After reading this article, you will have a
better understanding of what makes a cryptocurrency valuable and why the cryptocurrency prices can change
violently in a single day.
What
determines Cryptocurrency price
Cryptocurrencies are generally not backed by
any central authority in the same way as fiat currency or any other
government-sanctioned medium of exchange. Government support can improve
confidence in the value of currency among consumers, and it provides a greater
spender and collector of currency. But since cryptocurrencies are usually
decentralized, they derive their value from other sources, including:
supply
and demand of Cryptocurrencies
The cryptocurrency price is determined by supply and demand, just like people want it to be. If demand increases faster than supply, the cryptocurrency price rises. For example, if there is a drought, the price of grain and produce goes up if demand does not change. The same supply and demand principle applies to cryptocurrencies. A cryptocurrency price gains value when demand exceeds supply.
The cryptocurrency's supply mechanism is
always known. Each crypto publishes its own token minting and burning schemes.
Some, such as bitcoin, have a fixed maximum supply. We know that there will
only be 21 million bitcoins. Others, such as Ether (Crypto: ETH), have no limit
on the supply. Some cryptocurrencies have mechanisms that "burn"
existing tokens in order to prevent the circulating supply from increasing too
much and slowing inflation. Burning a token means sending them to an
untraceable address on the blockchain.
The monetary policy of each cryptocurrency is
different. The supply of bitcoin increases by a certain amount with each new
block mined on the blockchain. Ethereum offers a fixed reward per block mined,
but it also pays to include “uncle blocks” in new blocks, which helps facilitate
the efficiency of the blockchain. As a result, supply growth is not certain.
Some cryptocurrency supplies are determined entirely by the team in charge of a
project, which may choose to issue more tokens to the public or burn tokens to
manage the money supply.
Demand may increase as awareness increases or
utility as a project increases. Widespread adoption of cryptocurrencies as an
investment also increases demand, while effectively limiting the circulating
supply. For example, when institutional investors began buying and holding
bitcoin in early 2021, the price of bitcoin increased significantly as demand
outpaced the pace of creation of new coins, effectively reducing the total
available supply of bitcoin. decreased from
Similarly, as more decentralized finance (DeFi) projects start rolling out on the Ethereum blockchain, the demand for Ether increases. Ether is required to transact on the blockchain, regardless of which cryptocurrency you are transacting with. Or, if a DeFi project starts on its own, its own token will become more useful, which will increase demand.
Cost
of Mining of cryptocurrency
New cryptocurrency tokens are produced
through a process called mining. Mining for cryptocurrency involves using a
computer to verify the next block on the blockchain. A decentralized network of
miners is what allows a cryptocurrency to function. In return, the protocol
produces a reward in the form of cryptocurrency tokens, in addition to any fees
paid by the exchanging parties to the miners.
Verifying a blockchain requires computing
power. Participants invest in expensive equipment and electricity to mine
cryptocurrencies. In proof-of-work systems, such as those used by bitcoin and
ethereum, the more competition there is for mining a certain cryptocurrency,
the harder it is to mine. That's because to verify a block, miners essentially
race each other to solve a complex math problem. As such, the cost of the mine
increases because more powerful equipment is needed to successfully mine.
As the cost of mining increases, so does the need for the increased cryptocurrency price. Miners will not mine if the value of the currency they are mining is not high enough to offset their costs. And, since miners are necessary for the blockchain to function, as long as there is demand to use the blockchain, the price will have to rise.
Cryptocurrency
Exchange
Mainstream cryptocurrencies such as bitcoin
and ether are traded on multiple exchanges. Almost any cryptocurrency exchange
will have the most popular tokens listed.
But some smaller tokens may only be available
on select exchanges, thus limiting access for some investors. Some wallet
providers will collect quotes for swapping any set of cryptocurrencies across
multiple exchanges, but they will charge a fee for doing so, which will increase
the cost of investment. In addition, if a cryptocurrency is traded less on a
smaller exchange, the exchange spread may be too large for some investors.
If a cryptocurrency gets listed on more exchanges, it could increase the number of investors who are willing and able to buy it, thus increasing demand. And, all else being equal, as demand increases, so does the price.
Competition
Thousands of different cryptocurrencies
exist, with new projects and tokens launching every day. The barrier of entry for
new competitors is relatively low, but creating a viable cryptocurrency also
depends on building a network of users of that cryptocurrency.
A useful application on a blockchain can quickly build a network, especially if it improves the range of a competing application. If a new competitor gains momentum, it takes value from the existing competition, thus sending the price of the incumbent down as the price of the new competitor's token rises.
Internal
governance
Cryptocurrency networks rarely follow a
stable set of rules. Developers customize projects based on the community that
uses them. Some tokens – called governance tokens – give their holders a token
into the future of a project, including how a token is mined or used. For any
changes to be made in the governance of the token, there has to be a consensus
among the stakeholders.
For example, Ethereum is working to update
its network from a proof-of-work system to a proof-of-stake system, effectively
rendering expensive mining equipment useless in data centers or people's
basements. This will undoubtedly have an impact on the value of Ether.
Generally speaking, investors prefer stable
governance. Even though there are flaws in the way cryptocurrencies operate,
investors prefer the devil they know to the devil they don't know. As such,
stable regimes where things are relatively difficult to change may be of value
by providing more stable values.
On the other hand, the slow process of updating software to improve the protocol could limit the upward movement of cryptocurrency prices. If an update would unlock value for cryptocurrency holders but take months to execute, it hurts current stakeholders.
Regulations
and Legal Requirements
There is some confusion about who will
regulate the exchange of cryptocurrencies. The Securities and Exchange
Commission (SEC) says 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 scheduling decision can provide greater clarity and
improve cryptocurrency values when opening the door to more widely traded
crypto-related financial products.
Regulation is needed to allow easier ways to
trade cryptocurrency. Products such as ETFs or futures contracts provide
investors with greater access to cryptocurrency, increasing its value. Additionally,
regulation could enable investors to take short positions or bet against the
price of cryptocurrencies with futures contracts or options. This should lead
to better price discovery and reduce the volatility of cryptocurrency pricing.
Regulations can also negatively affect the demand for cryptocurrencies. If a governing body changes the rules to dissuade cryptocurrency investment or use, it could send the price of the cryptocurrency lower.
Finding
Value in Cryptocurrency
If you understand the fundamentals of supply and demand that give cryptocurrency value and the factors that influence cryptocurrency price, you can make better cryptocurrency investment decisions. If you think demand is going to increase for reasons X, Y, and Z and you don't think supply will hold up, then cryptocurrency could be a good investment. But be aware that governments still do not have best practices in place for regulating cryptocurrencies, which makes it a particularly risky and volatile investment, no matter what.
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