What are cryptocurrencies and which factors decide crypto price changes, in simple terms
The answer is simple yet complicated
Crypto was born out of an idea, a vision, of creating a world and financial systems where everyone's equal, and no centralized entities like central banks or governments manipulate markets to their benefit…and to the detriment of the rest of us.
So let's be clear. It's far from that today.
Although cryptocurrencies don't behave the same way as normal, standard currencies like the euro or the dollar behave, they aren't really purely defined like Satoshi Nakamoto once conceived Bitcoin.
In fact, they behave completely differently, because fiat currencies are manipulated, while cryptocurrencies, in theory, aren't.
And may I insist, in theory.
When Bitcoin was conceived back in 2009, it was described as a digital currency whose value would be entirely defined by the law once detailed by Alfred Marshall in 1890, the law of supply and demand.
If cryptocurrencies behaved according to theory, then we would have reached the end of the article. But we certainly aren't.
More often than not, although in concept they actually do define their value by the laws of supply and demand, the reality is undoubtedly nuanced; many actors, market movements, and other intricacies determine how the value of a cryptocurrency decreases, or increases.
Consequently, how can we define how the value of a cryptocurrency fluctuates over time?
By the end of this short article, you will have at your disposal everything you need to know to understand why Crypto prices vary so much.
Cryptocurrencies are a unique concept in the financial world
Beforehand, it's necessary to understand what actually is a cryptocurrency, because everybody knows the concept or heard of it, but few really understand it.
Crypto explained in four short paragraphs
Cryptocurrencies are the native digital coins of blockchains.
Crypto blockchains are nothing more than a public - all transactions are visible - distributed database. As there is no central authority, people around the world willingly participate in it to ensure its operations by validating transactions.
However, people that participate in validating, demand an incentive to do so, as nobody is willingly giving their time and resources for free. Hence, blockchains have native cryptocurrencies that are paid as rewards for participating.
That is the goal of a cryptocurrency, incentivizing more people or entities, known as nodes, to participate. For a more detailed explanation of what a cryptocurrency is, check this article on what is a cryptocurrency.
In simple terms, the more nodes participate, the more decentralized the blockchain is. The more decentralized, the more secure and harder it is to hack. Adding to this, for an extremely detailed explanation of how blockchain security is, and why this technology is so superior for ensuring data integrity, security and availability, go read this other article.
Now we understand why cryptocurrencies exist, we need to understand how we define their value. Or, in simple terms, how are supply and demand applied to them.
Supply and market capitalization
Each cryptocurrency has a circulating supply. That is, similar to how public companies have a specific amount of outstanding shares, the majority of cryptocurrencies have a similar limit.
There are exceptions, like Ethereum, which have an infinite supply, but those aspire to become deflationary to encourage value, but more information on that in a bit.
Therefore, when people say "X cryptocurrency has a total value of Y million/billion/trillion dollars" they are essentially multiplying the total circulating supply of that cryptocurrency and multiplying it by the unitary price.
How this circulating supply is defined and distributed is what we define as tokenomics. This is a fundamental concept. No matter how useful your cryptocurrency is for its ecosystem, if tokenomics are bad, your coin isn't going to appraise the way you would expect.
Understanding the tokenomics behind a cryptocurrency is key when evaluating the attractiveness of such an investment.
But ultimately, how do we define the actual value of a cryptocurrency?
Easy, the value is determined by trade pairs and exchanges.
Similarly to fiat currencies, cryptocurrencies, except stablecoins, aren't pegged to any underlying asset.
In the case of fiat currencies, their value is determined by society's trust in them, and the support of central banks and governments as legal tender.
Thus, to measure their value, fiat currencies have a relative value between one another, what is known as exchange rates. For instance, as of October 2022, each dollar is worth around 1,03 euros. Or in other words, the dollar is slightly more valuable than the euro. That, of course, could suddenly change.
Cryptocurrencies follow a similar value appraisal system. The value of cryptocurrencies is determined by their relative value to another currency, normally the dollar.
Put simply, when people say Bitcoin is worth 20,000 dollars, this means that you would need 20,000 dollars to buy a Bitcoin.
So, understood how we derive a crypto's value, where do we buy it?
Crypto exchanges, the place to measure price
To buy a cryptocurrency you need to do so through an exchange.
These systems offer you trade value pairs, each with a certain amount of liquidity for you to buy the cryptocurrency you want if you dispose of the counterpart asset.
Let's see this with an example:
Binance offers a value pair that is BTC/USDT. That is, they have two pools of Bitcoin and Tether (a stablecoin that is pegged to the dollar).
Therefore, if you want to buy Bitcoin you first need to buy USDT.
Once you have USDT, you can go and buy BTC from that trading pair.
But, still, we haven't answered how the value of BTC is decided.
Happily, the concept is dead simple. As we mentioned, the value of a cryptocurrency is derived from its relative value to another asset, for example, the dollar.
Consequently, each exchange will have its own price of BTC according to the trade volumes in each of its BTC pairs, depending on the liquidity of the asset.
In simple terms, for a BTC/USDT pair, if more people are willing to buy BTC for USDT the value of BTC goes up with regards to USDT, and vice versa.
It must be said, however, that this is a sign of crypto markets being inefficient, as high-frequency traders can scan the different exchanges and do arbitrage, which in layman's terms is benefiting from the spread - the difference - of the value of BTC in a specific pair between exchanges.
For instance, if a trader sees that BTC is cheaper with respect to USDT in a specific exchange from another, he can buy BTC on that exchange and sell it in the other one for easy profit.
Although this doesn't seem like the right thing to do, it also helps to maintain similar prices between exchanges. Needless to say, the ideal thing would be for all exchanges to share a common price.
Maybe with the use of a unique decentralized oracle? I'm not really sure if there's an answer to such a question.
If you want to have a closer guess of what the actual value of a cryptocurrency is with regard to a certain asset, the higher the liquidity and market relevance of an exchange, the closer to the real value you are.
Now that we know how price is measured, the final question is, what causes its value to increase or fall?
How do they decrease in value
There are up to six reasons, and quite potentially many more, that explain cryptocurrency volatility:
- Market manipulation by whales
Whales are cryptocurrency holders that own vast amounts of the token with regard to the total supply. As token prices are ruled by supply and demand and are strictly related to market supply, these people can easily cause drops and price surges just with one simple trade.
Of course, due to their power, they can actually manipulate markets. On the flip side, some whales have a sense of responsibility and actually help maintain liquidity across pairs, a job that is known as 'market maker'.
- Blockchain demand
This one is dead simple. The more a blockchain is used, the higher the price for the underlying cryptocurrency. However, there's a catch.
You should thoroughly analyze the token's tokenomics, as some blockchains have tokens that aren't really affected by usage, like $ATOM in the Cosmos blockchain.
- Margin trading and liquidations
This is probably the biggest reason for market volatility, especially in downward trends. Many crypto trades are leveraged, which means that they are done with borrowed money.
When you make a trade on borrowed money, your borrower defines a threshold limit at which, the moment the price of the invested tokens falls below that threshold, the position is automatically sold.
Some crypto positions are so heavily leveraged that offer up to 25x the amount put as collateral.
Have this in mind: never, and I mean never, margin trade. Gains can be huge, but losses can be just as huge; we have seen people lose hundreds of thousands of dollars in a matter of minutes due to these very irresponsible trades.
For instance, a 25x margin trade can multiply your losses twenty five times, enough to ruin you and your next three generations.
Predicting markets is super complicated, and getting all trades right is an absolute utopian scenario.
This is the reason for those insane drops in price, as liquidations can ignite a cascade of selling positions that drop the price considerably, even taking it to zero, with examples like $LUNA.
- Vested allocations
As described earlier, the price of a crypto coin is determined by its total supply. Sadly, vested allocations can, suddenly, allow holders to sell their allocations, resulting in sudden price falls.
- New unexpected supply entries
Similarly, according to the tokenomics of the cryptocurrency, some of them have sudden increases in supply that also reduce the value of each unitary cryptocurrency.
- Inflationary/deflationary tokens
Much alike fiat currencies, the majority of cryptocurrencies are inflationary, which means that they eventually lose value over time and their value is maintained or increased as demand increases.
This is all too common in Crypto. For instance, DeFi protocols, during the DeFi craze, would pay the insane yields they were offering by issuing new tokens, much like a Ponzi Scheme.
Of course, eventually, demand would falter, new users wouldn't enter the space, and old investors would flee as the token become hyperinflationary due to the massive supply generated during those issuances.
Happily, some other Crypto projects have another approach, an approach to obtain deflationary tokens by the use of a concept known as 'burning mechanism'.
There are some types of blockchains known as Proof-of-Stake, or PoS, blockchains. These blockchains include such burning mechanism, that burns a percentage of the rewards for introducing blocks (validating transactions).
To eventually become deflationary. What this means, in layman's terms, is that the daily amount of cryptocurrencies issued during rewards is smaller than the amount of cryptocurrencies taken out of the system (burned).
As a rule of thumb, if your token is inflationary, the coin's value tends to decrease.
This is, once again, why it is so important to understand the tokenomics of the cryptocurrency.
You now understand what are blockchains, why cryptocurrencies exist, how they are bought, and how they are priced in those same exchanges you are using to buy them.
Adding to this, you also now know how the prices of such tokens behave, and how, by carrying out intensive research, you can be much better prepared to predict movements and benefit from them.
In general terms, Crypto markets are so heavily leveraged, and investments are so poorly researched, that the majority of traders lose money heavily.
Thus, be cautious and only invest that money you can afford to lose, and don't allocate a higher value than 20% of your portfolio to Crypto investments.
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