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How does cryptocurrency gain value?

OVIDIU POPESCU

19 November 20218 min read

Cryptocurrency markets are notoriously volatile, with dramatic price fluctuations often occurring over relatively brief periods of time. We’re all familiar with Bitcoin’s volatility, for example, which plunged 30% to $30,000 at one point in May 2021 before quickly recovering to $38,000.

While these sorts of swings make for attention-grabbing headlines, just how does a cryptocurrency such as Bitcoin gain or even acquire value? In the following article, we’ll take a look at the relationship between currency and value, beginning with fiat currency and variables such as supply and demand as well as inflation policies before thinking about digital assets.

How does cryptocurrency gain value over time?

Fiat first

The short answer to the question of why any given currency – whether fiat or otherwise – has value is simply the fact that enough people agree that it does, and that consensus then extends to the currency’s use as a medium of exchange. There is nothing intrinsically valuable about a one-hundred-dollar bill or a twenty Euro banknote – the paper itself is essentially worthless.

The widespread adoption of the American dollar resulted from the elimination of the gold standard, which held that every dollar be backed by actual gold. In the absence of that backing, people simply agreed that pieces of paper with the faces of dead American presidents could be exchanged for a specified amount of goods or services.

In addition to a lack of intrinsic value, paper money can be printed as often as needed, resulting in money supply growth and inflationary pressures, which can lead to hyperinflation and bubbles. In extreme cases, fiat currencies can lose their value when governments or central banks are unable to back them (recall Weimar or, more recently, Venezuela).

The value of a fiat currency is, among other things, a measure of supply and demand. Foreign exchange reserves contribute to the relative access or scarcity of USD. The more USD that international governments hold, the scarcer the supply and the greater the value. If the world’s governments were to cash in their reserves, then the dollar would collapse and with it the American (and likely global) economy.

A few thoughts on crypto

How does the creation and fluctuation of value for something immaterial like cryptocurrency work? Surprisingly, the mechanisms for digital assets are largely similar, if not identical. If we take Bitcoin as an example, there is a limited supply – capped at 21 million. Once that supply has been exhausted, that’s it. There will never be more than 21 million Bitcoin, which is one reason why many expect increased demand will continue to drive the cryptocurrency’s value upwards in the years to come. And unlike fiat currency, the fixed supply of cryptocurrencies means that devaluation through inflation is unlikely.

A limited supply is all well and good, but it would be of little consequence if Bitcoin had little-to-no practical utility. The fact that it does is one of the reasons why it has established itself as a private, decentralized digital currency. You can now use it to pay for goods or services across an increasingly wide spectrum of merchants and businesses. And since it’s an electronic payment system based on cryptographic proof instead of trust, your transactions are safe, secure, and documented, which brings us to our next point.

Bitcoin operates on the blockchain, a decentralized ledger of all transactions across a peer-to-peer network. The technology has many applications and offers increased transparency, precise tracking, and decreased costs due to the elimination of financial gatekeepers. As a result, Bitcoin cannot be counterfeited and all transactions are traceable.

For these reasons and others, a cryptocurrency such as Bitcoin has become an accepted digital asset, allowing it to be used in a manner similar to fiat currencies, whether for the purposes of buying or selling goods and services or as a store of value.

Determining crypto value and increasing gains

What gives Bitcoin its value? As with fiat currency, it’s largely a matter of faith or consensus. People believe that it has value, or have agreed that it has value, and so it does. Whether it will continue to have value, or whether its value will continue to increase in the future, remains an open question, particularly since it’s a relatively new asset, unlike gold, which has proven its value over a much longer period of time.

As we’ve seen, cryptocurrency establishes its value according to many of the same principles that regulate the value of fiat currencies (e.g. supply and demand, utility) and for different reasons of their own (e.g. freedom from financial gatekeepers, decentralization). But just how does cryptocurrency gain value?

Supply and demand

Gains in value for cryptocurrencies follow that age-old law of supply and demand. In the absence of demand, digital assets hold little value. However, the reasons behind demand can vary. Traders in China intent on circumventing restrictive regulatory controls might (in fact, did) turn to Bitcoin, thereby sparking increased demand. Similarly, Venezuelans concerned about soaring inflation and a devalued bolívar turned to Bitcoin, which increased its demand and value as a result.

And, as mentioned above, supply is fundamental to determining an asset’s price. Something that is scarce will likely have a much greater value than something that is widely available. Since its inception, Bitcoin’s protocol allows new coins to be created at a fixed rate, which slows over time. The supply of Bitcoin decreased from 6.9% in 2016 to 4.4% in 2017 and 4% in 2018.2 And Bitcoin halving events, which occur every four years, roughly correspond to a significant price increase, as it indicates a reduction in supply.

Competition

Competition can be a double-edged sword in terms of value. In the early days of the cryptosphere, there were relatively few players in the game, allowing Bitcoin to benefit from a general lack of competition. In 2017, Bitcoin accounted for more than 80% of the overall market capitalization of crypto markets. Fast forward a few years and estimates put the number of different cryptocurrencies at just over 6,000 and all of them are vying for the attention of traders. It should come as no surprise, then, that by 20221 Bitcoin’s overall market capitalization of crypto markets is hovering just under 50%. In Bitcoin’s case, increased competition hasn’t resulted in a loss of value, as supply and demand (among other reasons) continue to drive its value.

While competition can drive down the value of one asset, it can increase the value of other assets. Consider Ethereum, a decentralized, open-source blockchain with smart contract functionality, and its native coin Ether, which is now the second largest cryptocurrency by both market capitalization and daily volume. Since its launch in 2015, it has become the most actively used blockchain network with a range of uses, including the creation of fungible (ERC20) and non-fungible (ERC721) tokens, crowdfunding (e.g. initial coin offerings), decentralized finance, decentralized exchanges, decentralized autonomous organizations (DAOs), games, prediction markets, and gambling. As a result of growing interest in decentralized finance (DeFi) tokens, Ether has emerged as something of a competitor to Bitcoin. However, while the multiplicity of Ethereum’s uses has had an impact on Ether’s value, it now faces competition from the likes of Binance Smart Chain, Cardano, and Neo, among others.

Technological developments

Many cryptocurrencies gain value as a result of new developments or technological improvements to pre-existing infrastructure. Hard and soft forks, for example, can create buzz around a coin, altering traders’ perceptions. In August 2017, the forking of Bitcoin's blockchain into Bitcoin Cash resulted in significant volatility, but also new highs for the valuation of both coins.

Similarly, in August 2021 the price of Ether jumped before and after the London fork, which was one of the biggest upgrades to Ethereum’s blockchain in its six-year history. Bullish traders buoyed the value of Ether in the weeks leading up to the London hard fork, while its value surged 8% following the network upgrade.

A word of warning, though – upgrades don’t always translate into an increase in value. In August 2021, the value of Cardano’s ADA surged approximately 22% after news of its imminent smart-contract update, a major milestone in its roadmap that saw the launch of Plutus-powered smart contracts. However, September’s Alonzo hard fork was met with a muted response, yielding little impact on ADA’s value. In the aftermath of the Alonzo hard fork on 10 September, ADA dropped 10%, hitting an intraday low of $2.30.

The celebrity touch

Whether you love it or loathe it, a cryptocurrency’s ability to gain value can be helped (and, at times, hindered) by stardom. Elon Musk, Jack Dorsey, Mike Tyson, Maisie Williams, Mark Cuban, Snoop Dogg, Steven Seagal, Kanye West, Floyd Mayweather Jr., and Richard Branson are just a handful (or two) of celebrity holders of the now famous coin, spanning the worlds of sport, film, music, and business.

Dogecoin is a classic case in point. The coin itself was created as a joke, but its fortunes improved dramatically following various tweets by Elon Musk. His first Dogecoin-related tweet was made in December 2020 in which he wrote, “One Word: Doge,” after which Dogecoin’s value rose by 20%. In February 2021, its value rose by almost 40% after Musk wrote “Dogecoin is the people’s crypto” and “no highs, no lows, only Doge.” Only two months later, Musk tweeted an image of Joan Miró’s painting “Dog Barking at the Moon” with the caption “Doge Barking at the Moon.” Any guesses as to what happened? Bingo – the value of Dogecoin increased, this time by 100%.

However, as cryptocurrencies become more widely accepted, particularly within the corporate sector, the Elon Musk effect may begin to diminish. With the likes of PayPal and Morgan Stanely, among many others, entering the cryptosphere, individuals may find it harder and harder to influence the market with a simple tweet.

Whales

Some celebrities could be considered whales, but most whales are not celebrities. Huh? Let me explain. Crypto whales hold a large number of coins of a given cryptocurrency. Typically, the threshold for Bitcoin, for example, is 1,000 coins, while the number is usually much higher for altcoins given their lower market capitalizations. (Some speculate that Elon Musk might be a Dogecoin whale, but he hasn’t admitted as much and so there’s virtually no substantive proof.)

According to a recent article, “An anonymous buyer decided to go on a SHIB coin shopping spree over two days buying close to an enormous 6.3 trillion coins. The whale began his spree on October 1 when he went ahead and bought a mammoth 6 trillion SHIB coins [...and] then went ahead and bought another 116 billion coins the next day, followed by two more transactions of 159 billion coins and another 1 billion coins, the last three transactions happening in a span of a few hours.” An unrelated article reported that “on October 26, 2021, an Ethereum whale purchased 276,592,553,073 SHIB tokens, equivalent to $11,510,207.”

Such massive purchases can lead to price surges in either direction. In this case, the whale might be artificially inflating the value of SHIB coins by placing huge buy orders, forcing bidders to raise their bid price. As news spreads, fear of missing out begins to influence smaller investors. In other words, whales try to stimulate interest among other investors by creating a price increase, and these investors then become fearful of missing out on the surge.

Final thoughts

In the ever-changing world of crypto, assets can rise and fall with striking alacrity. Many factors influence the extent to which any given cryptocurrency gains value, from supply and demand, cost of production, availability on exchanges, competition, governance and regulation, celebrity endorsements, and the ripple effects of anonymous whales. And then there are always unforeseen intangibles, which can yield unexpected surges.

If crypto’s volume of transactions continues to increase, while volatility settles, keep an eye on long-term value and mass adoption, which could have a lasting impact on the future of both cryptocurrencies and fiat currencies.