How do cryptocurrencies work and gain their value? Since 2008, companies have created over 5,000. This fact gives us a digital token market in late 2020 worth around $500 billion. That may sound like a lot, but it is small when we compare it with something like the S&P 500, which is around $30 trillion.
The S&P 500 is 600 times bigger and only accounts for the 500 largest publicly listed companies in the USA. But where does this $500 billion come from?
How It Works With A Fictitious Cryptocurrency
How does a cryptocurrency get its value? To answer that, I’m going to use an example? Mary has just created a cryptocurrency called PowerCrypto Coin. This fictitious Cryptocurrency has a maximum of 1000 coins, and every coin is pre-mined. After mining the coins, they immediately become tradable. Initially, Mary’s cryptocurrency has zero value because no one has bought any of its coins.
Then, Steven hears about Mary’s cryptocurrency project and likes the sound of it. He agrees to buy $10,000 worth of Jenny’s coins for $20. Then, Mary decides to sell 500 coins to Steve through an exchange. By purchasing 500 coins, Steve has increased the overall value of Maria’s crypto project, and this process is called Market capitalization, to $20,000, with each coin being worth $20. After the sale, Jenny is delighted because she holds the other 500 coins and is now $10,000 wealthier.
If she wanted to, she could sell her coins now for a quick profit and crash the price or wait to see if the price increases over the long term. Then, Steve introduces Mary to Ben. He wants to buy 600 coins, and he is happy to pay up to $30 a coin for a total of $18,000. Ben privately believes the actual intrinsic value of the coin is around a hundred dollars.
How A Cryptocurrency Gain Its Value
Steve and Mary agreed to sell 300 coins each for a profit. Maria and Steve now have 200 coins each with the value of $6,000 (200 coins x $30) and $9,000 of gain (300 coins x $30). Now, Ben has his 600 coins with a value of $18,000. Both Steve and Ben helped give the project value and exchange for dollars by believing that they can create more value for themselves by exchanging the coin for more in the future.
In summary, we have this chart.
The maximum total number of coins 1000; therefore, the value of the cryptocurrency is akin to a bucket of water. The water represents money or capital coming in and out of the cryptocurrency. Some people sell their shares but, over time, provided the cryptocurrency with a good reason to exist. The number of people contributing, the new capital would increase, and the asset’s price, the water in the bucket, will rise.
Cryptocurrency Value Is Like Water In A Bucket
At a certain point, the number of people entering and exiting will be equal – more or less – and the buckets will be full to the brim. When it happens, we can say that a cryptocurrency reaches its full intrinsic value. Any new capital contributed mainly slushes out to the side of the bucket as people enter and exit accordingly.
The Value of Traditional Currencies And Assets
This idea is not just limited to cryptocurrencies. It also works for fiat currencies, stocks, shares, property, gold, or anything else that could be bought or sold. But these are not capped by cryptographically secure codes – we mine gold, print fiat currency, or companies create more shares. Think of these assets like an infinitely inflatable balloon. Money is pouring in all the time, but the number of units is limited. The balloon keeps getting bigger and bigger until it bursts because people have diluted it to such an extent that the asset is effectively worthless. Such a thing has happened multiple times throughout history, but Germany’s most famous example in the early 1920s, where the population started to use banknotes, such as the 10 billion Mark’s note.
This phenomenon will never happen to a cryptocurrency that has a fixed, predetermined number of units. The Cryptocurrency’s value exists as a negotiation among buyers and sellers for the useful life of the cryptocurrency.
So, should you reconsider investing in Cryptocurrencies?