How does cryptocurrency gain value?

Cryptocurrency is becoming mainstream — a 2022 report indicated that 21% of Americans have invested in or traded cryptocurrency at least once.

And the prices of cryptocurrencies have surged over the years. But what exactly makes crypto valuable? How does cryptocurrency work?

Compared to other assets, crypto has a unique valuation system. With something like a stock, the price is often influenced primarily by the earnings that the company produces or assets the company holds.

Cryptocurrencies are not companies and do not have “earnings” or hold other assets — so how does cryptocurrency gain value?

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What Makes Cryptocurrency Valuable?

Cryptocurrencies are digital currencies that are powered by blockchain technology. Popular examples include Ethereum (ETH) and Bitcoin (BTC).

Cryptocurrency is decentralized, meaning there is no central authority or government that is running the show. Who controls cryptocurrency, then? Most crypto networks are controlled by a decentralized network of computer nodes spread throughout the globe.

In many cases, these are volunteer participants who often earn a small amount of cryptocurrency for participating in the network.

Some of the benefits of cryptocurrency include fast transactions, cross-border capabilities, anonymous security measures, and low transaction costs.

Cryptocurrency can be used as a means of exchange (to buy and sell goods). It can also be used as an investment.

But why is cryptocurrency valuable? There are three main reasons:

Utility value: Crypto tokens have utility value because they can be used to pay for transaction fees on the blockchain. All sorts of applications can run on the blockchain, from alternative banking solutions to auction houses. Crypto tokens like Ether (the native token of the Ethereum blockchain) are quite useful for those in the crypto world.

Scarcity value: For most cryptocurrencies, there are a limited number of tokens available. For example, there are only 21 million Bitcoins in existence. Tokens are typically minted just once. After that, the same number of tokens remains in circulation. The supply tends to decrease, as some amount of tokens might be lost. Any resource that is scarce tends to be valuable — just think about diamonds or gold.

Investor value: Finally, cryptocurrencies are now a popular alternative asset class. Investors of all shapes and sizes believe in the future of blockchain and want to get in on the action. So, they invest in cryptocurrencies. Investors typically buy-and-hold crypto, reducing the available supply and increasing the price.

These three factors combine to make cryptocurrency have value.

How Does Cryptocurrency Gain Value?

Cryptocurrency is technically a currency — but in most cases, it’s treated more like assets such as stocks. Crypto tokens trade on digital exchanges, where investors buy and sell the tokens for fiat currencies like the US dollar.

If buyers demand more tokens than are supplied at a given price point, the price will rise higher. Demand can be generated by investors and crypto users alike.

This supply and demand factor is the most significant driver of crypto’s changing prices. But it’s not the only one!

Supply & demand

The law of supply and demand drives the value of most assets, including crypto.

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‍Supply: The quantity of a certain item that sellers are willing to sell at a certain price point.

Demand: The quantity of a certain item that buyers are willing to purchase at a certain price point.

Supply & demand: The relationship between supply and demand influences prices. If demand exceeds supply, prices will rise. If supply exceeds demand, prices will fall.

Crypto gains value when demand exceeds supply.

How much is 1 Bitcoin worth? The price changes daily, so let’s look at a hypothetical example.

Say that the current price of Bitcoin is $30,000. Holders of Bitcoin are willing to sell 1,000 Bitcoins at this price. Investors wish to buy 2,000 Bitcoins. The 1,000 BTC for sale at $30,000 each will sell instantly.

Now, demand is higher than supply. Other sellers will step in to sell their BTC — but for more than $30,000. They might demand $30,200 for their BTC, for example.

This process is happening 24/7, in real-time. Prices for cryptocurrencies constantly change based on investor activity in the markets.

This can sometimes lead to significant price changes — known as volatility — in the crypto market.

For example, if a crypto “whale” (a large stakeholder) decides to sell a huge quantity of Ether, it could potentially spark a large decrease in the price of ETH.

Project popularity

“Cryptocurrency” is a broad term. The cryptocurrency list now includes over 20,000 different projects, according to CoinMarketCap.

Projects like Bitcoin, Ethereum, Cardano, and Solana are considered some of the most popular and successful — but newcomers could overtake these coins in the future.

Each crypto project operates in a slightly different way. Some work with existing blockchain tech, while others create their own dedicated network.

Some projects gain popularity by being faster, better, or cheaper than their competitors. Over time, this can lead to their prices increasing more than the overall crypto market.

While BTC and ETH remain the dominant cryptocurrencies, it’s anyone’s guess as to which projects will dominate in the future.

Does mining crypto increase value?

Crypto “mining” is the process of tracking and processing cryptocurrency transactions. Many blockchain networks use distributed networks of crypto miners, each of which records transactions made on the public network. Transaction ledgers are then compared from many different miners to confirm the legitimacy of transactions.

Crypto miners are often rewarded with a small amount of cryptocurrency for their efforts. But miners must have high-end computer equipment in order to compete with other miners.

For this reason, miners must balance their costs — computer equipment and electricity, namely — with the rewards they earn from mining. As mining costs increase, theoretically, crypto prices should increase in tandem. In economics, this concept is referred to as the marginal cost of production.

Miners will simply stop participating if the rewards they earn don’t cover their costs. If enough miners withdraw, it could reduce the efficiency of the blockchain network.

So, some experts believe that mining itself influences the value of cryptocurrency. Miners will theoretically only participate when they can be profitable or at least break even.

How Does Cryptocurrency Lose Value?

The law of supply and demand works in both directions. If supply is higher than demand, sellers will be forced to lower their prices in order to make the sale — which causes the price to decline.

This happens 24 hours a day, 7 days a week — in real-time. And often, a series of price declines can cause more sellers to believe the price will keep dropping, encouraging them to sell. This can create a downward spiral which can cause prices to decline rapidly.

Cryptocurrencies are also loosely connected with the price of other asset classes. If the stock market crashes, it’s likely (but not guaranteed) that the crypto market might crash too.

Finally, cryptocurrency is a more speculative asset than other assets like stocks and real estate. Many investors purchase crypto with the hopes of quick profits — but they don’t necessarily believe in the technology in the long term. These speculative investors are often quick to sell when prices decline, which can create further downward pressure on crypto prices.

What About Stablecoins?

Stablecoins are a type of cryptocurrency designed to have stable values. In most cases, they are designed to track the value of 1 US dollar.

Coins like Tether (USDT), USD Coin (USDC), and Binance USD (BUSD) are examples of stablecoins.

The point of stablecoins is to provide a consistent and reliable means of exchange for crypto transactions.

When users utilize traditional cryptos like BTC to actually purchase goods and services, the volatility of BTC can be an issue. For example, they may buy a $100 product for X in Bitcoin — only for that Bitcoin to be worth $99 by the time the transaction goes through.

Stablecoins aim to fix this problem by retaining a price value of around $1. This makes them more similar to traditional currencies, which don’t tend to have as much volatility in their price levels.

Stablecoin tokens use different methods to retain price stability. Some hold assets in reserve — for example, they may hold $1 million in USD in a reserve and then offer 1 million tokens for sale at $1 each. In this case, the coin is backed 1:1 by real US dollars. Other stablecoins use complex algorithms to peg their value to the price of $1.

The price of stablecoins is less influenced by the law of supply and demand. Prices may fluctuate slightly — a stablecoin might trade for $0.9980 or $1.0020, for example. But ultimately, their value should always be close to their USD peg.

Of course, in extreme cases, algorithmic stablecoins can still crash dramatically. For example, Luna (UST), a popular stablecoin, collapsed dramatically in early 2022.

Bitcoin & Ethereum vs. “stablecoins”

Most cryptocurrencies — BTC, ETH, SOL, ADA, and thousands of others — change in value based on supply and demand. Their prices can therefore be fairly volatile.

Stablecoins — USDT, USDC, etc. — are much less volatile. In most cases, the tokens are intrinsically designed to be worth right around $1.

Cryptocurrency vs. Stocks: What Drives the Value?

When it comes to the price of these assets, what is the difference between how crypto’s price changes and how the prices of stocks change?

Stocks represent fractional ownership of a specific company. The value of a company is largely determined by its profits, growth trajectory, and expectations for the company’s future.

For stocks, there are various ways to measure value — for instance, the price-to-earnings ratio (P/E) compares the price of the stock to the company’s annual earnings per share.

As such, the value of a stock is relatively easy to assess and measure using hard data.

For cryptocurrencies, there are no underlying earnings. For this reason, the value is more difficult to measure — and is mostly based on investor expectations for the currency's future value.

Why Is Cryptocurrency Volatile?

You may have heard that crypto is a volatile asset class, but what does this really mean?

Volatility is a measure of how much an asset’s price changes in either direction. A highly volatile asset might jump from $5 to $8 and then down to $4 — in a matter of days or weeks.

A low-volatility asset might go from $5 to $5.05, and then down to $4.93 in the same time period.

Crypto assets are typically considered high volatility assets, meaning their prices frequently change (in both directions). Why is this?

There are a few reasons. For one, the price of Bitcoin and other cryptos is largely driven by investor behavior. Investors can buy and sell instantly and often follow market trends.

There’s also not much stability coming from actual users. To illustrate, compare Bitcoin to a commodity like steel. With steel, many companies are buying steel on the market to actually use it to make products. This creates a stable buying floor, where actual users are willing to step in and buy extra when the price gets cheap. With Bitcoin, demand from actual users is far lower than demand from investors.

Cryptocurrency is also a relatively new industry. It’s subject to influence from government regulation, celebrity influencers, external market conditions, and more.

Finally, crypto prices have surged in recent years. As the market attempts to determine the fair value for crypto assets over the long term, investors can expect more volatility to come.

Wrapping Up

Ultimately, the primary driving force behind the value of a cryptocurrency is supply and demand. If users and investors are demanding more of a currency than is supplied, then the price will increase.

Other factors influence supply and demand, of course. This includes the popularity/success of a project, the utility value of the currency, and more.

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