What Determines Bitcoin's Price?
Bitcoin (BTCUSD) is a cryptocurrency developed in 2009 by Satoshi Nakamoto, the name given to the unknown creator (or creators) of this virtual currency. Transactions are recorded in a blockchain, which shows the transaction history for each unit and proves ownership.
Unlike investing in traditional currencies, Bitcoin is not issued by a central bank or backed by a government. And buying a bitcoin is different than purchasing a stock or bond because Bitcoin is not a corporation. Consequently, there are no corporate balance sheets or Form 10-Ks to review.
Understanding What Determines Bitcoin's Price
Unlike investing in traditional currencies, Bitcoin is not issued by a central bank or backed by a government; therefore, the monetary policy, inflation rates, and economic growth measurements that typically influence the value of currency do not apply to Bitcoin. Conversely, Bitcoin prices are influenced by the following factors:
The supply of Bitcoin and the market's demand for it
The cost of producing a bitcoin through the mining process
The rewards issued to Bitcoin miners for verifying transactions to the blockchain
The number of competing cryptocurrencies
Regulations governing its sale and use and the state of its internal governance
News developments
Supply
The supply of an asset plays an important role in determining its price. A scarce asset is more likely to have high prices, whereas one that is available in plenty will have low prices. Bitcoin's supply has been dwindling since inception. The cryptocurrency's protocol only allows new bitcoins to be created at a fixed rate, and that rate is designed to slow down over time. Thus, the supply of Bitcoin slowed from 6.9% in 2016 to 4.4% in 2017 and 4% in 2018.2 Bitcoin halving events, which occur every four years, generally correspond to a significant bump in its prices because it means that the cryptocurrency's supply has been reduced.
Demand
While Bitcoin is yet to find favor as a medium of exchange, it has attracted the attention of retail investors. The locus of Bitcoin's demand shifts based on economic and geopolitical considerations. For example, China's citizens may have reportedly used the cryptocurrency to circumvent capital controls in 2020.3 Bitcoin has also become popular in countries with high inflation and devalued currencies, such as Venezuela.4 It is also popular with criminals who use it to conduct transfer large sums of money for illicit activities.5 Finally, investor demand for the cryptocurrency has also risen with increased media coverage.
All of this means that a shrinkage in supply has coupled with surge in demand, acting as fuel for bitcoin prices. Alternating periods of booms and busts have become a feature of the cryptocurrency ecosystem. For example, a run up in bitcoin's prices in 2017 was succeeded by a prolonged winter.
Cost of Production
Just as for other commodities, the cost of production plays an important role in determining the price of bitcoin. According to research, bitcoin's price in crypto markets is closely related to its marginal cost of production.6
For bitcoin, the cost of production is roughly a sum of the direct fixed costs for infrastructure and electricity required to mine the cryptocurrency and an indirect cost related to the difficulty level of its algorithm. Bitcoin mining consists of miners competing to solve a complex math problem – the first miner to do so wins a reward of newly-minted bitcoins and any transaction fees that have accumulated since the last block was found.
Arriving at a solution to the problem requires brute force in the form of considerable processing power. In monetary terms, this means that the miner will have to spend money on racking mining machines equipped with expensive processors. The bitcoin mining process also incurs costly electricity bills that, according to some estimates, account for between 90 to 95 percent of overall costs.
According to estimates by some sites, electricity consumption for the bitcoin mining process is equal to or more than that of entire countries.7 An indirect cost of bitcoin mining is the difficulty level of its algorithm. The varying difficulty levels of bitcoin’s algorithms can hasten or slow down the rate of bitcoin production and affect its overall supply, thereby affecting its price.
Competition
Though Bitcoin is the most well-known cryptocurrency, there are hundreds of other tokens vying for crypto investment dollars. As of 2021, Bitcoin dominates trading in cryptocurrency markets. But its dominance has waned over time. In 2017, Bitcoin accounted for more than 80% of the overall market capitalization of crypto markets. By 2021, that share was down to less than 50%.
The main reason for this was an increase in awareness of and capabilities for alternate coins. For example, Ethereum's Ether (ETHUSD) has emerged as formidable competition to Bitcoin because of a boom in decentralized finance (DeFi) tokens. Investors who see its potential in reinventing the rails of modern financial infrastructure have invested in ether, the cryptocurrency used as "gas" for transactions on its network. On Oct. 13, 2021, Ethereum accounted for almost 18% of overall market cap of cryptocurrency markets. Ripple's XRP (XRPUSD) and Cardano's ADA have also surged in popularity, while growth in stablecoins had attracted investor attention towards Binance's BNB token.
Even though it has siphoned away investment dollars from the Bitcoin ecosystem, competition has also attracted investors to the asset class. As a result, demand and awareness about cryptocurrencies has increased. As a flagbearer of sorts for the cryptocurrency ecosystem, Bitcoin has benefitted from the attention, and its prices have surged.
Regulatory Developments
Bitcoin was released in the aftermath of a financial crisis precipitated by the loosening of regulations in the derivatives market. The cryptocurrency itself remains mostly unregulated and has garnered a reputation for its border- and regulation-free ecosystem. Bitcoin's regulatory status has its benefit and drawbacks. On the one hand, the absence of regulation means that it can be used freely across borders and that it is not subject to the same government-imposed controls as other currencies.
But it also means that Bitcoin use and trade can invite criminal consequences in most financial jurisdictions. The vast majority of institutional investors are still wary of putting their money into the asset class, resulting in less liquidity and more volatility for its ecosystem.
El Salvador made Bitcoin legal tender on June 9, 2021.8 It is the first country to do so. The cryptocurrency can be used for any transaction where the business can accept it. The U.S. dollar continues to be El Salvador's primary currency.
The more governments around the world incorporate bitcoin into their economies and markets, the greater its chances of becoming a legitimate asset class for investment. Cryptocurrency investors and traders follow regulatory developments related to Bitcoin closely because it is an indicator of liquidity in crypto markets. These developments exert pressure on its price because they affect its supply and demand.
For example, China's moves to ban bitcoin trading and limit operations of bitcoin mining infrastructure affect the cryptocurrency's supply and demand.
In the United States, cryptocurrency rulings delivered by the Securities and Exchange Commission (SEC) often have a direct impact on the price of Bitcoin. For example, in November 2021, the price of Bitcoin surged above $68,000, shortly after when the SEC allowed trading of the very first bitcoin-related ETF, the ProShares Bitcoin Strategy ETF (BITO).
News Developments
Bitcoin's nascent ecosystem means that news developments have a direct impact on its price. These developments can be of various types. As mentioned earlier, regulatory news can move the cryptocurrency's prices substantially. Hard and soft forks, which alter the number of bitcoins in existence, can also change investor perception of the cryptocurrency. For example, the forking of Bitcoin's blockchain into Bitcoin Cash in August 2017 resulted in price volatility and spurred the valuation of both coins to new highs.
Bitcoin's governance policies, which are set by a group of core developers, also affect its price. Protocol modifications that alter the number of bitcoin in existence or philosophical disagreements between developers about the cryptocurrency's future direction are closely watched investor indicators.
The Bottom Line
Even though it has been around for more than a decade, Bitcoin is still a nascent asset class. That means its price is determined by a complex combination of factors that include production costs, competition, and regulatory developments. The cryptocurrency's technological roots mean that other factors, such as the difficulty levels of its algorithms, and forks on its blockchains can also play an important role in determining its price.
Frequently Asked Questions
What is the price of one bitcoin?
The price of a single bitcoin is determined by several factors, including demand and supply, competition, and its regulation. News developments also influence investor perception about the cryptocurrency. The intrinsic value of one bitcoin can also be estimated by computing the average marginal cost of production of a bitcoin at any given point in time, based on the block reward, price of electricity, energy efficiency of mining hardware, and mining difficulty. On Nov. 8, 2021, bitcoin reached an all-time high of $68,521.
Will Bitcoin's price increase?
As Bitcoin nears its maximum limit, demand for the cryptocurrency is supposed to increase. The increased demand and limited supply pushes the price for a single bitcoin upwards. Also, more institutions are investing in Bitcoin, stabilizing its markets and making it popular as an investing tool. If bitcoin becomes popular as a tool for retail transactions, its utility and price will also increase.
How does Bitcoin supply affect its price?
Since Bitcoin's introduction in 2009, its supply has been diminishing. Every four years, the cryptocurrency undergoes a halving event during which miner rewards are reduced by half on average. The decline in supply corresponds to increasing demand due to media coverage and its price volatility. A combination of shrinking supply with a boost in demand has resulted in surging bitcoin prices.
How are bitcoin production costs related to its price?
According to research, bitcoin market price is closely related to its marginal cost of production. The breakeven costs for bitcoin mining vary based on the price of mining equipment and electricity. Estimates put the total share of electricity in bitcoin production costs at between 90% and 95% of the overall bill.
How does Bitcoin make money?
Unlike stock, Bitcoin does not represent ownership in a company or entity. Owning Bitcoin is like owning digital currency, much like owning $1 is like owning paper currency. Bitcoin holders make money as the price per coin increases. For example, if you purchased 100 coins at $65.52 on July 5, 2013, and held it until its all-time high of $68,521 on March 13, 2021, you would have $6,168,386.
Compete Risk Free with $100,000 in Virtual Cash
Put your trading skills to the test with our FREE Stock Simulator. Compete with thousands of Investopedia traders and trade your way to the top! Submit trades in a virtual environment before you start risking your own money. Practice trading strategies so that when you're ready to enter the real market, you've had the practice you need. Try our Stock Simulator today >>
Comments
Post a Comment