What Drives the Valuation of Cryptocurrencies? – The Market Mogul

Introduction

Cryptocurrencies have recently attracted increasing attention from investors and businesses as they promise to provide innovative, secure and cost-effective solutions that improve the current money transfer system and enhance the efficiency of transactions. Cryptocurrencies have also proved to be a volatile market with unpredictable price swings and rapid introduction of new coins that constantly disrupt the current market equilibrium. In this article, I endeavour to explain the key factors that drive the valuation of cryptocurrencies.

A cryptocurrency is broadly described as a cross between a commodity and currency as it stores value and has a finite supply but is also liquid and can also be used to pay for transactions. Fundamentally, its price is determined by supply and demand, as any other asset price is determined. Most, if not all, cryptocurrencies have a finite supply that is either already in circulation or will slowly start decreasing until it reaches a known limit. Due to this, the price of cryptocurrencies is driven primarily by factors that affect demand.

The value and demand for any currency, especially fiat currencies, is derived from the trust of its users in its ability to preserve its purchasing power. When a currency loses trust, its value drops precipitously, exemplified by Argentinas peso during its hyperinflation days.

Cryptocurrencies are no exception. Bitcoin gained traction because users believe in the complete anonymity and security of its blockchain ledger. Since it could not be hacked or tampered with, it would always preserve its value. Similarly, Litecoins value rapidly increased when users understood that it had features that surpassed Bitcoin in certain aspects, such as speed of transactions, and they believed it was the silver to Bitcoins gold.

Government trust, in terms of regulations, also plays a vital role in the success of acryptocurrency and affects its valuation. The original scepticism with Bitcoin was principally due to the belief that governments would never legalise it, owing to fears of facilitating money laundering and black market trade. This was exacerbated by the fact that Bitcoin initially gained popularity as the method of payment in Silk Road, the first modern dark-net black market which was infamous as a platform for selling illegal drugs.

However, governments have looked at cryptocurrencies more favourably than originally assumed and have understood the potential that blockchain technology has in improving efficiency. The impact of government trust on valuations is evidenced by the price spikes that occur when governments legitimize it. Bitcoins total valuation soared to more than $1bn in mid-April this year when Japan and Russia moved to legitimize it. During mid-June, Ethereums price spiked to above $400 when some Asian governments legitimized it in part as a form of payment.

Value investors who invest in cryptocurrencies estimate their value based on the market capitalization of the process or asset it seeks to replace along with an estimation of how much market share the cryptocurrency will control. For example, Bitcoin enthusiasts who believe that bitcoin is a form of digital gold, as Satoshi Nakamoto intended, will take reference from the market cap of the gold market $7trn.

If Bitcoin were to control even 1% of golds market cap, its valuation should be $70bn compared to the current valuation of $36.5bn implying that it is undervalued. Other common examples are estimating Bitcoins value based on the remittance market and Ethereums value based on the IPO market which it seeks to replace with ICOs (Initial Coin Offerings).

However, this method of valuing currencies is risky as it depends on factors, such as the possibility of the emergence of more efficient cryptocurrencies, that are impossible to predict accurately. The investors personal beliefs are also reflected in his choice of the prospective market that the cryptocurrency would replace.

As with any other asset, speculation is a strong driving force in determining the value of cryptocurrencies. Speculation is affected by the perception of cryptocurrencies and is directed by new updates and developments. For example, improvements in liquidity through the establishment of new exchanges leads to a price increase as speculators believe that more people will start using the currency and drive up its price.

Similarly, the introduction of a new coin that performs the same function as an existing one but has increased transaction speed and lower cost would send the existing coins valuation spiralling downwards. The highest short-term price swings are currently in the cryptocurrency market some have spiked by 1000% in less than a week and this attracts traders and other investors who wish to profit from these swings. Furthermore, these wild swings are not just confined to the newer coins but are prevalent even in the established ones.

Many traders do not understand the technical aspect of this market and simply wish to gain from the greater fool theory wherein the assets fundamentals carry no importance if they can sell it to someone at a higher price. These trend-followers exacerbate the price movements by encouraging feedback loops and herd mentality. Furthermore, low-volatility and overvalued metrics in traditional markets have accentuated the attention of investors in cryptocurrencies as it remains one of the few areas which can rapidly deliver huge returns.

Cryptocurrency valueis driven by the demand-side factors that have been explained in this article and the trajectory that investors expect the market to take. Many investors and economists believe cryptocurrencies are currently in a bubble as ICOs are attracting a lot of capital, the market has an uncanny resemblance to the dot com boom and everyone is bragging about how easy it is to make money.

Others believe that the boom has just started and the valuations of cryptocurrencies will increase tremendously over the next decade as they replace traditional forms of money transfers and contracts. The rest believe that in the same way as the dot-com boom left behind Google, Facebook and a plethora of revolutionary technological companies, the cryptocurrency craze will eventually lead to a bust that will leave behind a few cryptocurrencies which will shape the way we transact.

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What Drives the Valuation of Cryptocurrencies? - The Market Mogul