What drives the value of crypto?
Everyone is talking about cryptocurrencies. But for those of us on the outside, their value is still something of a mystery
Thanks to Elon Musk and his 57.1 million Twitter followers, the noise around cryptocurrency is louder than it’s ever been before. While the Tesla and SpaceX CEO is far from solely responsible for the alternative digital asset’s rise to fame, his tweets have played a huge part in catapulting its value to new heights.
However, cryptocurrencies are intrinsically volatile. Since 2011, a year after bitcoin gained monetary value, the crypto poster child has fallen victim to its own inflated prices. That year, it went from highs of $32 (about £23) to lows of $2. The scale is different in 2021, but the volatility remains, with the cryptocurrency reaching highs of $64,000 and lows of near $30,000.
Despite bitcoin’s fluctuating price, it continues to correct itself at higher values. In June 2020, the price of bitcoin sat at around $9,000. A year later, its value is fluctuating around $35,000. That’s an increase of nearly 290%, a notable gain for longer-term investors.
Determining the value of crypto
While it’s easy to conflate crypto with bitcoin, there are actually around 4,000 such currencies in circulation around the world, more than the number of fiat (government-issued) currencies in existence. The number of cryptos is likely to keep growing, largely because it’s so easy to develop a new coin, which in basic terms is simply computer code generated by open-source software designed to transact value online.
The way a coin is developed, and for what purpose, has a massive bearing on its value. While there are thousands in existence, the top 20 coins are believed to constitute around 99% of the market by volume, according to crypto website CoinDesk.
Much like fiat currencies, the price of cryptocurrencies is heavily swayed by supply and demand. But it’s also determined by the cost of production. “Look at the use case of a coin,” says Edward Cooper, Revolut’s head of crypto. He emphasises utility as the most important component in a cryptocurrency’s value. “How much technical engineering is going on to update the protocol? What is the calibre of the founding team?”
For bitcoin, that utility is solving the problem of wealth storage, while ethereum, the world’s second-largest cryptocurrency, can be used as the foundation for apps. This compares to dogecoin, which was created in just two hours as a joke and enjoyed a nearly 20% value boost when Musk tweeted: “One word: Doge.”
Doge doesn’t pass some of the utility tests, says Cooper. “The value here comes from speculation.”
Retail investors should remember that bitcoin is a limited supply asset, with a 21 million cap written into its source code. This is why it acts as an effective store of value. Not all cryptocurrencies have a cap. Ethereum doesn’t – and neither does dogecoin.
However, a cap is not the only way to hedge against inflation. Ethererum, for example, has a set number of monetary policies, including a fixed supply and issuance schedule, to keep its value constant. As long as demand outweighs supply, its price will keep going up. Tether, one of the best-known stablecoins, is pegged to the US dollar to anchor its value.
External drivers of crypto’s value
External factors also influence the value of a cryptocurrency, including the words or tweets of high-profile figures like Musk. In June 2021, the billionaire drove up the value of cumrocket, an alternative coin for adult creators, by nearly 400%. But he also sparked a price dip of more than 7% in bitcoin after he suggested he was “breaking up” with the cryptocurrency.
Diana Biggs, a former HSBC executive who now leads cryptocurrency startup Valour, notes that “cryptocurrencies are still in their infancy” and market caps tend to be relatively small. This contributes to their volatility and makes them susceptible to the influence of individuals. Still, “the more big companies invest, the more individuals will find it hard to move the market”, Cooper notes.
That investment is already happening. Ten years ago, bitcoin was deemed a tender of the “dark web”. Now PayPal’s millions of American wallet holders can spend bitcoin like they would the dollar. And the first major US bank, Morgan Stanley, has begun offering global clients access to bitcoin funds. Buy-in from the establishment is growing, and fast.
Biggs also cites greater government clarity around crypto usage as a major driver in cryptocurrency’s route to adulthood and thus a more predictable value. This month, El Salvador’s decision to become the first country to adopt bitcoin as legal tender sent the coin’s value up 6%.
That works both ways, however. The national ban on cryptocurrency services by Chinese regulators in May sent bitcoin plummeting by close to 20%. “To say Musk is the driver [behind a recent fall in bitcoin’s value] probably gives him too much credit,” says Yang Li, chief growth officer at crypto account provider Ziglu. “He definitely plays a part, but at the same time you’ve got the crackdown on bitcoin mining in China, or in the US they’re looking at new taxation for crypto profits.”
Li is right. Many of Musk’s assertions have been compounded by regulatory decisions. The Chinese ban, for example, furthered a weeklong decline in bitcoin’s value after Tesla said it would no longer accept bitcoin transactions for its electric cars. Musk may seem like a crypto market mover, but he’s far from alone.