One of the largest investors in the world, Warren Buffett, believes that bitcoins have no value because they produce nothing. The entrepreneur has long criticized the world’s largest digital coin by capitalization and called it a “mirage” rather than a means of payment. But judging by the way bitcoin and other digital coins are growing, the value of cryptocurrency cannot be denied. The market of financial instruments has been replenished with another type of asset.
Initial reasons for the emergence of cryptocurrency
Bitcoin was created in 2009 as an alternative to fiat money. But despite the development of digital assets, society is still calculated using national currencies. National monetary units have value only because they are issued by a central bank and used in the economy.
Bitcoin was developed to conduct transactions without a third party. There is no central bank or any other financial organization involved in the transfers. The cryptocurrency system allows for settlements thanks to encryption algorithms. It is enough to certify a transaction protected by a digital signature for the payment to be executed.
Cryptoassets offer cheaper and faster peer-to-peer (no intermediaries) settlement options. Unlike the traditional monetary system, there is no need to provide personal data when transacting with virtual assets. This is how anonymity appears – another feature of decentralized payments.
Cryptoassets are gradually gaining recognition as financial instruments. But due to high volatility, consumers are still unable to pay for goods and services with them. Digital finance is decentralized and rarely used for payments.
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How cryptocurrency and blockchain work
Coins and tokens are referred to as “decentralized money.” They are created, stored and processed outside of a bank or government.
Blockchain is a decentralized data registry that can be compared to a regular notebook. Each block is a new sheet that contains transaction information. When a user transfers coins, another entry occurs. New “pages” appear on average every 10 minutes.
As of June 2022, the size of the Bitcoin blockchain is over 390 gigabytes.
Unlike traditional fiat money, such assets have no physical form. They are just data protected by cryptography. When information is encrypted, it is converted from one form to another – a less distinguishable form. The end user can then revert the data back to its original form.
Cryptocurrencies work like a secure cloud file system. Due to decentralization, units of account on the blockchain do not need to interact with third-party servers and institutions that often engage in bulk data collection and allow controlled access to user funds. The lack of connection to the government (banking) system makes it possible to process transactions anonymously.
Cryptoassets lack one of the main properties of fiat money – there is no single government agency that is responsible for maintaining the supply of coins and tokens.
Blockchain is the registry that stores information about digital asset transactions in a decentralized way (without intermediaries). Many different computers (nodes) hold identical copies of this log of cryptocurrency transactions and verify them by performing complex calculations. They record the information in blocks with limited memory size, and all these stores of information form a chain (blockchain).
If the user understands the basic benefits of blockchain, he will realize the value of cryptocurrency.
Transactions
Cryptocurrencies keep an open record thanks to a public register of transactions. When payments are transferred, the corresponding records of the transaction remain in the data chain. It is not possible to change or delete a transaction made on the network. This independent ledger of transactions is much more secure than paper records or a centralized database that can be hacked and overwritten.
The distributed ledger platform encrypts information about the buyer and seller of cryptoassets and records it in the form of a hash (a string of letters and numbers). The latter is generated by performing a complex mathematical function. Each hash is directly linked to the identifier before it. Thus, unauthorized changes in the block will become immediately obvious if new transaction details are added to the register.
As a structure reaches a certain number of hashes, it is converted into a block and linked to other elements of the chain. The Bitcoin blockchain is updated every 10 minutes and is stored on multiple servers hosted by thousands and millions of users in different countries.
Issuance of new coins
Some cryptocurrencies operate in a closed system (BTC, ADA, XRP and others). This means that the number of such assets is limited and new units are created according to a strict set of rules. Since digital currencies are issued according to pre-selected algorithms, the timeframe required to fully issue these units can be predicted. For example, the limit of bitcoins is 21 million coins. Most (~90%) of the possible supply in 2023 has already been mined and is in circulation. The last BTC is expected to hit the market in 2140. This limited number of coins creates the value of cryptocurrency.
In June 2022, Ethereum had a circulation of ~121 million ETH coins. The unlimited supply of the asset suggests its inflationary nature. But this factor is regulated by burning a certain number of coins to reduce its supply and increase the value of the digital currency.
Regulation of the amount of cryptocurrency in circulation
The economics of digital assets is called tokenomics. Essentially, it is the analysis of factors (cryptocurrency quality, distribution and production) that affect the supply and demand of coins and tokens. It is important for investors to evaluate these phenomena. Thanks to this:
- An insight into the trends of the crypto market is formed.
- Opportunities for forecasting changes in asset value and cryptocurrency value are opened up.
- An understanding of why certain digital units dominate the market emerges.
Network participants work for the benefit of the blockchain and are rewarded for doing so.
| User Type | What they do. |
|---|---|
| Blockchain miners and validators | Validate transactions and create new blocks |
| Liquidity providers | Enable trading activity |
| Holders of digital control units | Make decisions related to making changes to blockchain operations |
| Developers | Use specific protocols to control the rate at which new units are created and, consequently, the total number of virtual currencies on the blockchain |
All users are rewarded for their work in the form of cryptoassets of the respective system.
The restrictions imposed by developers help to maintain the value of digital units by making users feel scarce. The value of virtual currency depends largely on the tokenomics of the project.
Investors should keep in mind the factors that are important in determining the value of cryptoassets:
- How the coin or token is used and what connection exists between the services being created and the digital asset.
- How many cryptocurrency units have already been issued, their limit and when they will be created.
- Who are the owners of the digital assets, how much supply is provided to the developers.
What is the value of cryptocurrency
Many digital assets have a limited supply. This gives birth to higher demand and increases their value. The limited issuance of virtual currencies distinguishes the digital asset market from the global financial system, where central banks can print an infinite amount of money. Although coins (tokens) are volatile, the development of promising projects can make investors’ investments more valuable.
Credibility
Like fiat currency, bitcoin and most altcoins have no intrinsic value. The value of any monetary unit depends on government support and people’s trust in the government. Cryptocurrencies have no intermediary, which begs the question, “What is the value of cryptocurrency?” Coins (tokens) can be recognized as a medium of exchange because of public acceptance. Full belief in the integrity and reliability of the blockchain determines the value of a virtual currency. Millions of miners, investors and traders use the Bitcoin network only because they trust the world’s largest cryptocurrency and determine its price based on the sole principle of supply and demand.
Capitalization
This is an indicator of the total value of a coin in the market. The market capitalization index is determined by multiplying the total amount of a particular cryptoasset in circulation by the price of the digital unit.
If Coin 1 has 200,000 units circulating on the market, each worth $3, the market capitalization of the virtual currency will be 200,000 * $3 = $600,000.
Similarly, if Coin 2 has 100,000 in circulation, each worth $4, the market capitalization will be 100,000 * $4 = $400,000.
The price of Coin 2 is higher, but the total value of Coin 1 is much higher. Thus, the market capitalization index of a digital currency is the best way to indicate its true price.
The total value of a coin (token) is considered an important indicator that reflects popularity. It is commonly thought that cryptocurrencies with higher capitalization are safer in terms of investment. Such coins (tokens) are not as volatile compared to units with a lower value, but still change their rate more often than traditional assets (e.g. stocks).
Information field
Social media and media outlets also affect the value of cryptocurrency. News about hacking of crypto exchanges has repeatedly led to a significant drop in the value of coins and tokens.
In February 2014, hackers attacked the major trading platform Mt.Gox. After the news, the price of the main coin fell c ~$900 to ~$600. Perhaps the decline would have been less severe had the public not been aware of these events.
Researchers studied the causes of bitcoin volatility and found that news and the media matter when predicting the price of digital assets. Negative events tend to cause larger movements in coin and token prices than positive events.
Other cryptocurrencies
There are over 10,000 alternative coins and tokens available on the market with different features and specifications and new ones are constantly emerging. As one crypto asset gains popularity, money flows into it from other projects. This affects the value of all digital currencies. The launch of new projects can lower the price of other virtual assets.
Bitcoin dominance determines how much of the total market capitalization BTC occupies. For example, the total value of all cryptocurrencies in June 2022 was about $1 trillion. The market capitalization of BTC was within $386 billion of this amount, Bitcoin dominance reaches 38%. This indicator helps to determine the altcoins position in a downtrend or uptrend against Bitcoin.
Utility
Also affecting the value of crypto coins is how many people use them and for what purpose. If they are actively being spent on goods and services rather than just held, the value goes up.
Whales
Researchers have found that large transactions play a role in cryptocurrency price movements. When accounts that hold a lot of virtual assets start selling off their holdings, it causes the exchange rate to drop. The owners of such accounts are called “whales.” They hold large amounts of virtual currencies and can manipulate the market.
Why cryptocurrency has increased volatility
Digital assets are still at an early stage of development compared to other forms of investment instruments. The result of this newness is high volatility. Investors are putting their money into different instruments, trying to find high-yielding assets. Hence, supply and demand arise.
Volatility often has a negative connotation because many people associate it with losses. When markets fluctuate wildly, investors anticipate extreme price changes, causing even greater rate spikes (declines).
Thefear and greed index determines emotional behavior in the cryptocurrency market. Activity increases when prices rise. Investors often sell their coins (tokens) at a loss due to fear of a falling market. There are 2 index values:
- Extreme fear (0 to 50) can be a sign that investors are too worried. This period is a good opportunity to buy crypto assets.
- When investors get too greedy (50 to 100), a correction is likely to await the market.
Keep in mind that cryptoasset volatility is the price investors pay for the limited supply of coins and tokens, as well as the absence of a central bank. These features, according to enthusiasts, give digital units value.
Real-world backed cryptocurrency
Stablecoins are tokens whose price is pegged to other financial instruments (often the US dollar). It is a digital interpretation of the underlying asset. For example, an organization that issues stablecoins creates a cash reserve at a financial institution. If the reserve is $100 million, the company can issue 100 million tokens with a fixed value of $1 per unit. When the steblecoin owner wants to cash out their holdings, the real money will be taken from the reserve.
This structure is different from most digital currencies, such as bitcoin and etherium, which are backed by nothing at all. Unlike stablecoins, the prices of other cryptocurrencies fluctuate wildly. This is due to speculation in the market.
Digital cryptocurrency tokens
Some projects apply a special economy system to avoid speculation. The dual token model allows one digital unit to be used to fund the ecosystem and the other to maintain the blockchain (e.g. MKR and DAI). It was created during the ICO (initial coin offering) boom in 2017. The dual token model increased trust and interest in the project from more cautious investors.
Frequently Asked Questions
❓ Who created the cryptocurrency?
The creator of the first Bitcoin coin was a person or group of people under the pseudonym Satoshi Nakamoto.
💲 Which crypto asset is the most volatile?
Speculative coins (tokens).
💻 How to check volatility?
You need to look at historical price charts to see the peaks and lows.
💵 Can cryptocurrency be sold without technology?
Shitcoins are released into the market and are subject to strong price changes due to speculation.
❗ Who owns bitcoin?
No one owns the technology of Bitcoin.
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Author: Saifedean Ammous, an expert in cryptocurrency economics.
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