An Investor’s Guide to Cryptocurrency; Part 1: The Mechanics of Cryptocurrency

A few weeks ago, we published an article titled “The Rise of Cryptocurrencies”, we gave an introduction on the history of cryptocurrencies and how cryptocurrencies are issued and traded. Since this article was published, there have been developments in the world of cryptocurrencies, the price of Bitcoin has skyrocketed, and new coins are being issued daily. There is an increased need for information on cryptocurrencies as more investors are trading in the crypto market.

As a response to this, we will be starting a three-part series on cryptocurrency titled “An Investor’s Guide to Cryptocurrency. The articles that would be published during this series are aimed at providing much needed information about the crypto market and reducing the ambiguity around crypto trading.

To start off, we will be discussing the mechanics of cryptocurrency in this article. Let us start by exploring the relationship between cryptocurrencies and blockchain technology. A blockchain is a decentralized ledger of all transactions across a peer to peer network. This technology allows participants to confirm transactions without the need of a centralized authority like a central bank. Blockchain technology increases transparency, ensures accurate tracking of transactions. It also serves as a permanent, unmodifiable ledger and is cost effective. However, there are also disadvantages associated with using blockchain technology such as a lack of a regulatory authority and a complex technology. Cryptocurrency is a medium of exchange, created and stored electronically in a blockchain using encryption techniques to control the creation of monetary units and to verify the transfer of funds. Cryptocurrencies have no intrinsic value. They have no physical substance, only exist on networks and their supply is not determined by a central bank.

Cryptocurrency transactions are executed using blockchain technology. The process starts when a request is made. The requested transaction is broadcast to a peer to peer network comprising computer users known as nodes. The network of the users/nodes validate the transaction and the user’s profile using a known algorithm. The transaction is completed after the validation and a new block is added to the existing blockchain. This makes the transaction permanent and unmodifiable. Once verified, the transaction is combined with other transactions to create a new block of data for the ledger.

Now that we understand the technology behind cryptocurrencies, let us discuss how the price of cryptocurrency is determined. The determination of the price of cryptocurrencies uses four basic concepts of economics; supply, demand, utility and scarcity. If a commodity is scarce and can be utilized for a specific purpose, then it has value and can be demanded at a specified price. The combination of scarcity and utility creates value by which the price of the cryptocurrency can be determined based on market forces, i.e. supply and demand. The supply of cryptocurrencies is limited as there is a finite number of blocks can be mined. There are 21 million bitcoins in existence and currently, there are about 16.2 million bitcoins already in circulation. This creates a visible scarcity. Cryptocurrencies like bitcoin are used for payments, this indicates utility. There are thousands of merchants globally that accept bitcoins as a means of payment.

The price of cryptocurrencies is not the same as the value. The prices of cryptos are determined by the forces of demand and supply. The ongoing interaction between the buyers and sellers determine the price of any commodity. Like any other commodity, cryptocurrencies follow the laws of demand and supply. The law of demand states that the higher the price of a commodity, the lower the demand of that commodity by buyers. While the law of supply states that the higher the price of a commodity, the higher the supply of that commodity by the sellers, all things being equal. Both laws interact to determine the actual market prices and volume of goods that are traded on a market. This also applies to cryptos.

In the following weeks, we will discuss the risks associated with trading cryptocurrencies and the volatility of cryptocurrencies.

Check out our previous post on cryptocurrency

The Rise of cryptocurrencies

References

PricewaterhouseCoopers. (n.d.). Making sense of bitcoin, cryptocurrency and blockchain. PwC. Retrieved January 10, 2021, from https://www.pwc.com/us/en/industries/financial-services/fintech/bitcoin-blockchain-cryptocurrency.html

Why does Bitcoin have value and how is the price determined? (2017, March 15). Luno. https://www.luno.com/blog/en/post/how-bitcoin-price-determined#:%7E:text=The%20price%20of%20Bitcoin%20is%20not%20the%20same%20as%20its,means%20of%20supply%20and%20demand.&text=However%2C%20when%20determining%20price%2C%20one,value%20of%20a%20specific%20item.

Fernando, J. (2020, November 29). Law of Supply and Demand Definition. Investopedia. https://www.investopedia.com/terms/l/law-of-supply-demand.asp#:%7E:text=The%20law%20of%20demand%20says,are%20traded%20on%20a%20market.

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