The cryptocurrency market can be volatile -- sometimes reaching record highs and other times dropping significantly. Understanding how cryptocurrency is valued can help explain these changes.
Cryptocurrency is not the same as the U.S. dollar or the Euro because there is no central authority -- such as a government body -- to manage its value. Without a centralized organizing body, there are no concrete reasons for cryptocurrency to change in value.
The main theory behind cryptocurrency value is if enough people agree it is valuable, then it becomes more valuable. Without regulation, demand can cause fluctuations -- and in some cases, the changes can be extreme -- depending on additional factors such as availability, utility and competition.
What is cryptocurrency?
Cryptocurrency is a digital and encrypted asset that is used for exchange. It can be used similarly to fiat currencies to exchange for goods, services and investments. Fiat currencies are government-issued -- such as the current money system people use every day.
Cryptocurrency is different from digital currency. Digital currency can be turned into cash by going to an ATM or bank because it is backed by a financial institution. With cryptocurrency, transactions are recorded on the blockchain and are not verified by a financial institution like digital currency. The blockchain is a financial ledger or database that stores electronic information digitally to show ownership.
Users can exchange cryptocurrency directly with others.
History of cryptocurrency
The idea of cryptocurrency originated in the 1980s. The idea was to send currency that could not be traced and didn't require centralization. David Chaum -- an American cryptographer -- created anonymous money called DigiCash. It was the first form of electronic payment requiring software and encrypted keys to send and withdraw money.
Next, came Bit Gold, which is often considered the precursor to Bitcoin. Nick Szabo designed it in 1998, and it required solving a puzzle to get the reward. When these two concepts are put together, they are similar to Bitcoin.
In 1998, Satoshi Nakamoto published Bitcoin – A Peer-to-Peer Electronic Cash System, a white paper that described the blockchain network and its technology. He described Bitcoin as "an electronic payment system based on cryptographic proof instead of trust." He also said in this paper that cryptocurrency would not be possible without blockchain technology.
Satoshi Nakamoto mined the first bitcoin in 2009. The first block of 50 bitcoin -- known as the Genesis Block -- had no real value for the first few months. Then in April 2021, the value of one bitcoin reached 14 cents. The value then surged to 36 cents in November 2021.
Bitcoin began to steadily rise. With publicity in publications such as Forbes, prices started to increase. Other forms of cryptocurrency then started to be created, using blockchain technology. Now there are several different types of cryptocurrency with new ones emerging regularly.
Other well-known cryptocurrencies include the following:
- Shiba Inu
- Binance Coin
- USD Coin
Learn more about the history of blockchain technology here.
Cost of production
Mining is the process of creating new cryptocurrency tokens. This process involves using software to verify the block on the blockchain to decentralize and form the token. To verify the blockchain, participants need to use computing power and solve transaction-related algorithms. However, there is a competition to mine certain cryptocurrencies largely due to the miners racing each other to verify the next block, which can make it more difficult to mine.
The cost to mine increases when more powerful equipment is needed, which can be costly. Higher mining costs push up the value of the cryptocurrency to offset the costs of production. Because the costs are high, attackers use cryptojacking with unauthorized use of other systems to mine cryptocurrency for the power demands. Cryptojacking can also be completed by a cryptomining bot installed on a target system.
The more popular cryptocurrencies, such as Ether and Bitcoin, are available to trade on multiple exchanges. The smaller tokens may only be on certain exchanges, which limits access.
If a cryptocurrency is listed on more exchanges, they will be available to more investors, which can increase the demand.
To purchase cryptocurrency, users need to create an account on a cryptocurrency broker, such as Coinbase, eToro or Gemini. Opening an account on these exchanges is similar to opening any other investment account.
If a user wants to exchange one cryptocurrency for another, this is possible using cross-chain bridges. It's similar to the exchange between different country currencies. There are several cross-chain bridges to help explore various blockchain ecosystems.
Learn more about the best cross-chain bridges available here.
After purchasing cryptocurrency, the next step is storage. Since they are not backed, they are at risk for theft. There are three methods to store cryptocurrency.
- Leave cryptocurrency in exchange. After buying the cryptocurrency, the exchanges have a cryptocurrency wallet to store purchases. This method is the most at-risk for theft because the exchange markets are a prime target for thieves. For example, in February 2022, thieves stole more than $320 million on the Wormhole cryptocurrency platform.
- Hot wallets. These cryptocurrency wallets are stored online outside of the exchange. They run on all internet devices and run a risk of theft since they are stored online. In addition, there are apps for smartphones to store cryptocurrency, and these are also considered hot wallets.
- Cold wallets. Unlike hot wallets, cold wallets are stored offline on an external device. All the information is stored within this device making it the safest option. But don't lose the keycode, or it may be difficult to get the cryptocurrency back.
Learn more about securing a bitcoin wallet here.
How does cryptocurrency gain value?
In the stock market, a company's worth is determined by multiplying the stock price by the number of shares to show market capitalization. The price of the stock can go up or down depending on supply and demand. Higher demand stock have higher prices, such as Apple and Amazon.
The same theory applies to cryptocurrency. Higher demand pushes prices up. If demand goes higher than the amount available, the price of that cryptocurrency increases.
Some cryptocurrencies have a maximum supply and only increase by a fixed amount, such as bitcoin. Other cryptocurrencies – such as Ether – do not have supply limitations.
Demand for cryptocurrency depends on many factors, including how useful the coins are and if businesses accept them. There are other factors that also determine the value of cryptocurrency, including the following:
- Mining. When trying to create the new block, miners compete for that encrypted number, and the first miner wins the newly minted cryptocurrency. Mining can be expensive, especially with the amount of electricity needed to complete it.
- Increasing utility. Utility increases when businesses accept cryptocurrency and if there is an investment opportunity. Being able to use it in decentralized finance protocols or decentralized apps can also affect value. Think about an Amazon gift card versus a small store gift card -- there are more options for the Amazon gift card, giving it more utility.
- Competition. If there are several to choose from, they may lose value.
- Popularity in media. The prices tend to fluctuate when media covers a cryptocurrency, and this also includes promotions on social media.
- Regulation. The lack of regulation can be a positive or negative factor when it comes to valuation. Some investors appreciate the freedom of no regulations while others fear the lack of regulation and security.
- Availability. If the cryptocurrency is more readily available on numerous exchanges, it may be more valuable.
Regulations and governance
Developers adapt projects based on current and future use. However, governance tokens require stakeholders to give consensus for any changes.
Investors like stable governance, and this can be considered a flaw with cryptocurrency. There is volatility in its value and it can make severe swings. For example, bitcoin's value fell below $20,000 in June 2022 after hitting a high of $68,789.63 in 2021.
There is some uncertainty in terms of the regulation of cryptocurrencies. There is confusion on whether cryptocurrency is a commodity, such as gold or silver, or a security, such as stocks or bonds. Because of this indecision, neither the Securities and Exchange Commission nor the Commodity Futures Trading Commission can regulate cryptocurrency.
Regulations could have a positive impact because investors would feel more secure about purchasing cryptocurrency as an investment. However, regulations could also negatively affect the value of cryptocurrency by lowering the demand and changing rules for investments.
Learn more about a Senate bill to regulate cryptocurrency.