Specific factors, issues, and narratives may dominate the market for shorter periods – such as Tether’s dominance and questions about its stability, or Bitcoin’s energy use. There are, however, certain core drivers that are persistently relevant to value creation and to investor sentiment in the crypto asset space.
Adoption
Whether a cryptocurrency is accepted as a store of value, or a medium of exchange, or derives its value from the level of activity on the platform, adoption is the core value driver.
Because of the network effect, accelerating adoption translates into an exponential increase in value. This is relevant both for the market as a whole, and for comparing projects.
Beyond economic value creation through greater participation in a network, adoption of crypto assets as investment products is also very relevant as it drives fund flows into the asset class.
Innovation
As one of most innovative sectors currently, a lot of value is created through new use cases emerging, technological solutions allowing previously impossible or uneconomic activities to take place, and constant improvements that facilitate or catalyse adoption.
New functionalities that improve the user experience, the security, cost, speed, or privacy fuel the continuation of the growth trend for the sector.
Projects usually advertise their efforts as significant innovation – but not all of them are, and it is important to assess the veracity of the claims.
Regulation
In terms of value creation, the primary relevance of regulation is that it significantly influences adoption, liquidity, and profitability.
Regulation can be either a positive or a negative. Banning certain activities or platforms shrinks the opportunity set, however, providing clarity and guidance facilitates adoption.
When regulators started providing clarity on the status, taxation, and anti-money laundering requirements for crypto projects, it opened the way for institutions to enter the market without unreasonable regulatory risk.
Tech challenges
As the technology is still young and very much evolving, difficulties with scalability, transaction speed and cost, energy use, security – and on the positive side, solutions to these difficulties – are important drivers of the market.
Code audits and ironing out bugs in the code are an important part of launching new projects and need to be ongoing activities for all protocols.
The major blockchain protocols are constructed in a way that they are very difficult to hack, the cost/benefit to a potential hacker is unattractive, and the network can quickly rebuild. Bitcoin has never been hacked.
However, there are vulnerabilities in terms of the users’ storage of their funds, or intermediaries such as exchanges that temporarily hold users’ funds. Most of the hacks and resulting losses have occurred on crypto exchanges.
Macro factors
In the early days, the crypto market was largely driven by idiosyncratic factors, uncorrelated to other asset classes either in a positive or negative way. However, as cryptocurrencies are increasingly embraced by institutions and enter the mainstream, they are traded more in the same context as other assets and the investment decisions are increasingly driven by macroeconomic factors.
As some crypto investors, especially corporate treasuries, regard cryptocurrencies (primarily Bitcoin) as an inflation hedge, inflation trends have become a relevant macro factor for crypto assets. And with the institutionalisation of crypto, the market is increasingly influenced by the macro trends that drive risky assets.
Sentiment
With the crypto market dominated by retail investors, sentiment and the cycles of fear and greed have been quite dramatic. As institutional investment is more disciplined, often valuation based and contrarian, we can expect this to subside. Nevertheless, sentiment indicators remain important in crypto.
As the crypto market structure matures, it is also becoming less vulnerable to manipulation; however, it is still important to notice the signs.
Key to remember
While timing the crypto market over the short term is a challenge, there are certain factors that are driving the direction of the market over the medium term. The underlying trends in investor and user adoption, enhancements and improvements in the technology, as well as the external economic and regulatory environment drive value creation in the crypto asset space.
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