Op-Ed: How Do Cryptocurrencies Become Valuable?

Executive Brief

In part one of this series, I talked about how money derives its value as a medium of exchange, and how cryptocurrency could appreciate in value if adopted by a much broader user base. Currencies like Bitcoin are often used to escape local capital controls, process faster remittance payments, provide improved anonymity and security, and reduce transfer fees. However, Bitcoin—the largest cryptocurrency—remains a long way from mainstream adoption. A significant portion of any digital currency’s price value and demand is purely speculative and based on its potential future superiority over fiat money (government issued currency). Part two of this series will explore the main drivers of short-term digital money market volatility, and explore their emergent qualities in the more distant future.

Read the full story below. 

Part Two - What Drives Demand for Cryptocurrencies?

The Bitcoin price

Bitcoin is the main reserve currency for most cryptocurrencies. When you want to buy a digital currency that isn’t Bitcoin, you’ll probably need to purchase Bitcoin first. Because most—if not all—digital currencies are priced in Bitcoin, when the price of Bitcoin changes, most cryptocurrencies will be similarly affected.

Sometimes this relationship is negated by investors changing their behavior in response to Bitcoin price changes. When Bitcoin’s price falls against the US dollar, some people decide to trade their Bitcoin for other cryptocurrencies to hedge their investment against Bitcoin’s slump, and many digital currency investors choose to take profit after Bitcoin’s price has risen, which can first require them to sell their alternative currency positions for Bitcoin, before exchanging the Bitcoin into US dollars. These preferences change the demand and market value of all currencies involved.

For example, if Bitcoin is worth $1000 then goes up by 50%, it logically follows that it would now be worth $1500. CoinX—a cryptocurrency that costs 0.1 Bitcoins (or $100)—would also rise in value by 50% to $150. Some of the holders of CoinX then decide they want to take profits from the rise in the Bitcoin price and swap back into USD which requires them to first sell their CoinX position for Bitcoin. This causes a fall in CoinX’s price of 33.33%. At the end of day’s trading, CoinX is worth the original $100, while Bitcoin has still gained 50%.

Trust - Belief in project’s stated goals, and successful release of new developments

Trust is the paramount currency in any business venture, being a main commodity that encourages investment in project development. Many cryptocurrencies and other blockchain-related projects have lost the trust of their community by under-delivering on their projects (development setbacks), or have been bad actors. Cryptocurrency teams that earn the trust of their stakeholders and potential investors are taken seriously when they announce new features and plans for the future, which can lead to speculation regarding future value, and higher prices.

Limited supply

Each cryptocurrency exists in limited number, with new units brought into existence at regular intervals over time. The lower the supply numbers, the fewer new units are available to be sold instantly on the market by miners (payment processors) who have no intention of holding onto the currencies they mine. This can improve price stability. Many currencies have a low number of maximum units that will ever be created—Bitcoin is 21 million—and when demand amplifies without a comparable increase in units available for sale (thanks to the currency supply limit), the price of an individual currency unit should rise.

Nations with unstable currencies, and highly insular countries.

Cryptocurrency payments are immune from shutdown by banking systems and Government decree. The transfers can also be sent anywhere in the world instantly at virtually no cost, making them ideal for use in countries experiencing economic trouble, or where movement of wealth is not possible through the traditional banking system. Many Venezuelans use Bitcoin as an alternative to the Bolivar, which has all but collapsed due to government mismanagement, and in China—which makes up a significant proportion of total cryptocurrency demand—Bitcoin and other alternatives are used by everyday people to circumvent the government’s strict capital controls for payments overseas.

Pump and Dumpers

Not all price increases in digital markets reflect a currency's true value. Pump and dump schemes frequently target smaller markets where the amount of trading volume required to affect the trading price is lower. Once the players have created a run of price rises from their buying activity, they begin to dump their positions, taking profits as the currency’s price crashes back down. In larger markets, it is still possible for groups of these bad actors to push prices up just enough to trigger algorithms (bots that have instructions to trade when certain market conditions are met) which then execute large trades that have even heavier effects on trading price levels. The ensuing excitement often leads to more people jumping into the market only to lose much of their investment.

It is best to attempt to explain the reasons for a currency’s price swings before making the decision to invest. Did they recently make an encouraging announcement? Have they procured a promising partnership? Did something in their environment change favorably? If you can’t see indicators for why the price may be moving, it is likely nothing more than a momentum trade, and you must be prepared to weather the probable volatility that will ensue.

World market sentiment

Markets do not rely exclusively on empirical data and direct value. They are psychological, and reflect everybody’s aggregated opinion about what will happen next. Real world events that affect for example: global trade, national currencies, and equity, bond, and precious metal markets can drastically affect capital flows to and from those for digital money. Negative sentiment in world markets often sees capital flowing into digital currency because they are viewed as a harbor from market turmoil, while bull runs (appreciation) in world markets, or trouble in the digital money markets themselves can see capital flowing the other direction.

Regulatory environment

Digital money markets are sensitive to the regulatory changes passed by national governments pertaining to their ownership and use. The value of digital money lies in its foreseeable ability to enter mainstream use. Favorable regulatory decisions strengthen the idea that cryptocurrency could one day be adopted as mainstream money, which can lift prices, while other regulations may hinder their use, and create new costs and barriers to adoption.

News media

The media has a profound effect on public perception, which is exactly what markets reflect. The media’s understanding of digital money and blockchain is critical to the industry’s success. To date there has been a shortage of understanding and objectivity in the mainstream media, and negative coverage has caused many crypto devaluations.

Making the right investments in digital currency can require a lot of research and keeping up with industry news. Part 3 of this Cryptocurrency Investment Series will help you to understand your investment profile and propensity for risk, and provide the checklist to analyze individual cryptocurrencies and other FinTech related projects that will better your investment decisions.

The views expressed by the authors on this site do not necessarily represent the views of DCEBrief or the management team.

Author: Timothy Goggin

Timothy Goggin is an economic analyst with an interest in the application of moral philosophy and decentralized systems. He studied economics at the Business School at Victoria University of Wellington, New Zealand. His area of research is the consequential and moral dimensions of implementing digital currencies and the resulting synergies for consumers in the trading environment.

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