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Lesson 3
6 min

What determines the price of cryptocurrencies?

A look into what determines the price of cryptocurrencies.

Key Points:

  • Unlike a government issued currency, cryptocurrencies are not defined by a single entity such as a central bank.
  • The value of cryptocurrencies comes down to how effective the cryptocurrency is as a medium of exchange.
  • In terms of supply, bitcoin has a fixed supply for 21 million tokens, whereas ether isn’t capped.
  • The perceived ‘health’ of a cryptocurrency’s protocol can also have an influence on price.
  • Market sentiment and macro economic factors also play a role in influencing price.

What determines the price of cryptocurrency?

Cryptocurrency prices are influenced by an array of different factors, making it a key topic to understand when starting your crypto trading journey as it can help shape your trading strategy. For example, knowing which cryptocurrencies you wish to purchase, and when to do so is largely influenced by price. Therefore, understanding the underlying factors that influence cryptocurrency prices is a good starting point.

Why does fiat currency and bitcoin have value?

Unlike government-issued currencies, also known as fiat currency, cryptocurrencies are not defined by a single entity such as a central bank. To understand how cryptocurrency has value, reflected in its price, it’s important to have context as to how fiat currencies, such as USD, GBP and EUR, have value.

In lesson 1, what is cryptocurrency, we covered that the attributed value of fiat money comes solely from the government that declares it as legal tender. For example, the UK Government declared the British Pound as their legal tender, and the US Government declared US Dollar as theirs. Beyond this declaration, fiat currencies have no intrinsic value.

By contrast, the value of cryptocurrencies is based on how effective they are as a medium of exchange. Considering that a ‘medium of exchange’ can be defined as an item that is widely accepted in exchange for goods and services, and that currency is the most common medium of exchange today, this naturally leads well into one of the key influencing factors; supply and demand. 

The impact of supply and demand.

If we take it back to basic economics, we can apply the law of supply and demand. What this means is, in a free market, defined as an economic system where the price of goods and services is determined by unrestricted competition between privately owned entities, price is influenced by how much consumers want these goods and services. In a scenario where the demand exceeds the supply, the price is likely to increase. Similarly, where demand is greater than supply, the price is likely to decrease.

Considering that cryptocurrencies are tradable digital assets, similar to commodities, their prices are influenced by both an interest in buying them (demand), and the total supply. More specifically, in crypto terms, supply is commonly related to the supply mechanism of a token, referred to as tokenomics. For example, bitcoin has a fixed supply for 21 million tokens, whereas Ether isn’t capped. 

For tokens with no supply cap, it’s important to consider the role that upcoming supply plays. For example, additional supply could be viewed by some as unfavorable towards price as the market could anticipate selling pressure if large holders, such as the founders or early investors, choose to sell. Which is why, comparably, some market participants view fixed supply tokens like bitcoin as having less selling pressure.

Similarly, events such as halvings or token burns, which impact supply, can also influence the cryptocurrency price. If we take the example of the Bitcoin halving cycle, this process is part of the Bitcoin Protocol and serves as a mechanism to control the supply of new bitcoin. If we understand that new bitcoin is released through mining, which is the process of validating Bitcoin transactions and securing the historical records on the blockchain, we know that this is how new bitcoin is released. The halving cycle simply ‘halves’ the reward paid out to miners, and this occurs once every 210,000 blocks mined by the network, which occurs roughly every 4 years. 

At time of writing, the current reward per block mined is 3.125, having dropped from 6.25 BTC in April 2024. The next halving cycle the reward will drop to 1.56 BTC.

Influence of crypto protocols

A protocol is defined as the underlying set of rules that allows data to be shared between computers. Specifically for cryptocurrency, it refers to the rules that establish a distributed database, otherwise known as a blockchain. In the example of the Bitcoin Protocol, it details how digital money can be safely exchanged on the internet using blockchain technology.

The perceived 'health' of a cryptocurrency's protocol can also influence its price. To put this in context, consider the purchase of stock: fundamental factors such as profit margins, debt, and sales revenue may influence the decision to purchase, and thus place value on, the stock.

For cryptocurrency, the protocol provides similar indicators that investors may consider, such as the growth in network addresses, developer activity, and the potential for real-world use cases of the protocol.

Market Sentiment and Macro Economic Factors

Sentiment:

Sentiment refers to the thoughts, opinions, and ideas that people have about a topic. The way people think and feel about cryptocurrency can influence its price and perceived value. 

For example, some people may make emotionally charged purchasing decisions based on social media content. Recall July 2021, when Kim Kardashian tweeted about the Ethereum Max token to her 328 million followers, significantly influencing them to purchase the token based more on their admiration for Kardashian than on the substantive factors discussed earlier in this article. 

This kind of social media hype can also lead to a 'fear of missing out,' or 'FOMO,' which can trigger impulsive and unfounded purchasing decisions. Following Kardashian's post, the Securities and Exchange Commission (SEC) imposed a penalty of $1.26 million on her for promoting the token without disclosing a payment of $250,000 she received for the promotion.

Macros:

Macro economic factors are those that impact broader aspects of the economy. For instance, during inflation or a recession, people alter their purchasing behaviors, which can influence the prices of commodities, including cryptocurrencies.

If an economy is in a recession, consumers are likely to spend and invest less. Since crypto does not exist in a vacuum and is affected by macro factors, decreased buying or increased selling of cryptocurrencies to cover rising costs could lead to a drop in prices. Conversely, during periods of inflation, the dynamics might reverse.

Lesson 3: A roundup

  • The value of cryptocurrencies comes down to how effective the cryptocurrency is as a medium of exchange
  • If we consider that cryptocurrencies are tradable digital assets, similar to commodities, the price of which is therefore influenced by both an interest in buying them (demand), and the total supply.
  • The perceived ‘health’ of a cryptocurrency’s protocol can also have an influence on price.
  • The way in which people think and feel about crypto can influence price and perceived value.
  • Given that crypto doesn’t exist in a vacuum, the price is not immune to the impact of macro economic factors.
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