The price of stocks and other assets is somewhat anchored by the value of ownership and future income but also moves because of supply and demand. Crypto is very new, with tremendous uncertainty about which projects will be successful or generate income. As a result, current price movements are guided almost entirely by the forces of supply and demand.
Demand for crypto
The demand for crypto is based on how many folks out there are looking to buy. We'd expect the price of crypto to rise if the market for it continues to grow. Here are some factors that would affect demand.
As new investors flock to the market, many buy coins merely because the price is going up, not really understanding why. This creates more demand, keeps prices rising, and incites others to join until a bubble forms.
However, bubbles inevitably pop. So while speculating can be exciting, the demand is fleeting and not sustainable. Dogecoin anyone?
As developers build more applications on blockchains, the coins become more useful, expanding the number of people using them. The increased utility drives stronger demand and more growth, making it a better investment. Ethereum is an example of a utility-based coin.
As a good rule of thumb, consider the crypto's utility to avoid buying in on a bubble.
Circulating supply of crypto
Proof-of-Work (PoW) or Proof-of-Stake (PoS) systems add coins to the supply of a cryptocurrency when they add blocks to the underlying blockchain. Each blockchain network may use a different way of calculating mining/staking rewards. Blockchains use one or the other, not both mechanisms. Keeping demand the same, increasing the supply of coins often lowers the price.
Proof-of-Work is the original consensus mechanic used by Bitcoin for a decentralized network to agree on things like account balances and the order of transactions.
The Proof-of-Work algorithm sets the difficulty and rules for the work miners do.
There are two components to the reward: any fees attached to the transaction and the block subsidy. People add fees to their transactions for priority, so they get added to a block before others.
- Strong incentives: More miners are incentivized to join the network as the value of a cryptocurrency grows, which increases its power and security
- Security: Because of the amount of processing power involved, it becomes impractical for any individual or group to meddle with a valuable cryptocurrency's blockchain
- Energy-intensive: the process takes a tremendous amount of computing power to mine blocks
- Lacks scalability: the high energy costs of adding a block also means that it has difficulty increasing the speed of transactions
Proof-of-Stake was created to address the pitfalls of proof-of-work. In a PoS system, staking replaces PoW's mining to add transactions to the blockchain.
The network selects a winner based on the amount of crypto each validator has in the pool and the length of time they've had it there — choosing the most invested participants. Then, all participating validators receive a reward in the native cryptocurrency when they forge a block.
- Security: higher security per locked capital
- Energy efficiency: less energy-intensive
- Scalability: more predictable block times and faster transactions
- Untested: still new and has not been tested at scale on large blockchains; however, Ethereum plans to migrate to proof-of-stake from proof-of-work
- Pay to play: since the validation is dependent on the crypto staked, it can result in a rich-become-richer scheme
Use knowledge of the different consensus mechanisms to understand how the supply of a cryptocurrency might change over time and how it impacts the supply and demand economics that drive price changes.
For instance, look at Bitcoin and Ethereum:
- Bitcoin's Proof-of-Work, halving, and the cap on the total number of coins place more limitations on its supply than a cryptocurrency like Ethereum. Those restrictions cause more scarcity which can lead to higher prices.
- On the other hand, Ethereum has more utility which causes more demand that can lead to higher prices.
To earn a return, consider investing in cryptos with sustainable growth in demand while having a sustainable supply. You can also use staking as an income strategy for any crypto we own.