How Does Cryptocurrency Gain Value?

Cryptocurrencies are intangible assets—they have value, but you can't hold them in your hand. To new traders, the seemingly abstract nature of cryptocurrency can lead to confusion.

How Does Cryptocurrency Gain Value?

Cryptocurrencies are intangible assets—they have value, but you can't hold them in your hand. To new traders, the seemingly abstract nature of cryptocurrency can lead to confusion.

Cryptocurrencies differ from traditional assets in that they do not have clear data points, such as earnings reports or independent third-party valuations, to support their value. Instead, cryptocurrencies exist on decentralized computer networks or blockchains, which makes it more difficult to determine their true value compared to traditional assets. In short, because cryptocurrencies are a distinct asset class, traders require a distinct framework and toolkit to conduct market analysis.

So, how does cryptocurrency gain or lose value, and how can traders determine the valuation of digital assets? Although challenging, there are a few key metrics traders use to evaluate prices in the market.

How Is Cryptocurrency Valued?

Similar to traditional assets, cryptocurrencies rise or fall in relation to supply and demand. "Supply" means how much of a product or service is on the open market, while "demand" refers to how many people want it. Whenever demand outweighs supply, the market price for an asset increases. Conversely, market prices fall when there's too much supply and too few buyers.

Understanding the relationship between supply and demand is crucial in the world of economics, including the determination of cryptocurrency value. When more people buy a cryptocurrency, the value increases as long as the supply does not become too overwhelming. On the other hand, if the supply of a cryptocurrency outweighs the demand, the market value decreases until it reaches a point where traders are willing to buy it.

While this concept helps explain how cryptocurrencies experience price swings, it doesn't address why these digital assets accrue value in the first place. After all, if no one were interested in purchasing these assets, they wouldn't be worth anything on the marketplace.

Every cryptocurrency has its own specific functions, but the most important aspect of blockchain-based digital assets is decentralization. Satoshi Nakamoto, who is a cryptographer, created Bitcoin (BTC) with the main goal of establishing a digital payment network that relies on peer-to-peer transactions and operates independently from the influence of governments, central banks, and corporations. BTC and other cryptocurrencies utilize blockchain technology to validate digital payments without the need for centralized intermediaries, thereby giving coin holders complete control over their assets.

Unlike government-backed fiat currencies or traditional assets such as stocks, cryptocurrencies exist outside the jurisdiction of governments and financial institutions. For many, the decentralization of blockchains provides a unique trading opportunity and access to revolutionary digital payment networks. For these reasons, traders see value in digital assets and create demand for cryptocurrency.

What Backs a Cryptocurrency's Value?

In most cases, cryptocurrencies are only valuable within their respective blockchain networks. For instance, BTC has a 1:1 value on the Bitcoin blockchain, while Ether (ETH) has a 1:1 value on the Ethereum blockchain. However, BTC and ETH don’t have equivalent worth.

Each cryptocurrency project is responsible for its own value as they are not backed by any government or bank. The value of a cryptocurrency's native asset is likely to increase if more traders perceive value in its decentralization, utility, or security. Conversely, if traders identify issues with a blockchain's decentralization, utility, or security, the prices of its native assets will likely decrease as traders exit their position. It is worth noting that declines in the value of one cryptocurrency have sometimes led to declines in the values of cryptocurrencies in general. Cryptocurrency values can also be influenced by broader sector events, such as the collapse of a major cryptocurrency exchange, or macroeconomic events, such as changes in interest rates or banking sector instability. The transparency and efficiency of decentralized blockchain networks are the primary features that give cryptocurrencies their value.

However, a class of cryptocurrencies called "reserve-backed stablecoins" doesn't rely on blockchain technology for their value. Stablecoins are digital tokens mirroring the price of real-world assets, such as the U.S. Dollar (USD). If a stablecoin project is "reserve-backed," the stablecoin's issuer holds itself out as maintaining equivalent fiat or other reserves in banks and securities to back each stablecoin in existence. Tether (USDT) and USDC are two well-known examples of reserve-backed USD stablecoins. There are risks to stablecoins that the price will de-peg from the U.S. Dollar or other asset it tracks, causing volatility that could result in losses for a cryptocurrency trader. The most notable instance of a stablecoin de-pegging was when TerraUSD collapsed, causing significant losses for traders.

How Does a Cryptocurrency's Value Increase and Decrease?

The value of a cryptocurrency increases only when its demand exceeds the supply, which means all explanations for the rise should correlate with buying activity.

Cryptocurrency prices can increase or decrease due to a variety of reasons, but ultimately it comes down to supply and demand. If more traders invest in a project, its value (market price) will increase. On the other hand, risks associated with cryptocurrencies can cause their value to decrease. Additionally, cryptocurrency prices can be highly volatile, resulting in sudden and drastic fluctuations. The following are some factors that can affect price fluctuation:

Network Activity: Blockchain analytics firms—such as Chainalysis—constantly monitor total wallet addresses and average daily transactions on large blockchains, including Bitcoin and Ethereum. These data points help traders determine how many people use a blockchain and when network activity increases or decreases. Generally, when more people use a blockchain (implying increased trading, transactions, and purchasing), it has a positive impact on the value of the underlying cryptocurrency. On the other side of this, a decrease in network activity would likely have a negative impact on a cryptocurrency’s underlying value that results in a lower price.

Regulation: Although governments do not have direct control over cryptocurrency, they have an indirect influence on public perception and the potential uses of a cryptocurrency through legislation. For instance, El Salvador's recognition of Bitcoin as legal tender in 2021 caused a surge of optimism for BTC's trading and daily currency potential. On the other hand, when China banned Bitcoin mining the same year, traders feared increased cryptocurrency restrictions and slowed its adoption. The more countries introduce favorable cryptocurrency regulations that encourage the growth and development of cryptocurrency projects; the more likely digital assets will increase in value. However, there is a risk associated with purchasing crypto assets, as strict regulation that prohibits or limits access to cryptocurrency projects could result in decreased supply and demand, leading to a lower price. Additionally, regulation that imposes registration and compliance requirements on cryptocurrency trading could negatively affect cryptocurrency prices.

Business Adoption: Compared to fiat currencies, cryptocurrencies aren't as widely accepted as a legal tender or a means of payment. However, companies like Tesla have put Bitcoin on their balance sheets, and businesses like McDonald's have begun experimenting with cryptocurrency payments. As more companies become involved with relevant trading or payment solutions, interest in cryptocurrency may increase and drive greater demand. If businesses decline to adopt cryptocurrency or move away, this could signal to traders that the value in the underlying assets will not be sustained, thus increasing the risk for any cryptocurrency trader.

More Use Cases: Besides P2P payments, blockchain developers are working on dozens of potentially valuable use cases for digital assets. For example, decentralized finance (DeFi) platforms like DexToro offer a way for eligible users to trade cryptocurrency, stocks, and forex without relying on central brokers. There's also a growing interest in digital collectibles like non-fungible tokens (NFTs) and blockchain-based video games like "Axie Infinity." Growing cryptocurrency utility can drive demand and value, incentivizing more traders to become holders.

Trust: The credibility of cryptocurrencies is not on par with traditional fiat currencies or established institutions. This is due to the fact that the cryptocurrency industry is less regulated compared to conventional markets, leading to persistent issues like scams and hacks. These concerns can lead to a decrease in buyer demand and ultimately lower the overall value of a blockchain, digital asset, or project. In order to increase the value of a cryptocurrency, it is essential for more traders to have trust in the security standards of the blockchain protocol.

Burning and minting mechanisms and dilution and inflation: In crypto, "burning" means removing cryptocurrency from the total supply, and “minting” means adding cryptocurrency to the total supply. Some blockchain protocols use burning mechanics to add deflationary pressure to their coin issuance schedule. For example, Ethereum burns a portion of ETH in every transaction fee, reducing the total amount of ETH entering the market daily. If demand for a coin like ETH remains steady or increases, these burning mechanics positively impact the asset’s price as supply is decreased. If a cryptocurrency mints more coins or tokens, or the project team or other parties holding large amounts of a coin or token sell large portions of their stake, then there will be more supply in the market, reducing the value of each individual coin. Traders should research a crypto project’s team to evaluate whether they have before minted more tokens or are likely to do so in the future so the trader can better establish what the relevant risks with their purchase are.

Comparisons to competing payment platforms: Many financial services, such as fiat currencies, remittance services, banks, and fintech apps, compete with cryptocurrencies. Customers may find cryptocurrencies more appealing due to their lower fees and faster transaction speeds and may choose to use them instead of traditional payment services. This could increase demand for cryptocurrencies and make them more valuable to traders. However, customers may still prefer traditional payment platforms because they are more regulated and offer insurance protection in case of any issues. It's important to weigh the risks and benefits before deciding which payment method to use.

What Are the Risks Associated With Cryptocurrencies?

Cryptocurrencies involve various risks, some of which may be substantial. The principal risks include:

Risks of hacks: It is possible for hackers to gain access to blockchain nodes and manipulate a blockchain by taking over 51% of the chain's power. This has occurred in the past with chains like Ethereum Classic and Bitcoin Gold. However, as blockchain networks continue to grow and become more decentralized, node operators are increasingly motivated to follow the rules. As more computers join the network, the cost of attacking a blockchain becomes prohibitively high. Other common hacks include attacks on traders' hot or cold wallets, as well as attacks on exchanges, resulting in the loss of traders' funds. It is important to be aware of fraud risks when entering the cryptocurrency world, such as investing in fraudulent token or cryptocurrency projects that turn out to be scams, leading to the loss of funds.

Volatility: It is important for traders to understand that cryptocurrencies may experience sudden and significant changes in value due to the speculative nature of this sector, which can lead to significant losses. In addition, the liquidity of cryptocurrency markets can also impact their prices. Many cryptocurrency markets are relatively small compared to other asset markets, which can limit liquidity and result in increased volatility.

Lack of centralized trading or pricing: It is possible to trade cryptocurrencies through private negotiations and various cryptocurrency exchanges and intermediaries across the globe. However, it should be noted that many of these entities are not regulated. This lack of a centralized pricing source can create difficulties in determining accurate valuations, particularly when prices vary greatly across different markets. The decentralized nature of cryptocurrency markets means that local and regional events can unexpectedly impact the liquidity, prices, and volatility of cryptocurrencies. Additionally, market participants may face challenges when attempting to exit a position due to dispersed liquidity, especially during times of stress, which can result in increased volatility.

Concentrated or opaque ownership: The liquidity of cryptocurrencies and the volatility of cryptocurrency prices also depend on the concentration of owners of a cryptocurrency or the traders in such cryptocurrency. There is little transparency in the ownership of or trading interest in most cryptocurrencies, nor are there generally limits on concentrated ownership or trading interest. Ownership of or trading in particular cryptocurrencies can be concentrated in a limited number of countries or regions and may be controlled by a small number of persons or entities. Events in such countries and regions, or events that affect such persons or entities, could have a disproportionate impact on the prices of virtual currencies. This includes political and economic events. Greater concentration in ownership or trading interest can also lead to heightened volatility due to sharp swings in the level of supply or demand. High levels of concentration can also make a market susceptible to manipulation or distortion.

Transaction fees: When using cryptocurrencies, there is often a fee for validating transactions on the blockchain. This fee can be paid through operating a validator node on a proof-of-stake chain or by mining on a proof-of-work chain. It is important to pay this fee to ensure that your transaction is promptly recorded on the blockchain or distributed ledger. The amount of the fee is subject to market forces, and during periods of stress, the fee may increase substantially. This increase in cost and time could affect the speed of building the relevant block on the blockchain or ledger where your cryptocurrency transfer is recorded.

No insurance protections: Cryptocurrency transactions and assets are not covered by any government or private insurance funds. If an individual lose their crypto funds in engaging in financial transactions such as payments or remittances, their coins or tokens are likely gone for good. Major losses, sometimes due to fraud or hacks, have led to the collapses of multiple major cryptocurrency exchanges, lenders, brokers, and funds, which have in turn caused traders and others to suffer significant losses, without any protection from public or private insurance schemes.

This summary cannot cover all the risks of cryptocurrency transactions and holdings, which are subject to additional risks.

How To Calculate Cryptocurrency Value

A cryptocurrency's value primarily depends on unquantifiable factors such as trust, trader demand, and public perception. However, there’s a simple formula traders use to determine the current market price of a cryptocurrency:

  • Funds currently circulating in a cryptocurrency / Circulating supplyof coins or tokens = Market price per coin or token

The first variable measures how much money is currently trading in a cryptocurrency project, while the "circulating supply" is the number of coins currently in the open market. For example, suppose $450 billion USD trades in Bitcoin, and there are 19.3 million BTC in circulation. The value of one BTC could be determined as follows:

  • $450 billion USD /19.3 million BTC = $23,316 USD per BTC

Traders can find the data points needed to calculate a cryptocurrency's market price on third-party crypto price aggregator websites. Popular sites, such as CoinMarketCap and CoinGecko, provide real-time data on the market caps and circulating supplies of thousands of cryptocurrencies.

Discover More Cryptocurrency Education on DexToro

Cryptocurrency and blockchain are exciting yet complex developments. At DexToro, we want to make learning about the world of digital assets as simple as possible. For more easy-to-understand guides on cryptocurrencies, check out the DexToro Academy, and to learn more about our product, take a look at our blog. DexToro also offers eligible traders a decentralized derivatives exchange with access to Bitcoin, altcoins, forex, and stocks, with up to 50x leverage. Head over to our main page to start trading on DexToro today!

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