What drives the value of crypto?

Thanks to Elon Musk and his 57.1 mil­lion Twit­ter fol­low­ers, the noise around cryp­tocur­ren­cy is loud­er than it’s ever been before. While the Tes­la and SpaceX CEO is far from sole­ly respon­si­ble for the alter­na­tive dig­i­tal asset’s rise to fame, his tweets have played a huge part in cat­a­pult­ing its val­ue to new heights.

How­ev­er, cryp­tocur­ren­cies are intrin­si­cal­ly volatile. Since 2011, a year after bit­coin gained mon­e­tary val­ue, the cryp­to poster child has fall­en vic­tim to its own inflat­ed prices. That year, it went from highs of $32 (about £23) to lows of $2. The scale is dif­fer­ent in 2021, but the volatil­i­ty remains, with the cryp­tocur­ren­cy reach­ing highs of $64,000 and lows of near $30,000. 

Despite bit­coin’s fluc­tu­at­ing price, it con­tin­ues to cor­rect itself at high­er val­ues. In June 2020, the price of bit­coin sat at around $9,000. A year lat­er, its val­ue is fluc­tu­at­ing around $35,000. That’s an increase of near­ly 290%, a notable gain for longer-term investors.

Determining the value of crypto

While it’s easy to con­flate cryp­to with bit­coin, there are actu­al­ly around 4,000 such cur­ren­cies in cir­cu­la­tion around the world, more than the num­ber of fiat (gov­ern­ment-issued) cur­ren­cies in exis­tence. The num­ber of cryp­tos is like­ly to keep grow­ing, large­ly because it’s so easy to devel­op a new coin, which in basic terms is sim­ply com­put­er code gen­er­at­ed by open-source soft­ware designed to trans­act val­ue online. 

The way a coin is devel­oped, and for what pur­pose, has a mas­sive bear­ing on its val­ue. While there are thou­sands in exis­tence, the top 20 coins are believed to con­sti­tute around 99% of the mar­ket by vol­ume, accord­ing to cryp­to web­site Coin­Desk.

Much like fiat cur­ren­cies, the price of cryp­tocur­ren­cies is heav­i­ly swayed by sup­ply and demand. But it’s also deter­mined by the cost of pro­duc­tion. “Look at the use case of a coin,” says Edward Coop­er, Rev­o­lut’s head of cryp­to. He empha­sis­es util­i­ty as the most impor­tant com­po­nent in a cryp­tocur­ren­cy’s val­ue. “How much tech­ni­cal engi­neer­ing is going on to update the pro­to­col? What is the cal­i­bre of the found­ing team?” 

For bit­coin, that util­i­ty is solv­ing the prob­lem of wealth stor­age, while ethereum, the world’s sec­ond-largest cryp­tocur­ren­cy, can be used as the foun­da­tion for apps. This com­pares to doge­coin, which was cre­at­ed in just two hours as a joke and enjoyed a near­ly 20% val­ue boost when Musk tweet­ed: “One word: Doge.” 

Doge doesn’t pass some of the util­i­ty tests, says Coop­er. “The val­ue here comes from spec­u­la­tion.”

Retail investors should remem­ber that bit­coin is a lim­it­ed sup­ply asset, with a 21 mil­lion cap writ­ten into its source code. This is why it acts as an effec­tive store of val­ue. Not all cryp­tocur­ren­cies have a cap. Ethereum does­n’t – and nei­ther does doge­coin. 

How­ev­er, a cap is not the only way to hedge against infla­tion. Ethere­rum, for exam­ple, has a set num­ber of mon­e­tary poli­cies, includ­ing a fixed sup­ply and issuance sched­ule, to keep its val­ue con­stant. As long as demand out­weighs sup­ply, its price will keep going up. Teth­er, one of the best-known sta­ble­coins, is pegged to the US dol­lar to anchor its val­ue.

External drivers of crypto’s value

Exter­nal fac­tors also influ­ence the val­ue of a cryp­tocur­ren­cy, includ­ing the words or tweets of high-pro­file fig­ures like Musk. In June 2021, the bil­lion­aire drove up the val­ue of cum­rock­et, an alter­na­tive coin for adult cre­ators, by near­ly 400%. But he also sparked a price dip of more than 7% in bit­coin after he sug­gest­ed he was “break­ing up” with the cryp­tocur­ren­cy.

Diana Big­gs, a for­mer HSBC exec­u­tive who now leads cryp­tocur­ren­cy start­up Val­our, notes that “cryp­tocur­ren­cies are still in their infan­cy” and mar­ket caps tend to be rel­a­tive­ly small. This con­tributes to their volatil­i­ty and makes them sus­cep­ti­ble to the influ­ence of indi­vid­u­als. Still, “the more big com­pa­nies invest, the more indi­vid­u­als will find it hard to move the mar­ket”, Coop­er notes. 

That invest­ment is already hap­pen­ing. Ten years ago, bit­coin was deemed a ten­der of the “dark web”. Now Pay­Pal’s mil­lions of Amer­i­can wal­let hold­ers can spend bit­coin like they would the dol­lar. And the first major US bank, Mor­gan Stan­ley, has begun offer­ing glob­al clients access to bit­coin funds. Buy-in from the estab­lish­ment is grow­ing, and fast.

Big­gs also cites greater gov­ern­ment clar­i­ty around cryp­to usage as a major dri­ver in cryp­tocur­ren­cy’s route to adult­hood and thus a more pre­dictable val­ue. This month, El Sal­vador’s deci­sion to become the first coun­try to adopt bit­coin as legal ten­der sent the coin’s val­ue up 6%.

That works both ways, how­ev­er. The nation­al ban on cryp­tocur­ren­cy ser­vices by Chi­nese reg­u­la­tors in May sent bit­coin plum­met­ing by close to 20%. “To say Musk is the dri­ver [behind a recent fall in bitcoin’s val­ue] prob­a­bly gives him too much cred­it,” says Yang Li, chief growth offi­cer at cryp­to account provider Ziglu. “He def­i­nite­ly plays a part, but at the same time you’ve got the crack­down on bit­coin min­ing in Chi­na, or in the US they’re look­ing at new tax­a­tion for cryp­to prof­its.”

Li is right. Many of Musk’s asser­tions have been com­pound­ed by reg­u­la­to­ry deci­sions. The Chi­nese ban, for exam­ple, fur­thered a week­long decline in bit­coin’s val­ue after Tes­la said it would no longer accept bit­coin trans­ac­tions for its elec­tric cars. Musk may seem like a cryp­to mar­ket mover, but he’s far from alone.