Cryptocurrencies have attracted a lot of attention due to their extreme volatility. For example, it's not uncommon for the most prominent cryptocurrencies to move 10 to 20% in just a week. But these movements beg the question: How does cryptocurrency gain value? What makes cryptocurrency go up in price?
Cryptocurrencies are well-known for their extreme price movements, but what causes cryptocurrency to gain value?
Let's examine what influences a cryptocurrency's value and how you can determine its fair value.
How Does Cryptocurrency Gain Value: “Value” In Crypto Explained
To answer the question, “how does cryptocurrency gain value?” you must first understand the definition of value.
Most people believe that a higher price equates to a higher value. After all, if you buy a cryptocurrency at $1.00 and it goes to $2.00, then you've doubled your account value. The problem is that all cryptocurrencies don't start their life with a $1.00 base value. In fact, the price of a cryptocurrency is entirely separate from its value.
The real value is its market capitalization—or the number of coins multiplied by the price per coin. So, for example, a $100.00 cryptocurrency with ten outstanding coins is only worth $1,000, but a $1.00 cryptocurrency with 1,000,000 outstanding coins is worth $1,000,000, even though the coin price is lower than the $100 coin.
Crypto investors should also be mindful of market liquidity—or the dollar value of transactions. For instance, suppose an entrepreneur creates a new cryptocurrency with 1,000 coins outstanding, and a family member buys the first coin for $1,000. Does that mean that the cryptocurrency is worth $1 million (1,000 x $1,000)? Of course not!
In short, the actual value of a cryptocurrency is equal to its market capitalization in a liquid marketplace.
Price Movements in Crypto vs. Conventional Markets
The next step in answering the question, “how does cryptocurrency gain value?” is understanding the different ways that cryptocurrencies work.
Most financial markets consist of debt and equity, and the value of these securities is pretty straightforward to calculate. For instance, the value of a bond is roughly equal to the net present value of future cash flows (e.g., principal and interest payments). On the other hand, stocks are typically valued based on their earnings (e.g., the price-to-earnings ratio).
Unlike stocks and bonds, most cryptocurrencies don't inherently generate any cash flow. Instead, they're comparable to precious metals, like gold or silver. The price of these assets typically depends on supply and demand from producers (e.g., miners), consumers (e.g., jewelers), and investors (e.g., those using gold as an inflation hedge).
Of course, there are a growing number of cryptocurrencies challenging these dynamics. Tokenized securities, non-fungible tokens, utility coins, and other types of cryptocurrencies have different factors influencing their valuations. As a result, it's critical to adjust your valuation method depending on the specific type of cryptocurrency.
In short, conventional cryptocurrencies trade like commodities, but each cryptocurrency has unique factors influencing its valuation.
Most conventional cryptocurrencies have prices driven by investment supply and demand. While Bitcoin's founder envisioned revolutionizing online commerce, traders and investors are the primary drivers of Bitcoin demand. Traders may be looking to capitalize on technical price movements while investors seek to diversify their portfolios.
Market capitalization influences the magnitude of cryptocurrency price movements. For example, a $1,000 trade will significantly impact a cryptocurrency with a $100,000 market capitalization but have a negligible impact on Bitcoin's massive half-trillion-dollar market capitalization. As a result, those seeking huge gains might buy into smaller cryptocurrencies.
Why is crypto going up as a whole? Many short-term traders have embraced cryptocurrencies due to their volatility, which makes it easier to win or lose large amounts of money in a short period of time. On the other hand, many investors are interested in crypto because it’s not correlated with conventional stocks and bonds, making it valuable for diversification.
ICOs & Tokenized Securities
Initial coin offerings, or ICOs, were the brainchild of J.R. Willett in 2012, who launched a Kickstarter-like campaign and raised $500,000 on a mere promise. Predictably, the success attracted many unscrupulous individuals and sparked a bubble that popped in 2018 when the SEC began to shut down projects making outlandish promises.
That said, the idea of an ICO morphed into more legitimate Security Token Offerings, or STOs, that are popular today. While STOs are identical to ICOs from a technological standpoint, STOs are subject to regulatory oversight. STOs have unique characteristics and ownership rights outlined in their prospectus that influence their valuation.
Non-Fungible Tokens (NFTs)
Non-fungible tokens, or NFTs, are the latest craze to hit cryptocurrency markets. Unlike conventional cryptocurrencies, these tokens are not interchangeable. Instead, they represent a unique digital item, such as a trading card or piece of artwork. As with physical collectibles, the value of an NFT depends on the market for each item.
In some cases, the value of an NFT can be much higher than a typical cryptocurrency. For example, Everydays: The First 5000 Days was a piece of digital art that sold for $69.3 million, while Jack Dorsey sold his first tweet for $2.9 million. The catch is that NFTs are a lot less liquid than conventional cryptocurrencies since each one is unique.
Utility tokens help users interact with a company's products or services. For example, Ripple enables payment providers to expand into new markets, speed up settlements, and lower foreign exchange costs. Ripple gains in value as more companies use the cryptocurrency's platform to settle their international payments.
Crypto Tax Remains the Same
The IRS taxes all cryptocurrencies as property. When you sell a cryptocurrency, you owe capital gains tax on any profits—or the difference between your cost basis and sale price. The actual tax rate depends on how long you held the cryptocurrency before selling it, your tax bracket, and other potential factors.
ZenLedger makes it easy to accurately complete your cryptocurrency taxes each year by aggregating transactions across wallets and exchanges, computing the capital gains and losses, and auto-filling the IRS forms you need. So whether you're investing in Bitcoin, selling NFTs, or earning interest from DeFi, ZenLedger keeps you out of hot water with the IRS.
Checklist of Top Cryptocurrencies
The following checklist helps illustrate how price has little to do with market capitalization—even among the largest cryptocurrencies. For example, Tether and Binance Coin have market capitalizations in the $40 billion range, but the prices differ by 300x.
The Bottom Line
Cryptocurrencies are notoriously volatile, but how does cryptocurrency gain value and how does crypto go up? The answer is: it depends.
Cryptocurrency price movements occur for a wide range of reasons. While conventional cryptocurrencies move based on investment supply versus demand, NFTs, STOs, and other cryptocurrencies move based on different factors. Traders and investors should understand these differences to maximize their odds of success.
Regardless of the cryptocurrency, the IRS requires everyone to pay capital gains taxes on any profits. ZenLedger can help make sense of the IRS' constantly evolving rules to ensure that you're not overpaying and minimize your audit risks. Try it for free today!