How does the cryptocurrency market work?
With most items of value, whether they be precious metals, natural resources, or collectibles, their value is dependent on supply and demand. If oil becomes scarce, the value goes up. If a new gold mine is discovered, the value of gold goes down. It’s a very simple market mechanism, and it could be argued that is it the central tenet of capitalism as we know it.
This does not seem to apply to the market of cryptocurrencies, however. New research into the inner workings of the cryptocurrency market has revealed that the value of any given cryptocurrency is solely determined by the mood swings of the investors, and the hype generated by the media covering the market. Perhaps this could explain the at times extreme volatility of the market in general.
How did everyone think it worked?
Blogs like Bitconnect (which subsequently has been discredited) have previously claimed that a number of factors were involved in determining the price of cryptocurrencies. First, there is supply and demand, like in any other market.
Then there is the energy required to sustain and secure the blockchain. The world of cryptocurrencies is notorious for consuming copious amounts of electricity, and this undoubtedly has an impact on the value – or so one would think.
Another factor is the difficulty of solving the mathematical problems necessary to mine for cryptocurrencies. As more coins or tokens are released into circulation, the time and processing power required to mine for new coins increases.
There is also the market dilution to take into consideration. With more and more cryptocurrencies being released onto the market, the value of all cryptocurrencies would be expected to fall.
Finally, there are the government regulations of cryptocurrencies, which many have thought would be the reason for the recent downturn and loss of value.
Maybe all of this is false
Daniele Bianchi, a researcher from the University of Warwick Business School, has now arrived at the conclusion that none of the above reasons are true. Rather, the market is “driven purely by the mood swing of investors“. How did she arrive at this? Bianchi has analyzed the trading patterns of the largest cryptocurrencies in circulation, such as Bitcoin.
Bianchi’s research showed that the fluctuations in value were purely down to investors observing the changes in value and then reacting. This makes cryptocurrencies very different from regular currencies, which are much more complex to understand when evaluating how much they are worth. Bianchi said of her findings:
Cryptocurrencies have more in common with an equity investment in a company than an investment in a traditional currency. For instance, holding Bitcoin can be ultimately seen as an investment in the blockchain technology rather than a simple speculation. Having said that portfolio returns are highly volatile, thus negating the chances of using the popular momentum strategy for trading in cryptocurrencies. Although there is some predictive power of past performance for future returns, the profitability of a momentum strategy in cryptocurrency markets is significant only in the very short term.