What drives cryptocurrency prices?

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For many, there is no intrinsic value in a cryptocurrency and therefore it becomes difficult to say what a ‘fair’ price might be as you may easily do for equities. That said there is little to determine fair value in commodities and FX; and cryptocurrencies have characteristics more like these two asset classes than stocks, although investor behaviour seems to be the reverse. Simply put, there is a ‘supply and demand’ logic at work.

Here are some factors that have appeared to exert influence on the price of cryptocurrencies.

SPECULATION

There are two aspects to this. First, crypto enthusiasts say the technology will supplant existing
financial systems and therefore it is wise to invest early. Based on this, speculators have bought
in the expectation that certain cryptocurrencies will be worth more in the future. Fundamentally,
with no intrinsic value in the assets, the primary basis for the rapid rise in prices seems to have
been speculatively driven. This does not necessarily mean that prices are in a ‘bubble’, but a key
characteristic of asset price bubbles is that they are driven by speculative buying based on the hope
that the asset will be worth more in the future than it is today.

Cryptocurrencies produce no earnings (or yield) and therefore there is an opportunity cost associated with holding them – the cost of having your money invested in cryptos rather than a yield-bearing asset such as bonds or stocks. For example, if £100 of HSBC stock produces a dividend of £5 every year and there is no capital growth (ie, the stock price doesn’t change), in order for £100 of investment in a cryptocurrency to return more, you would be depending on capital growth in your crypto investment of at least 5%. The lack of yield on cryptocurrencies and the opportunity cost of holding them is seen as a barrier to price growth which is in addition to concerns about price volatility.

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HEDGING

A reason touted by crypto enthusiasts for their ‘value’ is that they act as a hedge against financial
meltdown or currency manipulation by governments and central banks. Because they are based on
blockchain technology, they cannot be devalued in the way that fiat currencies may be. As a hedge
against financial turmoil, however, it’s highly debatable to what extent they demonstrate any use.
Volatility in prices means their value as a means of exchange and store of value is dubious. In contrast, gold, which enthusiasts would like to supplant with cryptos, is far less volatile and has been used as a financial hedge for centuries. However, if a consensus builds around the ‘fair value’ of one or two certain cryptocurrencies and prices settle down for a number of years in a reasonably narrow range, then they may be said to exhibit the kind of stable characteristics desired by investors.

PRODUCTION COSTS

Mining is the process that creates new coins and it comes at a cost, both in terms of financial (energy) and time. The financial cost of bitcoin may be said to underpin its price – it has to be worth more than it costs to mine or no one would bother. However, cost of supply does not determine market value.

REGULATION

Regulations act as a driver but their effect can vary. Regulation can be seen as a good thing, bringing
cryptocurrencies into the mainstream and making them more legitimate in the process. On the
other hand, regulation can reduce the appeal of cryptocurrencies as well; for example by requiring
investors to pay tax on profits or by simply banning trading on exchanges. It remains unclear whether regulatory clampdown will crush cryptocurrencies or whether it will allow some or all to flourish. Until now, cryptocurrencies have been able to thrive in a relatively unrestricted marketplace as regulators simply haven’t known what to do with them. Increasingly, however, there appears to be a global, partially-coordinated effort to control and restrict cryptocurrencies.

SUPPLY

Existing cryptocurrencies may suffer declines in value if and when emerging new cryptos appear
that do things faster and/or cheaper than those that have gone before. Indeed the infinite potential
supply of new cryptocurrencies is one of the key arguments against investing in them as an asset
class. On the other hand, the limited supply of Bitcoin is an argument in favour of its price appreciating; i.e. it is said to have deflationary characteristics as opposed to the fiat currencies
which are inflationary as the supply of new money is limitless (the Bank of England can if it chooses
to, print as much as many new pounds as it wants). It is worth remembering that the post-crisis
quantitative easing policies pursued in many developed countries has been linked to the development of cryptocurrencies as they are viewed as a means to avoid what some monetary purists perceive as open manipulation of the money base by central banks.

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