July 22, 2017    5 minute read

What Drives the Valuation of Cryptocurrencies?

The Right Price    July 22, 2017    5 minute read

What Drives the Valuation of Cryptocurrencies?

Cryptocurrencies have recently attracted increasing attention from investors and businesses as they promise to provide innovative, secure and cost-effective solutions that improve the current money transfer system and enhance the efficiency of transactions.

Cryptocurrencies have also proved to be a volatile market with unpredictable price fluctuations. The rapid introduction of new coins constantly disrupts the current market equilibrium.

Cryptocurrencies are broadly described as a cross between a commodity and a currency as they store value and have a finite supply. However, they are also liquid and can be used to pay for transactions.

Fundamentally, their price – just like that of any other asset – is determined by demand and supply. Most, if not all, cryptocurrencies have a finite supply that is either already in circulation or will slowly start decreasing until it reaches a known limit. Due to this, the price of cryptocurrencies is driven primarily by factors that affect demand.

Trust

The value and demand for any currency, especially fiat currencies, is derived from the trust of its users in its ability to preserve its purchasing power. When a currency loses trust, its value drops perniciously, as was the case with Argentina’s peso during its hyperinflation days. Cryptocurrencies are no exception. Bitcoin gained traction because users believe in the complete anonymity and security of its blockchain ledger.

Since it could not be hacked or tampered with, it would always preserve its value. Similarly, Litecoin’s value rapidly increased when users understood that it had features that surpassed Bitcoin in certain aspects, such as transaction speed, and believed it was the ‘silver to Bitcoin’s gold’.

Government trust, in terms of regulations, also plays a vital role in the success of cryptocurrencies and affects their valuation. The original scepticism with Bitcoin was principally due to the belief that governments would never legalise it due to fears it would facilitate money laundering and black market trade.

This was exacerbated by the fact that Bitcoin initially gained popularity as the method of payment on Silk Road, the first modern darknet black market which was infamous as a platform for selling illegal drugs.

However, governments have looked at cryptocurrencies more favourably than originally assumed and have understood the potential that blockchain technology has in improving efficiency. The impact of government trust on valuations is clearly outlined by the price spikes that occur when governments legalise it.

Bitcoin’s total valuation soared to more than $1bn in mid-April this year when Japan and Russia moved to legitimise it. During mid-June, Ethereum’s price spiked to above $400 per unit when some Asian governments legitimised it in part as a form of payment.

Valuation of Prospective Market

Value investors who invest in cryptocurrencies estimate their value based on the market capitalisation of the process or asset it seeks to replace along with an estimation of how much market share the cryptocurrency will control. For example, Bitcoin enthusiasts who believe that bitcoin is a form of digital gold, as Satoshi Nakamoto intended, will take reference from the market cap of the gold market – $7trn.

If Bitcoin were to control even 1% of gold’s market cap, its valuation should be $70bn compared to the current $36.5bn, implying that it is undervalued. Other common examples are estimating Bitcoin’s value based on the remittance market and Ethereum’s value based on the IPO market which it seeks to replace with Initial Coin Offerings (ICOs).

However, this method of valuing currencies is risky as it depends on several factors impossible to predict, such as the possible emergence of more efficient cryptocurrencies. An investor’s personal beliefs are also reflected in their choice of the prospective market that the cryptocurrency would replace.

Speculation

As with any other asset, speculation is a strong driving force in determining the value of cryptocurrencies. Speculation is affected by the perception and new updates and developments.

For example, improvements in liquidity through the establishment of new exchanges lead to a price increase as speculators believe that more people will start using the currency. Similarly, the introduction of a new coin that performs the same function as an existing one but has increased transaction speed and a lower cost would send the existing coin’s valuation spiralling downwards.

The cryptocurrency market is currently experiencing the highest short-term price swings – some prices have spiked by 1000% in less than a week – and this attracts traders and other investors who wish to profit from these movements. Furthermore, these wild swings are not just confined to the newer coins but are prevalent even in the established ones.

Many traders do not understand the technical aspect of this market and simply wish to gain from the “greater fool theory” wherein the asset’s fundamentals carry no importance if it can be sold to someone at a higher price. These trend followers exacerbate the price movements by encouraging feedback loops and herd mentality.

Furthermore, the low volatility and overvalued metrics in traditional markets have accentuated the attention of investors towards cryptocurrencies as it remains one of the few areas which can rapidly deliver huge returns.

Investor Perspective

Cryptocurrencies are driven by the demand-side factors that have been explained in this article and the trajectory that investors expect the market to take. Many investors and economists believe cryptocurrencies are currently in a bubble as ICOs are attracting a lot of capital. The market has an uncanny resemblance to the dotcom boom, and everyone is bragging about how easy it is to make money.

Others believe that the boom has just started and the valuations of cryptocurrencies will increase tremendously over the next decade as they replace traditional forms of money transfers and contracts.

The rest, including the author, believe that, in the same way as the dotcom boom left behind Google, Facebook and a plethora of revolutionary technological companies, the cryptocurrency craze will eventually lead to a bust that will yield a few cryptocurrencies which will shape the future of transactions.

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