reducing the total available supply of bitcoins.
Similarly, as more decentralized finance (DeFi) projects are launched on the Ethereum blockchain, the demand for ether is growing. Ether is needed to execute transactions on the blockchain no matter what cryptocurrency you are transacting with. Or, if a DeFi project takes off, its own token becomes more useful, thereby increasing demand.
New cryptocurrency tokens are produced through a process called mining. Cryptocurrency mining involves using a computer to verify the next block in the block chain. A decentralized network of miners is what allows the cryptocurrency to work the way it does. In return, the protocol gives a reward in the form of cryptocurrency tokens in addition to any commissions paid by the exchange parties to the miners.
Blockchain verification requires computing power. Participants invest in expensive equipment and electricity to mine cryptocurrency. In a proof-of-work system such as those used by Bitcoin and Etherium, the more competition for mining a particular cryptocurrency, the harder it is to mine. This is because miners are essentially competing with each other to solve a complex mathematical problem in order to verify a block. Thus, the cost of mining increases because more powerful equipment is required for successful mining.
As the cost of mining goes up, it requires an increase in the value of the cryptocurrency. Miners will not mine if the value of the currency they mine is not high enough to offset their costs. And, because miners are necessary for the blockchain to function, as long as there is a demand to use the blockchain, the price will have to rise.
Major cryptocurrencies such as bitcoin and ether are traded on several exchanges. Almost any cryptocurrency exchange will list the most popular tokens.
But some smaller tokens may only be available on certain exchanges, which limits access for some investors. Some wallet providers will aggregate quotes to exchange any set of cryptocurrencies on multiple exchanges, but they charge for this, which increases the cost of investing. In addition, if the cryptocurrency is rarely traded on a small exchange, the spread that the exchange accepts may be too large for some investors.
If cryptocurrency is listed on more exchanges, it can increase the number of investors willing and able to buy it, thereby increasing demand. And, all other things being equal, the price rises as the demand increases.
There are thousands of different cryptocurrencies, and new projects and tokens are launched every day. The barrier to entry is relatively low for new competitors, but creating a viable cryptocurrency also depends on creating a network of users of that cryptocurrency.
A useful application on blockchain can quickly build a network, especially if it improves over the constraints of a competing application. If a new competitor gains momentum, it benefits from existing competition, thereby lowering the price of the incumbent, as the new competitor’s token sees its price rise.
Cryptocurrency networks rarely follow a static set of rules. Developers adapt projects based on the community that uses them. Some tokens, called management tokens, give their owners a say in the future of the project, including how the token is mined or used. In order to make any changes to token management, there must be consensus among stakeholders.
For example, Ethereum is working to upgrade its network from a proof-of-work system to a proof-of-ownership system, effectively rendering much of the expensive mining equipment in data centers or people’s basements useless. This will undoubtedly affect the value of ethereum.
In general, investors like stable management. Even if there are flaws in a cryptocurrency’s performance, investors prefer the devil they know to the devil they don’t know. Thus, stable management, in which something is relatively difficult to change, can have value by providing more stable pricing.
On the other hand, the slow process of updating software to improve protocols could limit the growth potential of cryptocurrency value. If the update opens up value to cryptocurrency holders but takes months to complete, it will hurt current stakeholders.
Regulations and legal requirements
There is some confusion about who should regulate the exchange of cryptocurrencies. The Securities and Exchange Commission (SEC) states that cryptocurrencies are securities like stocks and bonds, while the Commodity Futures Trading Commission (CFTC) states that they are commodities like coffee or gold.
Both cannot claim regulatory authority over cryptocurrency exchanges. A decisive ruling could provide more clarity and improve the value of cryptocurrency by opening the door to more widely traded cryptocurrency-related financial products.
Regulation is needed to make cryptocurrency trading easier. Products such as ETFs or futures contracts provide greater access to cryptocurrency for investors, increasing its value. In addition, regulation could allow investors to open short positions or bet against the price of cryptocurrencies with futures contracts or options . This should help to better identify prices and reduce the volatility of cryptocurrency pricing.
The rules could also negatively affect the demand for cryptocurrency. If the governing body changes the rules to discourage the investment or use of cryptocurrency, it could lower the price of cryptocurrency.
Finding value in cryptocurrency
If you understand the basic principle of supply and demand underlying what gives value to cryptocurrency and the factors that influence it, you can make more informed decisions about investing in cryptocurrency. If you think that demand will rise for reasons X, Y and Z and you don’t think that supply will rise, this cryptocurrency may be a good investment . But keep in mind that governments still do not have best practices for regulating cryptocurrency, which makes it a particularly risky and volatile investment no matter what.