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How is crypto valued and what influences prices?

Jan 18, 2022
byNDAX Labs

Cryptocurrencies like Bitcoin often make the news when they hit all-time highs or when their prices take dramatic nosedives. When this happens, it leaves many people wondering the same thing. What determines the value of cryptocurrency?

That’s a good question. After all, cryptocurrency doesn’t physically exist like a dollar bill or a gold bar. So what gives crypto value?

In short, people find it useful and believe that it has intrinsic properties that give it value. This premise isn’t so different from other forms of currency. To explain, let’s take a look at why we assign value to traditional financial assets.

How are traditional currencies valued?

Historically speaking, most currencies were tied to the value of other assets such as gold or silver. Later, paper currency was developed as a way to represent this value without carrying around the precious metal itself.

However, most currency today is no longer backed by valuable physical assets. In 1971, the U.S. detached the dollar from its gold reserves. When that happened, fiat currency became the world’s primary system of financial exchange.

That begs the question: what determines the value of fiat currency? After all, without the backing of the gold standard, central banks have the power to print an unlimited supply of banknotes.

Essentially, currencies hold value because people have faith in the financial system. They believe that money possesses the value that the government claims it does.

It’s by no means a perfect system. As we’ve seen throughout history, political, social, or natural events can drastically alter money’s perceived value and cause upheaval across global markets.

What is the value of cryptocurrency based on?

Cryptocurrency may be a newer concept than fiat. However, it isn’t so different from traditional currencies in the way it derives its value.

Like gold or other physical assets, cryptocurrencies like Bitcoin have built-in scarcity mechanisms to preserve their value over time. But just like fiat, crypto’s value is heavily determined by public perception and market demand.

Below are some of the main factors that affect the value of cryptocurrency.

·   Utility

Cryptocurrency has value that extends far beyond payments and speculative investing. Besides being the foundation for decentralized finance, crypto-driven platforms can be used for smart contracts, cloud storage, media streaming, NFTs, health records, gaming assets, supply chain monitoring, and much more.

·   Supply and demand

Like any asset, cryptocurrency’s value is driven by supply and demand. In terms of supply, many coins have intrinsic supply control mechanisms, which mitigates inflation. When it comes to demand, public perception and competition are the primary influencers.

The market and its investors also have a vital role to play. Whales – wallets that hold a large proportion of a cryptocurrency’s supply – and large institutional investors can manipulate the price action by either stockpiling coins or selling all at once and flooding the market.

·   User Adoption

The more users a cryptocurrency has, the more valuable it becomes. One key factor in user adoption is a coin or token listing on a major exchange. When this happens, it exposes the cryptocurrency to a broader user base and often results in a price boost. Thus, as the crypto industry continues to expand its reach, it benefits the market as a whole.

·   Scarcity

Most cryptocurrencies have inbuilt mechanisms for regulating their token supply. Bitcoin, for example, has a hard cap of 21 million coins and halves the rate of issuance every four years. Likewise, Ethereum has recently introduced inflation control measures like burning a set amount of its supply. Over $1 billion worth of ETH has already been burned.

·   Regulation

Cryptocurrency doesn’t exist in a vacuum. Even though a government or centralized bank can’t own the technology behind Bitcoin or Ethereum, legal guidelines still regulate their use and development.

On the one hand, countries like China can ban Bitcoin mining, which leads to temporary drops in the global hash rate. But on the other hand, countries like El Salvador are establishing Bitcoin as legal tender, which strengthens the regulatory framework around cryptocurrency adoption.

·   Competition

Thousands of different cryptocurrencies exist. Some are complementary projects built upon large blockchain ecosystems like Ethereum. Other blockchain ecosystems like Cardano and Solana offer competing alternatives with unique advantages like application versatility or transaction speed.

This competition is key to healthy supply and demand action. As more cryptocurrency projects emerge, funds are directed towards certain coins and siphoned away from others. Competition is a major factor in determining both the short-term and long-term value of a cryptocurrency.

What is market cap?

Many people assume that the higher a coin or token’s market price, the more valuable it is. But that’s not really the case. A better, but not perfect indicator of a cryptocurrency’s value is its market cap.

A cryptocurrency’s market cap tells us the total value of all the coins that have been mined and are in circulation.

Here’s the simple calculation:

Market Cap = Circulating Supply x Price

Let’s take Bitcoin as an example. At the time of writing, Bitcoin’s spot price of $60,972.71 CAD, multiplied by its circulating supply of 18,847,193.00 BTC, gives it a market cap of roughly $1.15 trillion CAD.

Bitcoin has the largest market cap of any cryptocurrency, but this isn’t just a factor of its current price. It also reflects the level of engagement in a project and its overall trading volume.

To demonstrate how a coin’s trading price doesn’t directly reflect its total value, let’s look at two examples.

·   Cryptocurrency A is priced at $100 per coin, with a circulating supply of 1,000. As a result, its total market cap is $100,000.

·   Cryptocurrency B is priced at $10 per coin, with a circulating supply of 100,000. As a result, its total market cap is $1,000,000.

·   As you can see, even though Crypto B is priced lower than Crypto A, its market cap is much higher due to having more coins in circulation.

Insights on Bitcoin and its value

Here’s an interesting fact. If you invested in Bitcoin at its launch, the return on your investment today would be over 45,000%.

Why did Bitcoin experience such incredible leaps in value? Over the years, millions of people worldwide have recognized that Bitcoin was the first significant step towards a world of decentralized finance. Furthermore, it inspired the development of countless crypto projects that possess the potential to affect almost every aspect of our life.

As mentioned above, Bitcoin’s value is primarily influenced by various factors, including utility, scarcity, regulation, and demand. But it also occupies a unique place in the market. It’s not the fastest blockchain, the most energy-efficient, or the one that supports the most decentralized applications.

Yet, even with its technical limitations, it functions as a reference point for the crypto industry. It’s the most widely known cryptocurrency, and institutional investors commonly view it as the safest way to enter the market. When Bitcoin’s price goes up or down, the rest of the market usually follows.

While other cryptocurrencies may overtake Bitcoin’s leading position in the future, its significance to the industry as a whole cannot be overstated.

What will create stability in crypto value?

Cryptocurrency has received massive attention in recent years, but it’s still in the early stages of development. As a result, price fluctuations can often be extreme, and regulatory frameworks are not fully established.

To move farther along on the road to increased market stability, several scenarios must converge, such as:

·   User adoption continues to grow at a steady rate.

·   Legal regulations do not create any significant barriers to cryptocurrency trading and development.

·   Technical advancements in blockchain and cryptographic security keep pace with user adoption.

·   Cryptocurrency utility continues to be proven in real-world applications.

·   Education about cryptocurrency reaches the greater population.

Even if all of these scenarios become a reality, there’s no guarantee that cryptocurrency value will be stabilized. And with so many micro and macro factors at play, it’s tough to predict where crypto will take us next.