A cryptocurrency is a virtual currency, often decentralised, that uses cryptography (the practice of coding information to ensure only the person for whom a message was written can read and process the information). Cryptocurrencies have arisen partly in an effort to address the flaws of traditional currencies such as inefficiency, limited access, opacity, centralised control and lack of interoperability.
They have value because they can be exchanged for real-world goods and digital assets, and many can be considered a store of value.
Many cryptocurrencies use blockchain technology – a decentralised ledger of all transactions that take place – to store and distribute digital information.
There are more than 20,000 different cryptocurrencies and most take the form of a coin or a token. Coins use their own blockchains to record transactions between two parties and are often used for storing and transferring a form of money. Examples include Bitcoin and Ethereum, which are the two largest cryptocurrencies currently in existence.
Coins can be issued in many ways including Initial Exchange Offerings, Initial Dex Offerings and Fair Launch distribution or, as with Bitcoin and Ethereum, need to be mined in order to be created.
Tokens don’t use their own blockchain, but instead, become part of an existing blockchain. As a result, they are much easier to create and can be used alongside a software application to verify and authenticate identity. Tokens are often issued to investors during an Initial Coin Offering (ICO) in exchange for funding.
Stablecoins are tokens (not coins) that are linked to one or more fiat currency (a type of currency that is not backed by any commodity such as gold or silver and typically is designated by the issuing government to be legal tender – examples include the US dollar, the British pound and the euro), and hence offer a greater degree of stability.
Utility tokens are cryptocurrencies that provide a service to a particular platform, in addition to ownership of the token. An example of this is MANA, which allows holders to buy virtual properties within the metaverse.
Ripple is a popular token used across the Ripple network. The network is used primarily by financial institutions to support cross-border transactions that are relatively cheap, irrevocable and settle quickly.
As an asset class, the value of cryptocurrencies is materially affected by the same things that influence many asset classes (supply and demand, market sentiment, and so on), but the relatively small size of the market and lack of liquidity can make moves particularly dramatic.
The chart below of Bitcoin’s price from April 2021 to April 2022 shows examples of supply and demand in action. The bar chart at the bottom indicates the volume (number of Bitcoin’s traded per unit time) with red for sell and green for buy. When the price fell or rose sharply there was an increase in volume compared with when the price was moving sideways. A high volume being sold indicates an increase in supply and a resulting fall in price – typical of a normal asset.
However, as well as being affected by supply and demand, some cryptocurrencies are also impacted by market sentiment and media coverage.
Prices can change when an announcement is made that drastically affects how the asset functions and/ or if a new company starts accepting cryptocurrency for payment. When Elon Musk announced that Tesla would start accepting Bitcoin as payment in March 2021 there was an initial rise in demand resulting in a rise in value.
In 2020, market sentiment contributed significantly to rising prices for cryptocurrencies as many individuals used their government support payments to invest in cryptocurrencies - especially given low returns from bank deposits.
Another factor is the presence of ‘whales’ – individuals who control large amounts of coins and tokens. In October 2021, 49% of all Bitcoin was held by whales and in 2019 Bloomberg reported that 376 individuals owned one-third of all Ethereum. These large and often hard-to-trace holdings can enable market manipulation and prevent prices rising beyond a certain threshold (as a large price rise could cause these whales to sell off large volumes of their holdings).
Commercial activity in the virtual world is another big driver of cryptocurrency value. Many cryptocurrencies have implemented uses for their coins and tokens on platforms such as Decentraland (based on the Ethereum blockchain) encouraging demand of the token.
Some cryptocurrencies such as Bitcoin are affected by external factors. Rising energy costs directly impact mining activity and have led to a reduction in the number of people creating new bitcoins. New rules and regulations can also affect prices (an announcement by the People’s Bank of China in September 2021 resulted in a fall of 3.65% in the value of a bitcoin).
One of the biggest observable trends is how altcoins (coins other than Bitcoin) generally follow Bitcoin’s price movement. As Bitcoin represents nearly 50% of the total cryptocurrency market cap, the public typically considers Bitcoin as either the main or the most secure coin. Often when Bitcoin decreases in price, altcoins can fall even more as there remains a positive sentiment underpinning Bitcoin as well as greater name recognition.
Some cryptocurrencies can be more heavily affected by normal supply and demand. As some cryptocurrencies become more popular, especially if they have a small market cap, a large influx of new investors can quickly drive up prices significantly.
The table below shows the correlation between different cryptocurrencies and assets. Many altcoins, such as Litecoin (LTC), are simply Bitcoin clones and therefore have a high correlation to Bitcoin. Stablecoins have no correlation to altcoins and utility tokens are uncorrelated but do move in line with general market sentiment towards to sector.
During 2022, cryptocurrencies fell in value – some as small as 5% through to the 50% decrease that Bitcoin experienced. A key reason was rising US interest rates – providing investors with additional sources of yield enhancement (typically unattractive during the preceding period of sustained low interest rates). In addition, the turbulence in the decentralised finance (DeFi) space, and the failure of FTX affected general market sentiment towards all cryptoassets.
Crypto assets like Bitcoin are often seen as an alternative investment as they are not considered to be correlated (positively or negatively) to equity or fixed income markets. While that may be true during periods of general confidence in the investment markets and when interest rates were low, the recent changing macro-economic outlook has highlighted a number of fundamental differences in governance, transparency and regulations between cryptocurrencies and more traditional investment vehicles.
The graph below shows how the gold and equity markets responded in 2022, following the invasion of Ukraine. It demonstrates gold’s traditional role as a counter-cyclical investment hedge – equity markets fell (S&P 500 shown in red) but gold went up (shown in green).
Within the universe of cryptocurrencies there is a wide range of different assets. There are general trends that can affect the overall market (such as regulations in key markets and monetary policy) but also unique drivers (such as the presence of whales) that can affect a specific cryptocurrency. For anyone looking to use cryptocurrencies (either in the short or medium term) it is important to understand the dynamics of the market itself and also of the specific currency.
Naresh Aggarwal is associate director, policy & technical, at the ACT. Dashiell Ratcliffe is a research analyst