An Explanation for Beginners
One of the most common questions that we get is "What gives cryptocurrencies value?". The answer is abstract and a bit complex as it involves some basic understanding of economics, of the laws of supply and demand, of behavioral finances and even of philosophy. In this text, we will try to explain the combination of factors that lead to cryptocurrencies’ economic value in a simple way, using examples that everyone can understand.
Let’s start by thinking about the money that we use every day to buy our goods and stuff. If you think about our paper bills and coins, you’d quickly realize that they are pretty much worthless per se. Bills are just pieces of paper with some numbers on them, and coins are mostly made from very common metals such as nickel, copper, and zinc. This lack of intrinsic value gets easily exposed if you travel somewhere where your bills and coins are not legal tender or are not commonly accepted as a form of payment.
What makes our money valuable then? History aside, our traditional currencies derive their value today from governmental authorities that state how they must be used as means of payment within a certain jurisdiction and large enough groups of people accepting this order. In fact, we call our money fiat, which means “by decree”. Now let’s try and understand…
One of the most basic principles in economics postulates that, all else being equal, in a competitive market, the price of a tradable good or service will increase when there is more demand or less supply of it. Conversely, its price will decrease if there is less demand or more supply of it.
Ever seen price surges in the Uber app? How about fruits being pricier when they are out of season? These are some mundane examples of the same principle, which carries itself to all free markets however complex they might be, and which include those of real estate, stocks, commodities and, you guessed it, cryptocurrencies. Supply and demand mechanics organically lead to…
Free markets result in a nice feature called “Price Discovery”, by which the price of an asset, good, or service is determined through the commercial interactions between buyers and sellers. The easiest example of this mechanism can be seen in traditional auctions, where the highest bid for a good becomes the price of it. All else being equal, the auctioneer has no incentive to sell for a lower price than he is offered and the buyer has no incentive to pay more than what he thinks the good is worth.
Modern electronic trading systems have greatly accelerated the pace and efficiency of price discovery but the principle remains. In stock and centralized cryptocurrencies exchanges, the process works so quickly it is practically happening in real-time, through the continuous bidding and offerings of many participants and which results in prices that update by the second, reacting to new information almost instantly!
In the same way that a screwdriver has value for its functionality and utility – in contrast to only the materials that form it - cryptocurrencies that serve useful purposes earn intrinsic value. When Ethereum introduced smart contracts and the possibility to build decentralized applications on top of a blockchain, that set it apart from Bitcoin and added value to the ETH tokens.
For other tokens, utility can come from voting power, from being part of a community, from a share of a protocol’s earnings and more. As an interesting note, if enough people become willing to exchange goods, services, or traditional money for a cryptocurrency, it then earns the intrinsic utility of a form of payment. However we must also consider…
Speculators are people that buy cryptocurrencies hoping only that their value will increase over time and allow them to sell for a profit. They are generally less interested in the intrinsic value of their tokens and more focused on price fluctuations.
Because, according to Behavioural Finance, emotions can spread among market participants, excessive speculation can lead to asset bubbles and market instability. Speculative emotions like greed or despair can move prices rapidly either upwards or downwards, and are amplified when the liquidity in a market is low, which can be the case for most cryptocurrencies.
The price of cryptocurrencies comes from a combination of various factors including the forces of supply and demand, the perceived value of their tokens, the intrinsic utility they might offer, the network effects they obtain and the speculation that happens around them. While they are not backed by either physical commodities or government guarantees, cryptocurrencies have some value and thus trade with a price, that comes from their unique characteristics and that fluctuates constantly. As our markets continue to evolve, understanding all these factors will be key for anyone seeking to engage as a buyer, a seller or a hodler!
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