Bitcoin is the most dominant cryptocurrency out of the thousands that exist today. It is the largest in market cap, and it pretty much influences investor sentiment about the rest of the cryptocurrencies. Bitcoin was created by a mysterious developer with the pseudonym Satoshi Nakamoto.
Bitcoin transactions i.e., buying, transferring, spending of bitcoins, are recorded on a public blockchain. Its transactions are pseudonymous, that is, a user’s personal credentials are not publicly displayed, but their public address/key is. This public address can be used to trace the owner of a transaction if need be.
Unlike conventional currency, Bitcoin is not issued by a central bank or rallied by the state. As such, monetary policies, interest rates, inflation, and so on do not apply to Bitcoin.
Curious Bitcoin investors may thus be gnawed by this question:
What is it that determines the price of Bitcoin?
Several factors determine its valuation, and we’ll look at each below:
Supply and Demand
Before we look at the supply and demand of Bitcoin, we need to look at what partially determines the supply and demand of fiat currency. Actions like adjusting the discount rate, Lowering or raising the reserve ratio, and so on can impact a country’s currency exchange rate.
Now the supply of Bitcoin is determined by other factors. To begin with, new bitcoins are generated at a fixed rate through a process known as mining. Mining involves verifying and confirming blocks of transactions and adding those transactions on the blockchain. The Bitcoin protocol is designed in a manner that the coins released into circulation will reduce over time. For instance, coins were generated at a rate of 6.9% in 2016, and this reduced to 4.4% in 2017 and to 4.0% in 2018. As fewer coins are released, demand increases. Demand being higher than supply will result in the price going up.
Secondly, the supply of Bitcoin may be determined by the number of coins the system is programmed to allow. Bitcoin’s supply is capped at 21 million. When this number of coins has been generated, mining will no longer create new coins. Already, Bitcoin’s supply has reached 18.1 million – this represents 86.2% of the crypto’s supply at that particular time.
Once we reach 21 million coins, the price of Bitcoin will depend on several factors. For instance, will it be a practical currency, i.e., usable in day-to-day transactions? Will it be legally recognized? Will it be in demand – which will be determined by the demand for cryptocurrencies in general? The controlled generation of bitcoins will no longer have an impact on its price.
Bitcoin may be the most important and recognized cryptocurrency, but there are thousands more vying for the world’s attention. As of March 2020, Bitcoin is still leading the pack in terms of market capitalization – but other cryptocurrencies are giving it a run for its money. Some of them aim to outdo Bitcoin in one functionality or another – either by solving a problem that bitcoin cannot solve, or improving a certain functionality, or being more innovative.
Cryptocurrencies such as Ethereum, EOS, Litecoin, Ripple, Tether, and Binance coin are some of its closest competitors. Besides, there are few barriers to entry into the crypto space, and new cryptocurrencies are constantly making the news. However, Bitcoin still maintains the highest visibility for any cryptocurrency. This gives it a certain clout and an edge over the competition.
Cost of Production
Bitcoin is a virtual currency, but its production is not very different from other products that incur a real-life cost. Bitcoin is famous for consuming electricity, the equivalent of entire countries. Generation of new coins – or ‘mining’ involves miners solving complicated math problems – with the first miner to solve the puzzle being rewarded with bitcoins and a fraction of transaction fees.
But Bitcoin, unlike other produced products, has an algorithm that allows only one block to be found every ten minutes. This means that the more miners in the network, the more difficult it is to find the answer to the puzzle. This means more energy is consumed in the process.
It also means the more producers (miners) that join in the competition, the more the problem is difficult – and thus more expensive – to solve. Research has demonstrated that Bitcoin’s price is indeed tied to its cost of production.
Availability on Crypto Exchanges
Very much like how equity investors trade stocks and bonds over stock exchanges, crypto investors also trade crypto-currencies over cryptocurrency exchanges like Coinbase Bitfinex, Binance, Poloniex, Coinmama, Bitpanda, and so on. Also, just like the traditional exchanges, Crypto exchanges allow investors to trade crypto in pairs, e.g., Bitcoin/Ether (BTC/ETH).
The more popular an exchange is, the more traders and investors it draws. This increases market liquidity for currencies listed on the exchange, increasing their demand. Also, since these exchanges operate in jurisdictions where they are regulated, the presence of, let’s say, Bitcoin, implies regulatory compliance, rendering Bitcoin a legitimate currency in the eyes of the public and potential investors. This matters because the legal standing of cryptocurrencies is currently sort of in a gray area.
Regulation and Legal Matters
Bitcoin and other cryptocurrencies have become so popular that regulators are not sure how to classify them. For example, the Securities and Exchange Commission (SEC) classifies the digital assets as Securities, while the US Commodity Futures Trading Commission (CFTC) classifies them as commodities. This confusion over what kind of assets cryptocurrencies are, as well as the tumble over which regulator gets to set the rules, creates uncertainty that impacts the value of cryptocurrencies.
Also, the finance market is now witnessing the introduction of new financial products – such as exchange-traded funds futures and other derivatives that use Bitcoin as the underlying asset.
This impacts the price of Bitcoin. First, it expands bitcoin’s access to investors who could not afford to buy it. This increases Bitcoin’s demand. Secondly, it can mitigate the volatility of Bitcoin, since institutional Bitcoin derivatives’ investors can use their massive resources and market influence to bet on which direction Bitcoin’s price will move.
Governance Stability (or lack of) and Forking
Bitcoin is a decentralized and autonomous network – meaning it’s not governed by any single entity. As such, it relies on network participants to process transactions and protect the network. Any updates to the Bitcoin protocol are done only after consensus is reached, meaning issues take longer to resolve as opposed to a centralized system where decisions are made by those at the top and implemented as quickly as possible. This is frustrating for the community and might cause many people to invest in other cryptocurrencies.
Bitcoin’s scalability issue is another problem. Any blockchain’s volume of transactions depends on the size of the block, and Bitcoin’s current 1MB block size severely limits the number of transactions that can be processed in one second. This wasn’t an issue before cryptocurrencies became hugely popular, but the slow transactions on Bitcoin might push people towards cryptocurrencies with a faster transaction time.
Bitcoin enthusiasts have been at loggerheads over how to best increase the speed of transactions. This can be achieved via one of two types of software updates – which are called forks. Soft forks constitute rules or updates that do not permanently split the blockchain and result in a new cryptocurrency. Hard forks constitute a permanent split of the blockchain and, with it, the birth of a new cryptocurrency. The Bitcoin blockchain has previously undergone hard forks that resulted in Bitcoin Cash and Bitcoin Gold cryptocurrencies.
Hard forks do not just split the blockchain; they also split the community. The Bitcoin Cash fork was particularly acrimonious. When events like these happen, they splinter a cryptocurrency’s user base, which is also the investor base. This can reduce demand for that cryptocurrency, lowering its price. It can also negatively affect investor sentiment, which has the same effect.
Now that you know how the Bitcoin price comes to be, you’re better placed to know how certain events, either internal or external, to Bitcoin, affects its price. And while no one can accurately predict the exact price of the currency, at least you can foresee potential movements in its price long before it happens. This can help you know better decide if to buy or sell.