Market capitalization is a well-known indicator by cryptocurrency enthusiasts and the financial markets in general. Used regularly to judge the upside potential of a cryptocurrency, it is nonetheless questionable. Between genuine interest and unfounded beliefs, an overview of a valuable indicator for the rigorous investor.
Market capitalization: definition and utility
Like other assets, a cryptocurrency investor will always be interested in tools and indicators to measure their values. This value is essential because it allows identifying development prospects, whether they are positive when a cryptocurrency is undervalued or negative when it is overvalued.
It is from this context that the Market Cap or Market Capitalization derives its interest. It is the result of two attributes common to all cryptocurrencies: the price and the number of units in circulation.
The simplicity of this calculation probably explains why market capitalization is attracting so much interest. It is easily identifiable for each cryptocurrency, which allows them to be classified and categorized. This is the approach favored by CoinMarketCap and CoinGecko, two reference websites for information related to the cryptocurrency market.
Various properties are commonly associated with the size of a market capitalization. Generally, a cryptocurrency with a low market capitalization presents a higher risk of volatility than a cryptocurrency with a large market capitalization. While investing in the latter is therefore considered a more cautious strategy, the associated upside potential is on the other hand less.
Ethereum vs Fantom (FTM)
Take the example of two cryptocurrencies: Ethereum (ETH) and Fantom (FTM). ETH is ranked, as of December 2, 2021, as the second largest capitalization in the sector at $ 536 billion, FTM ranking 40th with $ 5.3 billion. Therefore, ETH has a market capitalization 100 times that of FTM. By keeping the same number of units in circulation, ETH’s market capitalization will need to increase by $ 530 billion to double its price. FTM’s market capitalization will only have to increase “just” by $ 5.3 billion …
In addition, observing the Market Cap allows to deconstruct the idea that a cryptocurrency whose price is low would have a greater upside potential than those whose price is high. In fact, at the same market capitalization, a cryptocurrency with a very high number of units in circulation will have a lower price than another, without this affecting its upside potential.
VeChain (VET) vs Internet Computer (ICP)
Let’s now take the example of VeChain (VET) and Internet Computer (ICP), two cryptocurrencies whose market capitalization is about the same: ± $ 7.3 billion. The VET price, on the other hand, is $ 0.11 compared to $ 40 for ICP. This difference is explained by the number of units in circulation, which is 350 times higher for FP. Therefore, despite these price differences, their upside potential relative to market capitalization is only appreciably similar.
Market capitalization: a limited indicator
While market capitalization can be useful as a comparison tool within the same asset class, it is nonetheless limited. The fault, among other things, in its two components: the price and the number of units in circulation.
The price, in the first place, is just the meeting of a supply and a demand at the same time T. Imagine, for example, that Alice makes the first transaction of a cryptocurrency with Bob, for a price of 10 dollars. Does this really allow you to judge the value of this cryptocurrency? Obviously not. The relevance of the Market Cap therefore depends on the “quality” of the price, that is, on the volume of supply and demand available: liquidity.
Also, contrary to popular belief, the market capitalization of a cryptocurrency is not equal to the amount of money injected. When a market capitalization falls, for example, by $ 10 billion, that does not mean that this $ 10 billion has left the market. Therefore, it is difficult to associate the notion of value with it.
Let’s take the example of a cryptocurrency X whose price is $ 10 and the number of units in circulation is 1000. The market capitalization of this cryptocurrency is therefore 10 x 1000 units = $ 10,000.
Alice, who owns 100 units of cryptocurrency X, decides to sell it to Bob at a unit price of $ 20. The value of this transaction is 20 x 100 units = $ 2,000. The new market capitalization for cryptocurrency X is 20 x 1,000 units = $ 20,000.
Thus, 2,000 dollars exchanged allowed the Market Cap to increase by 10,000 dollars.
The number of units in circulation, then, varies regularly depending on the Tokenomics (token economy) associated with a cryptocurrency. This Tokenomics is specific to each project and can include very different mechanisms of emission, distribution and monetary scarcity. From this distortion arises the appreciation of the upward potential of a cryptocurrency thanks to the Market Cap, neglecting the future evolution of the number of units in circulation in favor of an appreciation in an instant T.
Furthermore, when considering all units in circulation in its calculation, the Market Cap does not exclude units definitely lost after the loss of a private key or even after the death of its owner. However, these will never be in circulation again. A study published in April 2021 established, for example, that the number of bitcoins actually in circulation would never exceed 14 million, compared to the 21 million initially foreseen by the protocol.
Finally, the Market Cap is obviously not an indicator that allows to judge the fundamental quality of a project, the innovation provided, the developers involved, the loyalty of a community, etc. These are all factors on which the upside potential of a cryptocurrency also depends.
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Market Capitalization: A Self-Fulfilling Prophecy?
The search for a metric to estimate the upward potential of a cryptocurrency leads the investor, even educated, to sometimes forget an essential element: irrationality.
If most investors think that they find a reliable estimate of the value of a cryptocurrency in the Market Cap, are they not right? By using this indicator on a daily basis to judge the potential of a cryptocurrency, don’t you end up putting it to real use, as a self-fulfilling prophecy?
Self-fulfilling prophecies are especially destined to take place in an environment like finance, where individual psychology and speculation collide. A factor that, therefore, cannot be ignored.
Therefore, if market capitalization is too limited an indicator to solve on its own in an equation as complex as that of the upside potential of a cryptocurrency, it is interesting within an asset class that responds to the same codes and points of interest. reference. And while the markets have shaken a bit in recent days, continue to do your homework as a smart investor by reviewing, as a precaution, the 10 fundamental rules to prepare for a bear market.
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