What Determines the Value of Bitcoin and Other Cryptocurrencies
Traditional currencies have existed and evolved for centuries. Almost 11 years ago, the world saw a new form of currency take shape. Dubbed cryptocurrencies due to the underlying cryptographic technology, they contradicted the fundamental concepts of standard money and monetary transactions.
Cryptocurrencies, like Bitcoin, exist on top of global decentralized networks. This means there are no central banks issuing cryptocurrencies or controlling their flow. Technically, no centralized institution can restrict cryptocurrencies from functioning once they are deployed.
Due to their apparent benefits over fiat currencies, cryptocurrencies have started taking the financial landscape by storm. But as decentralized currencies, there’s often a common question as to how do cryptocurrencies attain their value? Do they have an asset like gold backing them or do they function like stocks of a company?
Before we answer that, let’s take a quick look at how currencies have historically been valued.
How are Traditional Currencies Valued?
Understanding the value of a currency lies in understanding what a currency actually is. We usually think of banknotes and coins when we speak of currencies. However, looking back in time, we can find that a currency is anything that two parties may use to exchange value. For example, a farmer who grows wheat can make a deal with a bakery owner to get a year’s supply of bread in exchange for a specified amount of wheat.
Today’s currencies do not possess any intrinsic value such as wheat or a loaf of bread. In the early 1900s, banknotes derived their value from an underlying asset such as gold. The value of a country’s currency depended on the commodity reserve its central bank held in possession.
As the dollar was already a global currency, the American President Richard M. Nixon realized that the U.S. may fall short of the gold reserve to support the demand. So, he introduced a new principle that valued currencies based on the fact that people had the faith that a said currency possessed a said value.
This is how most fiat currencies across the world gain their value. Also, there are factors such as exchange rates on forex exchanges, taxes, and trust in a government that impact how valuable a currency is in comparison to other currencies across the world.
Commodities such as gold, on the other hand, have intrinsic value due to their scarcity and surplus use cases. The value of gold also is inversely related to the value of a central bank currency. This is why when the financial system faltered during the pandemic, the value of gold rose tremendously.
How are Cryptocurrencies Valued?
Unlike fiat currencies, the value of bitcoin and other cryptocurrencies do not depend on how well a government is performing, the inflation rate, or the economical status of a country. But fiat and cryptocurrency have one similarity: the value of cryptocurrencies also majorly depends on how much trust and demand they have in the market.
There are several factors that affect the market demand for a cryptocurrency. Let’s go through them.
Utility, Adoption, and Exchange
The first cryptocurrency Bitcoin (BTC) has the highest value of all. It received a huge adoption over the years and the number of Bitcoin owners increased considerably with time. Bitcoin went from having almost no value in 2008 to being valued at over $20,000 in 2017. (At the time of writing this Bitcoin to CAD is valued at 23,177)
Similarly, there are better chances of a cryptocurrency gaining more value if it is owned and stored by more people. The number of ways in which people can utilize a cryptocurrency also has a considerable impact on how well a cryptocurrency is valued. A cryptocurrency that has more real-life use cases is sure to create more demand than those that do not have any essential use.
Listing on major cryptocurrency trading and exchange platforms also impacts the adoption and demand of cryptocurrencies. A cryptocurrency listed on popular trading platforms may get more exposure. And as more traders trade a particular cryptocurrency, the better chances it will have to gain value from its rising demand.
If we speak of fiat currencies, there’s no limit to the number of banknotes a central bank can print. Contrarily, most cryptocurrencies create a demand for themselves by limiting the total number of coins or tokens that may ever exist.
The supply algorithm of cryptocurrencies is hardcoded into the blockchain network on which they are based. The coins have an upper limit and are automatically generated with time. For example, there will only ever be a total of 21 million Bitcoins.
More than 18.5 million BTC has already been mined, and it is estimated that the network will take 120 years to produce the remaining 2.5 million. This is because the number of BTC generated over a period of time halves every four years.
The upper limit to the number of Ether (ETH), the second-largest cryptocurrency by market capitalization, is a hotly debated topic across the cryptocurrency community. Even the founders of the Ethereum network confessed that calculating the total supply of Ether is a complex task. It is only possible to get a rough estimate of the total of ETH that may exist.
XRP, the fourth-largest cryptocurrency, also has a fixed supply of 100 billion tokens. In the long run, the increasing demand for these cryptocurrencies and their decreasing supply is expected to add more value to them.
Bitcoin was first to the market but there are now thousands of cryptocurrencies competing to gain the top spot. It’s also true that a sizeable portion of the market is filled with cryptocurrencies that have no demand. The competition between cryptocurrencies is still strong as there are hundreds of valuable cryptos in the market.
One of the reasons why Bitcoin and Ether are in high demand is because they are also used as base currencies for a majority of trading pairs. Trading platforms that do not support fiat currency pairs usually list other cryptocurrencies against the top cryptocurrencies such as BTC, ETH, XRP, USDT, etc.
Regulations play a pivotal role in deciding the demand for cryptocurrencies and their value. And regulators around the globe are still struggling to create a proper regulatory framework that may strictly define cryptocurrencies and govern their use.
Suppose that regulators across every country suddenly banned the trade and exchange of cryptocurrencies. In that case, most cryptocurrency traders and holders will liquidate their holdings. This will result in a decrease in the demand for cryptocurrencies and may even bring the value of the highest-rated cryptos back to where they started.
In reality, the opposite is happening. More governments are legalizing cryptocurrencies and framing laws around them. This may help build more trust in cryptocurrencies and create more demand for them.
Future Prices of Cryptocurrencies
Recently, the price of Bitcoin surged by thousands of dollars in a matter of a week. Other cryptocurrencies have also seen considerable growth in their value. Even then, it is hard to predict what will be the next move of the market and where the prices of cryptocurrencies will go from here.
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