Cryptocurrency is a form of digital money that doesn’t require a traditional financial institution like a bank to verify transactions. It has become increasingly popular in recent years, with high profile business people like Elon Musk advocating for it. However, the market is still relatively young and many investors don’t fully understand how it works or its true value.
A cryptocurrency’s value is determined by its utility, scarcity and perceived value. Its utility refers to how useful the coin is in its specific blockchain network – for example, bitcoin’s popularity is due to its ability to store value. Its scarcity is also important: the maximum supply of a coin is set, and as demand increases it becomes more expensive. Perceived value refers to how desirable the currency is to potential buyers.
For example, the blockchain that powers Ethereum is open source and allows developers to create apps on top of it. In turn, these apps are open to the public and a wide range of participants can access them. As a result, the apps and the technology behind them can be used to build new services that can benefit the entire community. This can lead to a perceived increase in the value of Ethereum itself.
Another way to value a crypto asset is to compare it to other stores of value. Gold bullion, for instance, has a current market value of about $8 trillion. So, if a coin is able to replace gold as a store of value, it could potentially see its price rise significantly.
It is also worth considering the transaction costs associated with a crypto asset when determining its fair value. If a currency can be bought and sold quickly and easily, it will likely have low transaction costs. This makes it more attractive to use than traditional forms of money, which can take longer to process and are often subject to high fees.
The last important factor to consider is whether a crypto asset is backed by an underlying asset. This will determine its regulatory status and whether it can be treated as a financial instrument, for example. Currently, most cryptocurrencies are not backed by an underlying asset, but there are some exceptions such as stablecoins.
Many central banks are exploring introducing their own digital cash, known as central bank digital currency (CBDC). These initiatives promise the speed and other benefits of cryptocurrency but are intended to be safe havens from inflation.
Investors in a national currency typically look for a combination of factors, including price stability, good governance, low corruption and productivity. It is possible that researchers could work with economists to develop a similar set of metrics for crypto tokens. In this way, it may be possible to develop a valuation framework that takes into account both the traditional drivers of equity valuation and crypto assets’ unique characteristics. This would be a significant step toward ensuring that the emerging crypto industry is properly regulated and understood.