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This blog post explores Bitcoin's price factors, emphasizing supply and demand, scarcity, and the halving. It notes the impact of market dynamics and speculation while advocating for Bitcoin's use as a medium of exchange and a balance between holding and spending.
As a companion piece to Bitcoin’s price explosive rally, it’s time to unpack one of the industry’s biggest mysteries. Sure, the law of supply and demand is at the center of Bitcoin’s price discovery, but we’re talking about the world’s biggest decentralized network here. If an authority doesn’t determine the price, how does the magic trick work? The answer might surprise you.
On the one hand, it’s simple and only logical. On the other, it’s mind-blowing.
Let’s start with a few basic concepts and then dive in.
The main aspect that affects Bitcoin’s price is its scarcity. The open and hard-coded monetary policy also helps. Bitcoin’s supply is inelastic, the release schedule was determined at birth, and there’s a hard supply cap of 21 million BTC.
Let’s put it in simpler terms. With most other commodities, if the price rises, the demand rises and so does the production. The difficulty adjustment and Bitcoin’s hard-capped supply prevent that, so, what happens? If the market calls for more BTC and doesn’t receive it, the price keeps rising until the system achieves equilibrium.
For another perspective, let’s consult a not Bitcoin-focused organization. This is the CFA Institute’s take on Bitcoin’s price:
(Bitcoin) “Doesn’t generate cash flows, pay dividends, or otherwise offer yields, and thus may be more reminiscent of commodities, which are both cyclical in nature and notoriously difficult to value.”
To summarize, Bitcoin is not backed by an underlying asset and it’s not under any government’s jurisdiction. Bitcoin IS a real asset, but it’s also money. And in the complex world of foreign exchange, there’s a dollar value for it. The main tool to find that elusive number is the law of supply and demand.
The Bitcoin network rewards miners for their hard work validating transactions and securing the network. Those rewards solve the issuance problem by releasing fresh BTC into the ecosystem. However, every four years the system cuts rewards in half. Let’s recap what the halvening does to Bitcoin’s supply:
“Every 210,000 blocks, which amounts to approximately every four years, the Bitcoin network cuts the “block subsidy” in half. The event is called “the halving” or “the halvening” and it just happened, on April 20th we entered the 3.125 BTC per block era. Before that, the reward had been 6.25 BTC for four years; before that, it was 12.5 BTC for four years.”
Bitcoin’s price rises with demand and shrinks when demand subsides. Every four years, the system cuts the supply of new bitcoin in half. That shock causes the price surges that, in turn, shock the world. In about 100 years, the total supply of 21 million BTC will be out and available, and we’ll enter another era. That’s not today’s topic, though. Let’s focus on Bitcoin’s price.
Believe it or not, there’s not an official or central Bitcoin price. Each exchange or service quotes its own price based on its user’s activity. The price we see is just the last price someone processed a transaction. However, if that’s the case, how do different exchanges’ prices follow each other in a synchronized manner?
The price for an immediate sale is an ASK, the price for an immediate purchase is a BID, and the difference between them is the SPREAD. If prices between exchanges vary too much, someone makes money out of it. Traders who buy and sell to capture the spread and make a profit are called market makers. At the moment, market makers are mostly robots.
The more liquid a market is, the thinner the spread. Bitcoin is liquid enough for the market to autoregulate. Plus, of course, exchanges and services have access to each other’s numbers and use the data to base their prices. There’s no need for a central authority. This arbitrage game is enough to stabilize prices across the board.
To clarify further, this is Investopedia’s description of the double-auction market system:
“In an auction market, buyers enter competitive bids and sellers submit competitive offers at the same time. The price at which a stock trades represents the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept.”
Change “stock” for Bitcoin’s price and we’re good to go.
As described above, the Bitcoin network is a dynamic ecosystem in constant price discovery mode. The environment is not stable and will not be for a long time. This uncertainty is something every Bitcoiner has to deal with. The reason is simple, as River Learn puts it:
“Thanks to a finite supply and a relatively small market cap, the price of Bitcoin is also much more sensitive to changes in demand, resulting in increased price volatility.”
Another reason for the Bitcoin’s price wild mood swings is “the availability of liquidity in global capital markets.” Back to River:
“Based on available economic data, bitcoin’s price appears to be influenced by the availability of liquidity in global capital markets. When there is more money available, price tends to increase, generally speaking.”
The CFA Institute echoes the same idea, “under tighter macro conditions, bitcoin is less valuable. Under loose conditions, it is more valuable.” The CFA even came up with a third way to convey this fact, “Bitcoin is overvalued when short-term speculators hold more of the supply and undervalued when long-term holders predominate.”
Everything changed on December 17th, 2017. The CME started trading Bitcoin Futures and Bitcoin’s price took a hit. Before that moment, only Bitcoin-positive people were invested in the market. If you believed in Bitcoin, you bought BTC and that was it. After CME started trading, all the Bitcoin doubters had a vehicle to bet against the asset. That put downward pressure on the price and likely stiffened the historic bull run Bitcoin was on.
This is how Investopedia explains Futures trading:
“Futures are contracts to buy or sell a specific underlying asset at a future date. The underlying asset can be a commodity, a security, or other financial instrument. Futures trading requires the buyer to purchase or the seller to sell the underlying asset at the set price, whatever the market price, at the expiration date.”
How does Futures trading directly affect Bitcoin’s price? The Federal Reserve Bank of San Francisco explains it in simple terms:
“With offers of future bitcoin deliveries at a lower price coming through, the order flow necessarily put downward pressure on the spot price as well. For all investors who were in the market to buy bitcoins for either transactional or speculative reasons and were willing to wait a month, this was a good deal. The new investment opportunity led to a fall in demand in the spot bitcoin market and therefore a drop in price.”
Or, to put it another way, “the launch of bitcoin futures allowed pessimists to enter the market, which contributed to the reversal of the bitcoin price dynamics.”
Bitcoin doesn’t care. Tick tock, next block.
It took a while, but Bitcoin took all the hits and emerged victorious on the other side.
Nowadays, the Bitcoin market is even more sophisticated. Besides derivatives, the extremely successful Bitcoin ETFs are eating a large chunk of the demand. Or, for the optimists, creating institutional demand.
According to Investopedia:
“An exchange-traded fund (ETF) is a pooled investment security that can be bought and sold like an individual stock. ETFs can be structured to track anything from the price of a commodity to a large and diverse collection of securities.”
The good thing for Bitcoin is that the issuer of the ETF has to buy the underlying asset. The bad thing for ETF clients is that, even though they’re exposed to the price action, they don’t own or hold the Bitcoin themselves. And you know that Bitcoiners say, “Not your keys, not your coin.”
For every asset, there’s transactional demand and speculative demand. All the trading, the derivatives, and the ETFs fall into the second category. According to the FRBSF, “speculative demand is basically a bet on the price of the underlying asset or currency increasing, because the investor does not need the asset itself.”
HODLing also falls into speculative demand, and it makes sense because Bitcoin is an asset in perpetual price discovery.
However, the future of Bitcoin is in transactional demand. In Bitcoin as a medium of exchange. In circular economies. According to the FRBSF, “we know that bitcoin is used as a means of exchange in a number of markets. The amount of bitcoins needed for these markets to function constitutes transactional demand.” However, “as speculative dynamics disappear from the bitcoin market, the transactional benefits are likely to be the factor that will drive valuation.”
Stop HODLing your Bitcoin so close to your chest. Spend and replace. Support Bitcoin businesses and circular economies. Sowe the seeds for the next stage and Bitcoin’s price will surge accordingly.
Keep HODLing too, of course. Bitcoin can and should be a store of value AND a medium of exchange. When we achieve that, the world can follow in Prospera’s footsteps and use Bitcoin as a unit of account.
