It is a fairly known fact that cryptocurrencies are one of the most volatile asset classes in history. It is not uncommon for cryptocurrency assets to record triple-digit gains or losses in a single day as they grapple with the forces of supply and demand.
This feature of cryptocurrencies has attracted daring traders to the markets looking to strike a fortune, while still keeping risk-averse investors away from the space. While it may seem like crypto prices have a mind of their own, there is a science behind these price fluctuations.
As traders walk the tightrope of wild price swings, the use of a coin price tracker like CoinStats is a sure-fire way to always stay one step ahead of the volatility. The crypto portfolio tracker has features like auto alerts, a stellar news aggregator, and access to enterprise-grade research tools to take trading to the next level.
Several factors play a role in the wild price swings including the utility, cost of creating new tokens, and government regulations amongst others. This piece will delve into details on what determines the price of a cryptocurrency and without further ado, let’s dive right in.
1. Factors of Supply and Demand
Although cryptocurrencies stand apart from other types of assets, they are still governed by the forces of supply and demand. The general rule of thumb is that cryptocurrency prices increase when there is a spike in demand amongst traders, and an oversupply of a crypto asset will lead to a fall in prices.
To balance the forces of supply and demand, cryptocurrency projects have employed elaborate processes to control the circulation of tokens. Some of the processes are implemented in the token minting stage to regulate the creation of new tokens. For example, with each mined Bitcoin block, only a fixed amount of BTC enters into circulation. The use of a fixed maximum supply for cryptocurrencies is another method of maintaining equilibrium, with Bitcoin going the extra mile to introduce a halving feature to create scarcity.
Cryptocurrencies without a fixed maximum supply have adopted the strategy of burning existing tokens to put a lid on circulation. The common means of burning is to send the tokens to an unrecoverable address, and this strategy has been employed by projects like Shiba Inu and Ethereum to relative success.
2. Minting New Tokens
The creation of new tokens plays an integral role in crypto prices. Cryptocurrencies, especially those with a Proof-of-Work consensus mechanism, generate new tokens through mining, i.e. solving complex mathematical problems through computing power.
This method of crypto mining often requires the use of expensive mining equipment and large amounts of electricity supplies to function. Given the high costs of mining processes, miners will only be incentivized to secure the blockchain network when they will be sufficiently rewarded for their efforts.
The complexity of the mining process of a particular cryptocurrency contributes to an increase in its price. This is particularly evident in Bitcoin and Ethereum, the two largest crypto networks that have reached highs of $64,789 and $4,891 respectively, and consume the most electricity in their mining processes.
Cryptocurrency traders often approach the markets by focusing on technicals by peering at the charts for hours. However, reports and activities around a particular cryptocurrency project are often decisive in determining prices.
For instance, reports of technological advancement or a groundbreaking partnership will precede a bullish run. Ethereum’s London hard fork and Cardano’s Alonzo hard fork were the precursors for the bullish runs that led to the all-time highs of their native tokens.
Negative reports around a cryptocurrency project will send prices crashing to rock bottom as it triggers waves of bearish sentiments. Reports of a security breach or a botched upgrade have historically led to falling prices, with the DAO hack of 2016 leading to Ethereum’s decline.
4. Listing on Exchanges
Cryptocurrency exchanges play important roles in determining the prices of crypto assets. Projects listed on the popular exchanges increase the options of investors, leading to increased demand. This spike in demand correlates to an increase in asset prices.
For crypto projects listed on smaller exchanges, retail and institutional investors will not have diverse options to invest capital in those projects. A study from Messari noted the phenomenon of the “Coinbase Effect” in which crypto tokens recorded a marked spike in their valuations after being listed on leading exchanges.
Crypto exchanges play the role of providing liquidity to cryptocurrency traders. Low levels of liquidity are often behind high market volatility, while the presence of high liquidity ensures that the price swings are not chaotic. Bitcoin and other large-cap cryptocurrencies do not experience triple-digit swings in a day, but cryptocurrencies with small caps are susceptible to increased levels of volatility.
5. Government Regulations
The rise and fall of cryptocurrency prices can be linked to the actions of government agencies and legislative houses. One positive law giving cryptocurrencies legal status in a jurisdiction can send prices to new highs, and a crackdown on cryptocurrency activities can spell bearishness for prices.
China’s infamous crackdown on cryptocurrency activities in 2021 nearly sent the ecosystem to a crypto winter, and the SEC’s prolonged court case with Ripple Labs has had an adverse effect on XRP’s price.
On a positive note, the approval of Bitcoin ETFs in the U.S. and the European Union’s decision to not ban Proof-of-Work cryptocurrencies within its borders was a bullish moment for the crypto prices globally.
Cryptocurrency prices are determined by the interplay of several factors like government regulations, exchanges, media reports, and the duo of supply and demand. An understanding of these factors would be an added advantage for traders, helping them to make the right trading decisions.
Investors that are risk-averse may decide to stick with large-cap cryptocurrencies that do not have the downsides of erratic price changes, while those with a large risk appetite may wade to crypto assets with smaller market capitalization. Regardless of the side of the divide you stand on, a knowledge of the factors that determines cryptocurrency prices will be useful in navigating the markets.