What Drives Cryptocurrency Prices?

The value of fiat currencies, i.e., those issued by national governments, is affected by factors like monetary policy, inflation, employment, imports and exports, foreign exchange reserves, and so on. Since cryptocurrencies are not issued by any government, they are unaffected by these variables.

Also read: What Drives Cryptocurrency Prices

Still, cryptocurrencies are known to be highly volatile – their value falls and rises rapidly. Before we discuss why this happens, let us understand how cryptocurrency is controlled.

Who controls cryptocurrency?

Nobody controls cryptocurrency. 

The defining feature of cryptocurrency is that no one person or institution is in charge. If you know the basics of cryptocurrency, you must be aware that it works on a blockchain. Every block on the chain carries a record of some transactions between people on the blockchain. These blocks are verified by the process of crypto mining. 

Crypto mining is also the process by which new coins are pumped into circulation. As you can see, no authority is required for supplying coins, making transactions and auditing records. The system runs by the collective action of users on the blockchain. As a result, there is no one person, company or institution that you can look up to for controlling the price of the cryptocurrency.

If you know basic economics, you must be aware that the price of anything depends on supply and demand. This also applies to cryptocurrency. If the number of people who want to buy is less than the number of people who want to sell, the price will rise. But if the number of people who want to sell is more than the number of people who want to buy, the price will fall. 

So far, supply and demand is the only factor that shows a direct, clear cut effect on prices. But the tough part is that supply and demand themselves are affected by several factors, and it is hard to predict them. But let us look at some of the variables that can have a possible effect on the supply and demand of cryptocurrency.

Incentives for mining

This applies only in the case of mineable cryptocurrencies. Higher the incentives are given to miners, i.e., the greater the rewards, the more motivated they will be to mine. They will invest more in mining by buying hardware and software with high computational power. With greater computational power, they will verify the transactions more efficiently. 

The more secure the blockchain is, the more people will trust it, and the more they will invest in that cryptocurrency. As more people invest, the supply-demand equation will change. This connection between incentives and trustworthiness was tested by Sidharth Bhambawani and his two colleagues at Hong Kong University of Science and Technology. 

Safety of the technology

Apart from the performance of crypto miners, security also depends on how robust the technology is. A blockchain can be vulnerable to bugs, which gives hackers an easy entry. 

Blockchain fork

Sometimes when developers are modifying the features of the blockchain, they have conflicting opinions. Since they cannot agree on one thing, they go their separate ways, and after a certain point, the blockchain forks into two chains. Some users go with the old chain; others follow the newly formed chain. Because investors are divided, it can have a huge impact on the price of that cryptocurrency. 

Inflation of fiat currencies

When the value of fiat currencies like the dollar goes down, the price of cryptocurrency increases; for example, if the value of the dollar falls, people will get more dollars in return for bitcoin than what they used to get earlier. This means that the bitcoin will be worth more than what it was in dollars. In other words, the price of bitcoin will rise.

Government regulations on cryptocurrency 

Some governments have taken a liberal stance toward cryptocurrency, some have tried to regulate it, while some have completely banned it. For example, China and Saudi Arabia have banned cryptocurrencies. People from an entire country withdrawing from the market can have major implications for the prices of cryptocurrencies. 

News coverage and social media

Media reports about cryptocurrencies rapidly spread via mouth-to-mouth publicity and also on social media. Anecdotal stories, controversies, tweets by influential people and comments made by politicians have a powerful influence on how people perceive cryptocurrency, which affects demand.

Why are crypto prices falling?

Talking about Bitcoin specifically, on the 20th of May, 2021, the price of Bitcoin fell by 29%. After that, the Chinese Banking Association issued a statement saying that financial institutions should stop using cryptocurrencies, and the prices of all cryptocurrencies fell.

This could be because, in February 2021, Elon Musk had announced that his company, Tesla, had invested $1 billion in Bitcoin. From the next month, they started accepting payments in bitcoins. Then in May, he said that they would no longer be accepting it because crypto mining harms the environment. Following that, the price of Bitcoin fell heavily. 

Such instances are indicative of the extremely volatile and unpredictable nature of cryptocurrency prices. There are some contrasting arguments out there on whether we can really point out factors that affect the value of cryptocurrency since it is mostly based on trust and speculation. 

For example, a paper was published in 2015 by Chea and Fry; wherein they argued that the fundamental value of Bitcoin is zero. According to them, the rise and fall in prices are just fuelled by irrational speculation. Hence, there are no definite patterns of rising and fall. But the blockchain technology is still in its infancy, so there is a lot of room to agree to disagree.