In today’s Exponential Investor:
- What is the price of a cryptocurrency?
- Why do all crypto prices move together?
- How should you view (and make) an investment in crypto?
In 2010 and then into 2011 we saw the weirdest and most wonderful thing.
A digital “currency” going by the name of bitcoin rose in value from a few US cents to $1. Then it would go on to explode to over $30 and then “crash” all the way back to under $2.
It was wild. It was amazing. It was almost unbelievable.
It was also, insanely volatile.
This was our first view of the ferocity in which the price of bitcoin was able to move. It wasn’t that what hooked us though. If anything, the price of the cryptocurrency scared us away to start with.
But the idea that money could be created effectively from nothing, online and that anyone could get it, was thrilling.
And so began more than a decade of fascination, research and investment into the most exciting asset class of all time.
However, often the most common question about cryptocurrency revolves around the “price” of crypto.
How does cryptocurrency have a “price”?
First and foremost, when we talk about crypto price it’s important to understand what you’re really talking about.
The value (or price) of a cryptocurrency is determined in the same way to fiat (traditional) currencies or any other asset for that matter.
That is, through demand, supply and a market of buyers and sellers.
If I have one bitcoin and I want to sell it for sterling (pounds), then I just need to find someone who wants to buy bitcoin and spend sterling to buy it. This is a typical market. The price is determined by what the “market” is happy to buy and/or sell cryptocurrency for.
This is where the demand and supply dynamics of the market come into play.
If demand for a cryptocurrency rises, it’s expected that its price will rise, assuming there’s some restriction on the supply of that cryptocurrency.
If the supply of a token increases, it’s expected that its price will fall, assuming that demand stays constant or declines.
These are simple economic principles which help to determine the value of any asset or good or service in a market.
In essence, a crypto has value because the market (which is ultimately just people) determines that it does. Due to the fact the demand for trading, buying, selling, investing in cryptocurrency is so high, and covers so much of the world, its “price” is simply based on what anyone at any given time is willing to pay for it and what someone on the other side of that trade is willing to sell it for.
What makes the price of cryptocurrency fluctuate so much?
The price of cryptocurrency is only volatile due to the nature of how and what it’s traded into. For example, the price of bitcoin almost always quoted in US dollars. The US dollar price of bitcoin fluctuates because of market forces, involving demand and supply as explained above.
In that sense, cryptocurrency is highly volatile in fiat currency terms. But it’s remarkably stable if you change the denominator (the other side of the trade).
One bitcoin, for example, does not change in value like fiat currency does. One pound today has less purchasing power in the future because of the central bank’s monetary policy which impacts inflation in an economy. The central bank expands the money supply. That boosts inflation. In time, the pound is able to purchase fewer goods and services than previously.
One bitcoin, however, due to its lack of centralised authority, does not lose value relative to any central bank policy. It is by its very nature, deflationary. That’s because of its fixed supply.
So if you’re only ever pricing cryptocurrency in fiat money, you’ve got to consider not just dynamics of the crypto market, but the dynamics of global fiat currency markets and central bank interference in global finance and currency markets.
Why do all cryptocurrency prices move together?
It’s common for cryptocurrency valuations to increase or decrease together when you are pricing them in fiat money. For example, when macro-economic conditions are favourable and risk aversion from investors is low, the sentiment can reverberate throughout the whole crypto market and lead to many cryptocurrencies increasing in price.
However, what’s always overlooked in this idea of prices “moving together” is the trading pairs in which cryptocurrencies are priced.
What you find is there are typically three major trading pairs in crypto. Usually its fiat money (most often US dollars), Ethereum (ETH) and bitcoin (BTC).
Most of the time you’ll find that any cryptocurrency is priced in terms of one those three major assets.
Therefore, a fall in the price of bitcoin in US dollar terms will often be accompanied by a fall in the value of Ethereum in US dollar terms.
If you price your cryptocurrency in bitcoin and not fiat currency, you will often find that things aren’t as they seem.
When you start to price cryptocurrency in something like bitcoin, you’ll actually find the prices don’t move all together: in fact, they’re very much independent of others.
Yet when there’s a large market sentiment shift across the board, then the cryptos will have a greater tendency to move together. It is same as with other risky asset classes, such as high-yield bonds or emerging markets..
What can affect a cryptocurrency price?
Several factors can affect cryptocurrency prices. As stated above, the supply and demand of a cryptocurrency, and ultimately what investors are willing to pay for it, are key factors. In particular, the supply of a crypto token can be manipulated through mechanisms such as lockup periods, and coin burning or staking supply rewards.
Coin burning is when a network removes tokens from circulation to increase the value of existing tokens. Staking supply rewards are an inflationary mechanism that rewards token holders for simply holding on to certain cryptos.
Prices of cryptocurrency can also be influenced by news and speculation. When credible news sources print unnerving headlines about the “falling” crypto market, fear and uncertainty can grow and cause investors to sell holdings. Even celebrities and business magnates have been known to move the crypto markets. For example, a tweet from Tesla CEO Elon Musk caused the Dogecoin cryptocurrency to increase by over 50% in February 2021.
Another factor is the strength of a crypto network and community. Innovation and development are key to the growth of a crypto network and provide the foundation for a valuable token with a strong use case. This is particularly relevant with a crypto like Ethereum, which is known for innovation and a network that provides multiple use cases for developers and innovators.
In addition, traditional market regulation can affect cryptocurrency prices. Although crypto is decentralised, authorities are looking to regulate the crypto space.
An example of this is China’s bitcoin mining ban in 2021. In this instance, the negativity surrounding crypto may cause investor sentiment to wane – however, a restriction in mining could restrict the supply of bitcoin and lead to price rises. Either way, regulations can impact the price of cryptocurrencies.
Can you prepare and predict price changes?
The market has seen several big fiat currency prices swings over the years, each one bigger and wilder than the previous ones. The volatility comes with the territory.
That makes the market risky if you’re an investor. It’s crucial to manage your risk accordingly. A good start on the way to tackle the volatility is to simply only risk money that you can afford to lose.
That way you won’t be spooked by violent swings in price. That’s how we’ve survived over a decade in the crypto markets. It could all crash to zero tomorrow (it won’t): even if it did, we wouldn’t lose any sleep over it because we haven’t “bet the house”.
Not trying to time the market, but knowing that time in the market is one of the smartest strategies in crypto, will also help you to last in this market over the long term.
Until next time…
Editor, Exponential Investor
Anaylst, Exponential Investor