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Crypto supply and demand

Lesson in Course: Crypto (advanced, 8min )

What are some of the drivers behind the price changes of cryptocurrency?

The prices of stocks and other assets are anchored mainly by the value of future cash flows, subject to some supply and demand. Crypto is very new, and the future cash flows are uncertain, so the forces of supply and demand entirely guide current price movements.

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.

 

Speculation

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?

Utility

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 typically lowers the price.

 

Proof-of-Work (PoW)

Proof-of-Work is the original consensus mechanic for the decentralized network to agree on things like account balances and the order of transactions. Bitcoin and Ethereum currently use it.

Proof-of-work is the underlying algorithm that sets the difficulty and rules for the work miners do. Proof-of-work blockchains are secured and verified by virtual miners around the world racing to be the first to solve a math puzzle. The winner gets to update the blockchain with the latest verified transactions, and the network rewards them with a predetermined amount of crypto, called the block subsidy. 

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, adding them to a block before others.

Pros: 

  • 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

Cons: 

  • 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
Inside Iceland's massive bitcoin mine

 

Proof of Stake (PoS)

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. 

People sign up to be validators by staking their crypto in exchange for a chance of getting to validate new transactions, update the blockchain, and earn a reward. 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. 

 

Pros: 

  • Security: higher security per locked capital
  • Energy efficiency: less energy-intensive
  • Scalability: more predictable block times and faster transactions

Cons: 

  • 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 becomes a rich becomes richer scheme
Proof of stake - simply explained
 

Actionable ideas

Knowing the different concensus mechanisms helps us understand how the supply of a cryptocurrency changes over time, impacting the supply and demand economics that drive price changes. To earn a return, we want to invest in cryptos with sustainable growth in demand while having a sustainable supply. We can also use an income strategy for any crypto we own by staking.

Glossary

Proof-of-Work 

Proof-of-work is the original consensus mechanics for the decentralized network to agree on things like account balances and the order of transactions. It is currently used by Bitcoin and Ethereum. 

Proof-of-work blockchains are secured and verified by virtual miners around the world racing to be the first to solve a math puzzle. The winner gets to update the blockchain with the latest verified transactions and is rewarded by the network with a predetermined amount of crypto, the block subsidy.

Proof-of-Stake

Proof-of-stake is a faster and less resource consensus mechanism created to address the scalability pitfalls of proof-of-work. 

In a PoS system, staking replaces PoW’s mining to update transactions to the blockchain. People sign up to be validators by staking their own crypto in exchange for a chance of getting to validate new transactions, update the blockchain, and earn a reward. Ethereum plans to migrate to proof-of-stake from proof-of-work.

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