Have you ever thought about what drives cryptocurrency? Given that bitcoin is often unpredictable, you may be wondering what makes it valuable. It is not uncommon for the price of Bitcoin (CRYPTO: BTC) to fluctuate by 5% or even 10% on any given day. Smaller coins can see even greater price fluctuations.
After reading this article, you’ll have a greater grasp of what makes bitcoin valuable and why the price might fluctuate dramatically in a single day.
Understanding The Value Of A Cryptocurrency
Cryptocurrencies are not typically supported by a central authority in the same way that fiat currencies or other government-sanctioned mediums of trade are.
Government endorsement may boost consumer confidence in the value of a currency and give a large spender and collector of the money. (Think about paying your taxes with Bitcoin.) However, because cryptocurrencies are often decentralized, their value is derived from different sources, such as:
- Demand and supply
- Production costs
- Exchange availability
What Drives Cryptocurrency?
The value of cryptocurrencies, like the value of everything else that people want, is determined by supply and demand. If demand grows faster than supply, the price rises.
For example, if there is a drought, grain and product prices rise if demand remains constant. Cryptocurrencies follow the same supply and demand basis. When demand exceeds supply, cryptocurrency increases its value.
A cryptocurrency’s supply method is always known; each cryptocurrency discloses its token minting and burning plans. Some, like Bitcoin, have a defined maximum supply; we know there will never be more than 21 million Bitcoins. Others, like Ether (CRYPTO: ETH), have no production limit.
Some cryptocurrencies have systems in place to “burn” old tokens to keep the circulating supply from becoming too high and delaying inflation. To burn a token, transfer it to an unrecoverable address on the blockchain.
Each cryptocurrency has its monetary policy. With each new block mined on the network, the Bitcoin supply grows by a predetermined amount. Ethereum pays a set reward for every block mined, but it also compensates for adding “uncle blocks” in the new block, which increases the blockchain’s efficiency.
As a result, the supply rise is not as predictable. Some cryptocurrency supplies are determined by the project team, which might choose to release additional tokens to the public or burn tokens to regulate the money supply.
Demand might rise as a project becomes more well-known or as utility prices rise. Increased acceptance of cryptocurrencies as investments raises demand while effectively restricting circulation supply.
For example, when institutional investors began purchasing and holding Bitcoin in early 2021, the price of Bitcoin skyrocketed as demand outpaced the rate at which new coins were generated, thereby lowering the total accessible supply of Bitcoin.
Cost Of Production
Mining is the process through which new cryptocurrency tokens are created. Mining bitcoin entails using a computer to validate the next block on the blockchain.
The decentralized network of miners is what makes bitcoin possible. In exchange, the protocol generates a reward in the form of cryptocurrency tokens, in addition to any fees paid to the miners by the trading parties.
Verifying the blockchain necessitates the use of computational resources. To mine bitcoin, participants invest in pricey equipment and power. The more competition there is for mining a certain cryptocurrency under a proof-of-work system, such as those employed by Bitcoin and Ethereum, the more difficult it is to mine.
This is because miners compete to solve a complicated math problem to validate a block. As a result, the cost of mining rises as more powerful equipment is required to mine properly.
As mining expenses rise, the value of the cryptocurrency rises as well. Miners will not mine if the value of the money they are mining is insufficient to cover their costs.
And, because miners are required to make the blockchain work, the price will have to rise as long as there is demand for utilizing the blockchain.
Bitcoin and Ether, two popular cryptocurrencies, are traded on several exchanges. The most popular tokens may be found on almost any cryptocurrency market.
However, some smaller coins may be offered solely on specific exchanges, limiting access for some investors. Some wallet providers will aggregate quotations for any combination of cryptocurrencies across many exchanges, but they will charge a fee for doing so, raising the cost of investing.
Furthermore, if a cryptocurrency is lightly traded on a tiny exchange, the spread charged by the exchange may be prohibitively expensive for certain investors.
When a cryptocurrency gets listed on additional exchanges, it increases the number of investors who are ready and able to purchase it, hence raising demand. And, everything else being equal, when demand rises, so will the price.
There are dozens of different cryptocurrencies, with new projects and tokens being launched daily.
The barrier to entry is low for new rivals, but producing a sustainable cryptocurrency also requires growing a network of cryptocurrency users.
A good blockchain application can quickly create a network, especially if it addresses a deficiency of a rival service. If a new rival develops traction, it devalues the incumbent, causing the price of the incumbent to fall while the price of the new competitor’s token rises.
Cryptocurrency networks seldom follow a rigid set of rules. Developers modify projects in response to the community that utilizes them.
Some tokens, known as governance tokens, allow holders to vote on how a token is mined or utilized in the future. To make any modifications to the governance of a token, stakeholders must reach an agreement.
Ethereum, for example, is attempting to transition its network from a proof-of-work to a proof-of-stake mechanism, thus rendering most of the expensive mining equipment in data centers or people’s basements obsolete. This will surely affect the value of Ether.
In general, investors prefer a stable government. Even if a cryptocurrency has issues, investors choose the devil they know over the devil they don’t.
As a result, stable governance in areas where things are generally difficult to alter might be beneficial by offering more stable prices.
On the other hand, the sluggish process of upgrading software to enhance protocols may restrict bitcoin value appreciation. If an upgrade might unleash value for bitcoin investors but takes months to implement, current stakeholders suffer.
Regulations And Legal Requirements
There is some disagreement regarding who should regulate cryptocurrency exchanges. The Securities and Exchange Commission (SEC) considers cryptocurrencies to be securities, similar to stocks and bonds, but the Commodity Futures Trading Commission (CFTC) considers them to be commodities, similar to coffee or gold.
Both organizations do not have regulatory power over bitcoin exchanges. A deciding verdict might bring more clarity, boost cryptocurrency valuations, and pave the way for more widely traded crypto-related financial instruments.
Regulation is essential to facilitate cryptocurrency trading. ETFs and futures contracts provide investors a broader access to bitcoin, enhancing its value. Furthermore, regulation may allow investors to take short positions or gamble against the price of cryptocurrencies via futures contracts or options. This should result in improved price discovery and less volatility in bitcoin prices.
Regulations may also have a detrimental influence on bitcoin demand. If a regulatory body modifies the regulations to discourage cryptocurrency investment or use, the price of cryptocurrencies may fall.