Why market cap is a poor measure of cryptocurrency value
Changes in the cap don't represent real gains or losses.
Market capitalisation is an often-quoted measure for the value of a particular cryptocurrency, but one market observer suggests that it's a poor model to follow.
Market cap is a formula used often by the share market. Take the number of shares, multiple that by the share price and you get a measure of a company's value, representing what a business is worth to the people that invest in it.
Similar measures are being used by folks trying to value various cryptocurrencies, but the measure may not make as much sense in this context. A core difference is that the number of shares issued by a company through a stock exchange is regulated. Let's say The Pretend Company has 1,000 shares available to the market with a current value of $10 per share. That gives The Pretend Company a market cap of $10,000. If the company decides to either add more shares or conduct a stock split, it needs to negotiate with the issuing stock exchange so that the money placed in the market by existing shareholders is not devalued.
In the case of cryptocurrencies, there's nothing stopping the currency creators from adding more coins to the pool. For example, Stellar has a current coin supply of almost 18 million coins and a maximum of almost 104 million coins. But the total number of coins available is designed to increase by 1% each year.
In one sense, cryptocurrencies are similar to traditional shares in that you can buy coins at a low price and they can increase in value. We've seen this with the recent explosion in the price of bitcoin. But the current coin value of around US$11,000 on a pool of about 16 million coins doesn't represent US$176 billion dollars of funds in the market.
Writing for CNBC, Julian Hosp from cryptocurrency debit card TenX provides a useful summary of the issue:
So, for a cryptocurrency to have a market cap of $1 billion, maybe only $50 million actually moved into the cryptocurrency. Therefore, if that coin collapsed completely, its market cap would go from $1 billion to zero, but investors would have actually only lost $50 million".
In other words: the market cap isn't a very useful measure of risk or value. Hosp suggests that it is a crude measure and that many other factors need to be considered when it comes to understanding the value of different cryptocurrencies.
Hosp also addresses another important question: if the current valuations on cryptocurrencies are a bubble, what would make that bubble burst?
He suggests that changes in regulation in the US and Europe, the collapse of exchanges, a fall in coin prices causing those who purchased coins using credit to default, and the potential that Tether might not be as secure as some people believe, are all factors that could contribute to a collapse in cryptocurrency valuations.