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What factors influence the value of Bitcoin?

bitcoin price

If there are two things about the digital currency Bitcoin that have become synonymous with it, it’s people insisting that its value is based on nothing, and the legendary volatility in its price means you could experience a 25% change in a single day.

So, it is based on nothing? And why does that nothing keep changing price from something to something else? What is that nothing? Is it a share of something? Is it currency or property?

That last question is an important one: Bitcoin is recognised as a digital currency in many countries, but fewer countries have adopted it as legal tender. Some tax systems think of Bitcoin as a commodity rather than a currency, which changes how it’s taxed. And Bitcoin doesn’t represent a share in any real-world asset: it’s a store of value on its own.

If you were to look at most sources, they’re all in agreement with the rest of economics about what makes something worth something.

1. Scarcity

There will only ever be 21 million bitcoins, and it gets harder to mine them over time. Regardless of what it is, economists believe that the scarcity of something contributes to the value of something. That’s actually the argument for the value of NFTs, which are one-off tokens representing a digital asset. The problem with those is that while a single NFT is scarce, there are lots of competing NFTs.

Not all cryptocurrencies or tokens are limited in number: for instance, there can be infinite numbers of ETH. But, they’re not introduced all at once.

Some believe that scarcity is the engine of Bitcoin’s price growth over the long term.

2. Demand for Bitcoin

As we saw with NFTs, something can be as scarce as it likes, but if no one wants it, it’s worthless. Luckily, there’s a demand for Bitcoin – but that’s highly variable. At times of high demand driven by hype, Bitcoin has reached all-time highs undreamt of by people who were mining it when it was worth £1 (a bull market).

At other times, demand is so poor that supply outweighs it and the price goes down over time (a bear market). If it goes on for a while, it’s called a “crypto winter”. We’re in one now.

3. Production Costs

Part of the argument that Bitcoin is based on “something” and isn’t just created out of thin air is that work has to be done to mine it. Specifically, each bitcoin requires computers all over the world to compete to solve mathematical puzzles by brute force. Where in the early days it could be mined by a laptop, nowadays you need specialised hardware that dates surprisingly quickly, and a lot of electricity (70% of Bitcoin is mined from renewable sources that are cheaper: you don’t hear that statistic a lot).

There are times when the value of the Bitcoin mined is less than the production cost: in those times, miners have to have faith and HODL it until better times. People were still mining Bitcoin in late 2018 when it was just over $2000 and it cost a lot more than that to mine it. They were rewarded later with much higher prices.

4. Competition from other cryptocurrencies

You would think that competition from other cryptocurrencies would have an effect on the overall value of Bitcoin, but it’s not clear that’s happened, even though the market dominance of Bitcoin has decreased from over 80% to a shade over 45%. ETH has more competitors than BTC does, and it’s into ETH competitors that the market cap is going.

In the end, Bitcoin still pulls the market about more than being pulled about by the market (with the exception of one-offs, like the LUNA/UST coin selling off its bitcoin stash).

5. Regulation

Except for the panic caused by FUD news (fear, uncertainty, doubt), the impact of regulation on the price of Bitcoin is difficult to ascertain because regulators are slow-moving, and it could have two distinct effects.

  1. Regulation tightening Bitcoin controls (such as fiat off-ramps) might spark selling.
  2. Regulations friendlier to institutional involvement in Bitcoin might spark buying.

6. Bitcoin Community News

Sites such as Coindesk always feel like they have to explain why Bitcoin did something on a given day. Usually, that takes the form of looking at the news and then picking something that might (if you squint) cause selling/buying.

While the Bitcoin market was mostly whales and retail investors (because Bitcoin was out of bounds to institutional investors), it was always a bit silly to look at a large amount of Bitcoin being sold in a half-hour period and then somehow assume a lot of individual investors saw some news, decided to sell, went home, logged in, and panic sold – all in the same 30 minutes.

It is true that a whale selling could affect the market substantially: but wouldn’t it be strange if someone experienced enough to become a Bitcoin whale, who had endured crypto winters and threats from regulators was suddenly as twitchy as a newbie? It’s not likely.

However, there is one new kind of whale who is most definitely twitchy enough: at least, when enough of them act in unison with automated trading…

7. Institutional Involvement

You’d think that institutions and funds investing in Bitcoin would be stable and professional. But when a professional in charge of a fund raised on normal stock indexes sees the “risky” crypto part of his portfolio crashing, he’d rather sell now (“reduce his exposure”) and ask questions later.

This is why Bitcoin is now correlated with the stock market to an alarming degree, considering it was supposed to be an alternative investment.

There’s one more factor in the price of Bitcoin: more important than all of the other factors combined, at least on a day-to-day level.

And that’s derivatives with leverage. Or, as some like to call it, gambling.

8. Derivatives

There are many places where you can place bets on Bitcoin going up or down. This is no different in principle to other areas of traditional finance. The idea is that you place a bet on Bitcoin going up or down. The price of Bitcoin at the time you place the bet is all-important. The more Bitcoin moves in your preferred direction, the more money you make until you close the bet. Closing the bet involves Bitcoin being bought or sold using “market orders” – that is, just throwing orders at the market not caring about the price.

Now, one person closing a bet isn’t going to decimate the market. But, if Bitcoin moves the wrong way, the bet gets into more and more trouble until it’s “liquidated” by the exchange: that is, the bet is forcibly closed, Bitcoin is bought, and the gambler loses their money.

Whenever you see a big change in Bitcoin price over a very short amount of time (for instance, in 30 minutes), this will almost certainly be gamblers getting liquidated, with a flood of sells or buys driving the price up or down by brute force. If the price is going up, that’s called a “shorts squeeze” (a “short” is betting something will go down). The opposite, where the price goes down is a “longs squeeze”.

Now, none of this would be too much of a problem if people weren’t trying to magnify the size of their bet, sometimes up to 125 times its normal size, a process called “leverage”: the more leverage, the more you can make, but the more likely you are to get liquidated.

So…

Liquidations of leveraged gamblers are thus the biggest day-to-day effect on Bitcoin. When that’s not happening, Bitcoin usually moves more-or-less sideways, drifts down or drifts up. When whales or institutions dump, or liquidations happen, the price is wrenched up or down, only for the process to repeat.

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