Cryptocurrency and cryptoassets are assigned value by market forces and move with demand and utility changes. People who buy bitcoin and other cryptocurrencies may wonder exactly how value is determined and what level of value loss risk exists.
A cryptocurrency’s value cannot go any lower zero. When you buy a coin or token, the price you pay is determined by the current market value plus any trading fees. You can also receive cryptocurrency for services or products, or from mining. The lowest market value those cryptocurrencies can fall to is zero.
Cryptocurrency values can fluctuate wildly based on market speculation, but the values can never be lower than zero. That would essentially mean that you would have to pay someone to take your coins or tokens. No asset, property, security or currency can ever be worth less than zero. But you can end up with a negative balance in an account if you trade on margin or participate in short-selling, which is discussed below.
How Does it Keep from Going Negative?
Before explaining this, it is important for you to know how exactly the entire transaction process works. I’ll explain it a little bit more in detail in a later section, but just so you know the basics of it and why it can’t go negative.
Cryptocurrencies like bitcoin use p2p-network technology (peer to peer). The cryptocurrency algorithms and transactions run on a blockchain computer network comprised of many nodes. Anyone can run a node.
Each node is given a list of all transaction histories along with the balance of each address. As soon as a transaction is confirmed, the file will read something like “(blank) gave Y amount to (blank),” and it is then signed before the computer nodes validate the transaction with a specific algorithm. After the transfer is officially verified, it is put together with past transactions to complete a new data block for the record books.
The data block is then set with the rest of the blockchain and cannot be changed or altered, thus completing the transaction. During the case of having insufficient funds in the account, within the algorithm is a code that will reject the transaction.
But it is not actually a balance that is being checked, but rather the input and output. The output is checked when sending the coin out in a transaction.
If you need an amount that was less than the amount you were offering, the output would be added to the amount being given so that you would get back change. The best analogy to use would be if you paid with a $10 bill for something that was only $8, and you received $2 back.
Rather than having an actual address balance be checked after each transaction, the inputs and outputs are monitored each time a new block is added to the chain.
This code allows the prevention of a negative “balance” by tallying each coin spent, not allowing anyone to be allotted more than what is had. The system may still re-check each block for any invalid transactions and store it so newer blocks can be added quicker.
Every output added to the chain is given a designated value, and whenever one is spent, the outputs are given a new sum that can’t be any more than what is being used.
And if a node is given a transaction that does not meet up to the cryptocurrency enabler’s rules, the spending of that coin would be rejected. Or if the value is negative on the output within the transaction, the block that contains it will not accept it.
One function of the blockchain system is to keep users from double-spending. With this, there is no such thing as an overdraft fee or need for it because there is no such thing as overspending.
Every Cryptocurrency has a Price
I keep using bitcoin as the main example because it is more well-known than all of the other major cryptocurrencies. For bitcoin, though there is no such thing as overdraft fees, there is a spending/miner fee. In order to use your bitcoin, you have to have enough to also cover the fee or else you can’t spend it. Consider this to be a transfer fee.
Now, say the desired item of the purchase cost only $2.50; in order to use the Bitcoin, you would need $3.05. And you can only spend your bitcoins if you have the extra $0.55 or else the transaction would be automatically rejected. By this, you can see that either way, a cryptocurrency address could not go into the negative.
Miners are the intelligence behind the blockchains, the people that verify the transactions rather than a single authoritative entity like a bank or credit card company. Typical transaction histories for purchases are generally documented through the bank, point-of-sale, and given receipts—miners manually group together blockchains and add them to a record that is easily accessible. The nodes then keep them stored for future verification.
Along with adding the transaction block to the chains, the miners are also responsible for checking the accuracy of each transaction. Meaning that they check for any sort of duplications or “double-spending.”
This is important because any online or electronic info can be easily copied where the user sends an amount to one party and turns around and sends it to another without any amount being deducted from the previous transaction.
Comparing the verification process to a manual situation, if a cashier wanted to check if a customer was double-spending their money with real cash along with a counterfeit, all they would have to do is check the serial numbers on their bill to see if they were exactly the same.
Read more in Why do blockchains need cryptocurrency?
These fees are placed on the amounts spent as an incentive for miners to confirm each transaction they receive. These fees added are one way miners are compensated for their services.
Once the blocks are added to the chains, they are unable to be changed or reversed. Depending on the amount of the fee placed on the transaction, it can either take minutes, hours, days, or weeks to have the transaction confirmed.
This is because miners are able to pick and choose which transactions they want to confirm first. The higher the fee, the more likely the transaction will be confirmed sooner.
There have been times where if the confirmation took too long, the entire transaction was rejected by the network and the funds were given back to the user.
Users can check their settings to make sure that the miner fee is properly calculated in order to make sure that each of their transactions is confirmed on time, even when the network is bustling with other transactions.
If you have an insufficient number of bitcoins and are unable to pay the set or recommended miner fee in tandem with your outbound purchase, you can lower it. However, that does not guarantee that your transaction will be approved within an adequate range of time and may render it void.
What about cryptocurrency investment value?
All of the above applies to the value of the currency at the time of spending, using or transferring it. But the underlying value of cryptocurrencies is determined right now purely by market forces. Buyers and sellers decide what bitcoin and other currencies are worth when they trade the coins.
When buying or selling, the value can also not be lower than zero. In general, buyers and sellers cannot lose greater than 100% of their investment. However, there are two specific situations where you lose more than the amount of money you invested: Short-selling and buying on margin.
Short-selling involves borrowing an asset from another account holder, selling it at current market price, and then hoping price drops so you can repurchase, return it to the lender, and pocket the difference.
If the price of the asset being sold short continues to rise, the potential loss is unlimited. The higher it goes, the more you lose.
So most short-sellers place limit or stop loss orders to rebuy before their losses exceed a preset level. Never short sell unless you know exactly what you are doing.
Buying on margin
The second scenario involves buying on margin. Essentially you are borrowing money from your selected exchange to buy more currency than you have the cash to pay for. If the price rises, you will have a multiple return over just the baseline price.
But if it drops, particularly if price drops rapidly, you may be required to deposit more money to bring the allowed borrowing ratio back up. If it drops too rapidly before you can comply, the exchange will automatically sell your coins to cover what you owe, and you may still owe more to cover the difference.
Preventing loss greater than amount invested
Because of the volatility of cryptocurrency, many exchanges implemented restrictions on margin trading in 2017. Before that time, some exchanges allowed you to buy 10 or even 20 times the coins you had the cash to cover.
When you buy on leverage like this, there is a time limit on how long you can borrow the money for. So if the coin drops and your margin call date is approaching, you could lose up to whatever multiple of your money you actually invested. You could end up losing 20x more than your invested dollar amount.
In 2018, several exchanges shut down margin trading while others limited it to a maximum of 2x ratio, which is the same as the U.S. stock market rules. But remember, we are talking about currency trading now, not the underlying coin value.
Investors in 2020 now have another way to protect or limit their losses: futures contracts. These can be used to partially bolster short and long positions by buying the opposite option contract.
In the event a currency moves in the wrong direction, you regain some of the loss with the futures contract value rise.
But these methods should be employed by experience investors only, and much too complicated to cover in this brief article. Investopedia has this decent article explaining how to hedge positions using futures contracts.
A cryptocurrency, like most assets, can never have a negative value. The lowest most investment and real property or asset can reach is zero. Unless you are talking about short selling or trading on margin, you can’t lose more than your invested proceeds. You might want to also read What determines the value of cryptocurrencies?
These are particularly important points to keep in mind now that 2020 volatility has returned to 2017 and 2018 patterns.
My personal advice has always been to only invest what you can afford to lose, and avoid margin trading. Short-selling has a role, as do option contracts, but those are topics for another time. Just be aware both require considerable experience to effectively implement.