What gives cryptocurrency its value?
The potential for cryptocurrency to be used as a means of transaction is unparalleled, as it combines the benefits of digital money (allowing near-instantaneous cross-border payments of any value) with those of cash (offering anonymity and no need for bank accounts or credit cards). However, despite these benefits, cryptocurrencies are still not widely used for transactions due to their highly unpredictable value.
The volatility of cryptocurrency prevents it from functioning effectively as a currency. The significant fluctuations in its value result in prohibitive costs that hinder its usefulness as both a medium of exchange and a unit of account.
So what factors contribute to the value of a cryptocurrency and its volatility?
What influences cryptocurrency values?
Given that the supply of a cryptocurrency grows at a regular and predictable pace, the value of a cryptocurrency is essentially determined by the market forces of supply and demand.
In the stock market, the value of a stock is influenced by supply and demand, where higher demand can lead to higher prices. For instance, popular companies like Apple and Amazon may have higher stock prices due to their increased demand. However, the price of a stock can also decrease if there is a lack of demand.
Much like stocks, commodities, securities and so on, cryptocurrencies are a tradable asset (in the short term) whose price is largely driven by speculation and investor expectations and whose fluctuations essentially depend on changes in demand.
If there is a widespread expectation that the price will go up, there will be a rush to buy, leading to a buying frenzy and driving the price up, while pessimistic expectations can cause the price to fall as there are more sell orders than buy orders. It's also reasonable to assume that early investors intervene with significant purchases when the price falls too sharply, as they want to support the price and protect their investments from dropping below production costs (including electricity and computing power).
However, the law of supply and demand dictates that an increase in demand for a product results in an increase in production by suppliers to meet the demand and increase sales. However, this principle does not apply to most cryptocurrencies due to their limited maximum supply and distributed nature.
How crypto price is determined
Each token within the cryptocurrency space has unique attributes that prevent devaluation and help maintain its value in the market.
However, in general, most cryptocurrencies have the unique characteristic of having a limited or predetermined supply of coins. Most cryptocurrencies use mining, and as more coins are mined, the mining rate decreases, resulting in the overall supply being replenished only to account for lost units.
In the case of cryptocurrencies, when supply is limited and demand increases, the price of that particular cryptocurrency goes up. This is the simplest way to explain how cryptocurrency prices fluctuate.
We’ll see that the demand for a particular cryptocurrency can be influenced in several ways.
How does demand affect the value of crypto?
There are several ways in which the demand can increase the value of cryptocurrencies:
- Users can increase the demand for a particular cryptocurrency and increase its value by following the classic investment strategy of buying low and selling high;
- Cryptocurrency mining can be profitable and can also affect the overall supply of cryptocurrencies.
- As more institutions invest in and accept cryptocurrencies as a form of payment, their utility increases. Users can contribute to this process and help increase the value of cryptocurrencies in the long run;
- Media coverage can also affect the value of cryptocurrencies, and users can play a role in shaping this through their social media accounts.
Factors that affect cryptocurrency price
The price and volatility of cryptocurrency are influenced by similar factors as traditional markets, but the difference lies in the extreme level of volatility experienced in the cryptocurrency market. In a single day, investors can encounter significant gains or losses, which is not commonly observed in traditional markets.
Aside from these erratic fluctuations, some more significant factors can explain cryptocurrency price changes in the medium term:
- Supply and Demand - Like any other asset, the value of cryptocurrencies is primarily influenced by the principles of supply and demand. When the number of buyers exceeds that of sellers, the price of the cryptocurrency rises, whereas if the number of sellers outweighs the buyers, the price of the cryptocurrency decreases.
- Scarcity - Due to the fact that certain cryptocurrencies have a fixed amount available - such as Bitcoin, which has a limit of 21 million tokens - scarcity is a crucial factor affecting price fluctuations.
- Cost of Production/Mining Difficulty - Cryptocurrency mining costs, including equipment and electricity, can influence the market price since miners are unlikely to sell if the price doesn't exceed their expenses. If the cost of mining exceeds the reward, the value of the cryptocurrency may increase as miners are less likely to sell their reward. For example, if the cost of mining a single bitcoin is $5000, the miner is unlikely to sell unless the market price equals or exceeds $5000.
- Interest-rate adjustments - As with most markets, when interest rates raises, investors tend to move out of riskier assets and into lower-risk assets as yields rise, making these assets more attractive relative to their risk. As a result, assets such as tech stocks and cryptocurrencies are often among the first to fall when interest rates are raised. Conversely, when interest rates are lowered, the opposite effect is typically observed.
- Utility and Adoption - The level of adoption and usefulness of a cryptocurrency can significantly affect its value. The more individuals who use a cryptocurrency and the more real-world applications it has, the more valuable it becomes.
- Perceived Value of the Project - The value of a cryptocurrency is largely dependent on the success and growth of the underlying project development and contributes to the positive sentiment surrounding the project. Projects that continue to progress, reach milestones, establish beneficial partnerships or release user-friendly software become more valuable in the eyes of the market and affect the value of their cryptocurrency.
- Competition - The value of a cryptocurrency may also be affected by competition from other cryptocurrencies that offer similar features and benefits. Similar cryptocurrencies with different features and use cases can affect the value of a particular cryptocurrency. If a competing cryptocurrency offers better features or benefits, this may lead to a reduction in demand and price for the original cryptocurrency.
- Exchanges - Some cryptocurrencies are listed on many exchanges, while others are only available on a few. Wallet providers that aggregate prices from multiple exchanges may increase the cost of investing, while high fees on thinly traded exchanges may deter investors. The demand and price of a cryptocurrency may increase if it is listed on multiple exchanges.
- Market Sentiment - Like all markets, cryptocurrencies are subject to cycles that can affect their value. Investors' emotions or hype and fear can also affect its price. Positive news or sentiment can drive the price up, while negative news or sentiment can drive it down. A bull market tends to favour investors, while a bear market erodes value.
- News and Events - Events and news such as regulatory changes, technological advancements, adoption by mainstream companies and government policies can affect the price of cryptocurrencies. For instance, the launch of a cryptocurrency can attract media attention and investor speculation, leading to increased trading volumes and a rise in price. Other events such as listing on a major exchange, regulatory findings or updates such as Ethereum's proof-of-stake feature can also affect the price of cryptocurrencies.
- Regulations - Cryptocurrency prices can be influenced by government regulations and policies regarding cryptocurrencies, such as legalization, restriction, taxation, and anti-money laundering laws, as they can impact the demand and supply of cryptocurrencies.
- Technological Advances – Advances in blockchain technology, such as improved security, scalability and transaction speed, may affect the price of cryptocurrencies. These developments may increase the value and utility of cryptocurrencies, leading to greater demand and price appreciation.
In conclusion, the value of cryptocurrencies - like any other asset - is determined by market forces of supply and demand, and their volatility is a result of speculation and investor expectations. They have the potential to be widely used as a means of transaction, but their unpredictable value prevents them from functioning effectively as a currency.
The limited supply of most cryptocurrencies and the cost of production or mining difficulty also play a significant role in their value. Scarcity, interest rate adjustments, adoption and utility, and the perceived value of the project all influence the value of cryptocurrencies.
As the technology and adoption of cryptocurrencies continues to develop, the value of these assets will be affected by a variety of factors.
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