Posted: May 13th, 2023

Value determination of a cryptocurrency

Preliminary literature review
Value determination of a cryptocurrency
I’d like to start with a brief introduction into cryptocurrency structure. Cryptocurrency is a piece of data, computer code, created and used in a specific virtual system. This system is called blockchain – it is a highly protected, decentralised and distributed to all users, ledger. Its transactions are available to all users and changing the blockchain requires enormous computing power, meaning that, in practice, only majority of the users combined can make changes in the blockchain, one individual can’t. From a historical perspective, the cryptocurrency looks like a logical result of money evolution. From first metal coins to current fiat money, money has been changing into less physical and less centralised form. 2007 financial crisis made a lot of people lose trust in central banks and fiat money, so, Bitcoin, the first cryptocurrency, may have been created as a response to it, as an alternative system, without financial intermediaries.

This research aims to analyse how the price or value of a cryptocurrency is decided. The first article to understand this relatively new technology is an original message of Satoshi Nakamoto, a creator of Bitcoin. It starts with a statement that the current financial system needs a trusted third party to make transactions between two economic agents and this results in mediating disputes, transaction fees and fraud possibilities. Instead of trust in third parties, Satoshi proposes trust in cryptographic algorithms. The article explains how blockchain works and why it is safe. Before Bitcoin, there already existed peer-to-peer systems, however, they couldn’t solve the problem of double-spending – copying a piece of code that describes a specific transaction to make that transaction again and again. Bitcoin blockchain utilised cryptography signatures and a proof-of-work. Basically, it means that each block contains the information of all the transactions made in it, unique code (hash) of a previous block and a random number. All of it is encrypted in such a way that it is impractical to attack this system and change any existing transaction. However, if the majority of users (nodes) decide to make changes in the overall structure, it can be done, making this system flexible and direct when needed. Maintenance of such system and emission of coins is done by miners – computers that provide the system with computational power. In return, they receive newly created bitcoins and commission fees. Total number of Bitcoins is predetermined and, with time, it is more and more difficult to mine new Bitcoins. In the end, the article discusses the problem of privacy. The traditional, centralised system lets third parties control the private information of the people. In a blockchain, only your public key, which is an ID of your wallet, is known. Though, it means if the identity of a wallet owner is made known, all transactions can be traced. However, you can create as many wallets as you want. Satoshi concludes by saying that Bitcoin blockchain allows for electronic payments without relying on trust in third parties, but this is not entirely valid to me because any currency requires trust from the general public to be used as a medium of exchange, the same is true for crypto.

After understanding the mechanics of cryptocurrency, we should move on to the actual economy. The second article is “Evolutionary dynamics of the cryptocurrency market” by ElBahrawy et al. It gives a general overview of the cryptocurrency market, not concentrating on Bitcoin only or few dominant coins. The research includes data from 2013 (when Bitcoin suddenly boomed from 15 to 1200$) to 2017, taken from 157 exchanges. It shows that total market capitalisation had been increasing exponentially, exceeding 100 billion dollars in 2017, while a share of Bitcoin had been steadily decreasing. Then it focuses on the volatility of the market, but, unlike the majority of studies, it focuses on stable properties of the market instead of the very unstable price. Such properties include market share distribution, death and birth rates, average rank occupation time. These results were confirmed in a modified neutral evolution model that described an ecological model of the cryptocurrency market. This research finished by pointing that there is no best cryptocurrency and social/technical changes would strongly affect the market in the future. This article is important for understanding the market value of cryptocurrencies and stable properties of the market, however, it lacks an explanation on the price volatility and price determination.

Therefore, these aspects are covered in the following articles. The third article is “Cryptocurrency value formation: An empirical study leading to a cost of production model for valuing bitcoin” by Adam S. Hayes. Hayes implemented a cost-of-production model to relate the intrinsic value of a cryptocurrency to the cost of its production. It was done by using a cross-sectional data of 66 cryptocurrencies and OLS multiple regressions. The resulting model showed that around 84% of the relative price change is due to 3 factors: computational power, rate of coin production and hardness of the mining algorithm. All these factors can be considered as a production cost, the more difficult it is to mine a coin, the more valuable it is. Interestingly, such factors as the total number of coins and coin existing time were not found to be statistically significant. This study produced a logical and statistically strong result, it is also coherent with economic theory. However, it was focused on the internal, relative value of cryptocurrencies using Bitcoin as a denominator, not USD, which greatly reduced unknown factors of price volatility.

A different approach to the value formation was made in a more recent study by Yhlas Sovbetov in “Factors Influencing Cryptocurrency Prices: Evidence from Bitcoin, Ethereum, Dash, Litcoin, and Monero”. It used time-series weekly data from 2010 – Essay Writing Service: Write My Essay by Top-Notch Writer to 2018: 2024 – Write My Essay For Me | Essay Writing Service For Your Papers Online and ARDL models. Unlike the previous study, this one focuses more on external factors, which can be divided into the crypto market (attractiveness, trend, capitalisation), macro-financial (stock index, exchange rate, interest rate) and political like legalisation or ban. The results are statistically significant in both the short and long run and imply that 5 dominant cryptocurrencies strongly depend on cryptomarket factors and not on macro-financial factors. Specifically, crypto market price, trading volume, volatility and attractiveness (frequency of Google searches). Political factors were not analysed. I’d like to point out that this model used the price of a crypto market index as an explanatory variable for price changes of a specific cryptocurrency. As far as I know, it is supposed to be statistically wrong to explain price by price, though I accept that it might be just my lack of knowledge. Also, it didn’t include political factor saying that they couldn’t proxy it. But it should be possible to find such data and include it as a dummy variable, making 1 equal to legalisation in any country and 0 to “no changes”.

In some sense, combining two previous approaches, the last article studies both internal and external factors. Also, it includes a structural change in the market which is the bankruptcy of the largest Bitcoin exchange Mt. Gox in 2014: 2024 – Essay Writing Service | Write My Essay For Me Without Delay. It is supposed that most of the Bitcoins were stolen which greatly affected public trust. “The technology and economic determinants of cryptocurrency exchange
rates: The case of Bitcoin” by Li and Wang focuses on the Bitcoin-USD exchange rate over time, it uses time-series data and ADLR model. They find that the early market is more sensitive to social media and speculation, while the later market has matured and relies more on economic factors like interest rate and inflation. Interestingly, the cost-of-production effect, found in the third article tends to decrease over time as proof-of-work is being replaced by more effective algorithms requiring less electricity. Structural change in this study lets us see a difference between it and the previous article’s finding regarding crypto market factors such as volatility and trade volume. Results for the early market are the same, however, the later market is different. Short-run effect of trading volume has decreased while the short-run volatility impact has increased. Both long-run effects have become statistically insignificant.

It can be concluded that cryptocurrency value formation has some kind of intrinsic value, which is the cost of production, contrary to what general public claims. Also, it can be seen that just like any currency, cryptocurrency is affected by demand and supply, though supply is fixed and interest rates. The real sector has an effect mainly in the short run.

Reference list:
ElBahrawy, A., Alessandretti, L., Kandler, A., Pastor-Satorras, R., & Baronchelli, A. (2017).
Evolutionary dynamics of the cryptocurrency market. Royal Society open
science, 4(11), 170623.
Hayes, A. S. (2017). Cryptocurrency value formation: An empirical study leading to a cost
of production model for valuing bitcoin. Telematics and Informatics, 34(7), 1308-
1321.
Li, X., & Wang, C. A. (2017). The technology and economic determinants of cryptocurrency
exchange rates: The case of Bitcoin. Decision Support Systems, 95, 49-60.
Nakamoto, S., & Bitcoin, A. (2008 – Affordable Custom Essay Writing Service | Write My Essay from Pro Writers). A peer-to-peer electronic cash system. Bitcoin.–URL:
https://bitcoin. org/bitcoin. pdf, 4.
Sovbetov, Y. (2018: 2024 – Write My Essay For Me | Essay Writing Service For Your Papers Online). Factors influencing cryptocurrency prices: Evidence from bitcoin,
ethereum, dash, litcoin, and monero. Journal of Economics and Financial
Analysis, 2(2), 1-27.

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