What drives Bitcoin price?
Bitcoin’s roller coaster pricing is well documented. The cryptocurrency soared to nearly $20,000 per coin at the end of 2017, and then fell slowly throughout 2018. That slow decline, however, was punctuated by regular bursts of price increases. It’s a volatile picture and one that is hard for Bitcoin watchers to predict.
So what drives Bitcoin’s price? There are lots of factors but here are eight of the most important drivers behind price changes for Bitcoin and other cryptocurrencies:
- Supply and demand
The most basic principle governing the pricing of anything is supply and demand. When supply of something is low and demand is high, people are typically willing to pay more. When supply is plentiful and demand is low, prices tend to fall. In the case of Bitcoin, supply is ultimately limited. Once 21 million Bitcoins have been mined, no more will be created. That point won’t be reached until 2040, so for now supply of Bitcoin can be considered a constant. However, because of some of the factors we’ll cover below, demand has been steadily rising. This is a recipe for increasing price.
- Price discovery
The price discovery mechanism is the process of determining the value of a commodity, currency or a similar asset. It’s different from the process of pricing a new service or product, which typically sees a company do market research to determine what customers are willing to pay. Instead, price discovery takes into account supply and demand and things beyond that, such as the overall economy, risk attitudes of buyers, the number of buyers and sellers, the political climate and numerous other factors. As each trade is made, the market comes closer to an accurate price, but new information can always affect future trades. In the case of Bitcoin, which is based on a new technology, new information is arriving regularly, which has made for a volatile price.
- Investor herd mentality
Investors pride themselves on doing their research, assessing the market and determining their own appetite to risk before they make an investment decision. However, they don’t always act that way. Investors are only human, and they are subject to the same influences as everyone else. It’s easy for a herd mentality to arise when there’s the possibility of missing out on the next big thing. There have been such big gains to be made in Bitcoin’s rapid price rises that it’s easy to imagine many investors buying-in purely to avoid being left behind. Likewise, when everyone starts to sell, many investors ignore their instincts and expertise and simply follow the crowd, just in case they are left holding an asset that is no longer worth anything.
- Media coverage
We’ve already mentioned “information” several times. It’s a key factor in determining any purchasing decisions. You might have a need for a new phone, for example, and so you have decided to buy one that has specifications matching your needs. But you will probably consider other information too, such as reviews or reports that supply chain problems will make it hard to find in the shops. The same is true with buying something like Bitcoin. News stories can have a major impact on purchasing behaviour. A report that a major retailer is accepting Bitcoin will drive purchasing and boost price. An interview with a major influencer, who warns that cryptocurrency is a bubble, could see people sell, driving prices down. For example, Investopedia argues that negative press around the bankruptcy of the Mt Gox exchange and high-profile arrests of criminals using cryptocurrency to buy and sell drugs on the dark web, had a negative effect on adoption and price. Then there is simply the media cycle of hype. If consumers are interested in stories about something new, then the media looks for even more stories and the hype around the topic grows. That fuels excitement, causing some people to buy. However, hype tends to follow a curve and eventually people become disillusioned, so buyers are discouraged.
One of the fundamental principles behind Bitcoin and other cryptocurrencies is that they are decentralised and therefore not controlled by any one body, like a central bank or a government. But because they clearly operate in the financial services sector, which is heavily regulated for consumer protection, cryptocurrencies have been attracting attention from regulators. The approach that regulators take affects investor confidence. For example, when China announced that it was shutting down Bitcoin exchanges, prices fell by almost a third in just 24 hours. Investors were concerned about losing access to such an enormous market. Reactions to regulation are not always bad, though. Bitcoin prices rose immediately after Japan announced that it would consider Bitcoin to be legal tender. In the weeks following the announcement, prices rose by 160 per cent.
- Political and economic instability
One of the advantages of a decentralised currency is that it is insulated, to an extent, from the political and economic instability that can affect a nation’s currency. For example, when Greece was plunged into economic turmoil in 2015, some citizens bought into Bitcoin to protect themselves when Greek banks were closed. Similarly, in the weeks following the British Brexit vote in 2016, the value of the pound fell sharply. This was matched by a simultaneous increase in the price of Bitcoin. It’s very hard to prove a link between these two factors, but it is certainly possible that investors are seeing Bitcoin as a safeguard against political and economic problems in particular countries.
- The network effect
Any network grows stronger as more people use it. A telephone is part of a network, for example. There’s little point in being the only person with a telephone, but the more people who have one the more useful it is for everyone in the network. In contrast, cars are not a network. As more people use them the roads become more congested for everyone, and pollution, noise and so on increase. Bitcoin, like any currency, benefits from network effects. People are not going to use it as a currency until there are places where they can spend it, for example. As more outlets accept Bitcoin, the benefits of using it increase. This network effect is an important reason for the steady increase in demand.
- Governance issues
Bitcoin might be decentralised, but it still has its own rules and governance procedures. For example, Bitcoin transactions are verified in blocks by computers on the network that are known as miners. Miners receive a small amount of new coins as a reward for verifying the transactions. The method of verification and the size of a block of transactions are rules that are determined by the community and they can be changed. Major changes result in a divide in the blockchain, known as a fork. A ‘hard’ fork effectively creates a second, separate blockchain, and the two proceed separately. A ‘soft’ fork, in contrast, simply changes the rules for the existing blockchain. These changes often split the community. In any large group, not everyone will agree. But the resulting debate can be off-putting for investors, who fear for the stability of the project following the fork.
The interplay between the factors above is complex and unpredictable. For example, a change in governance procedures will generate media coverage that, in turn, will affect demand, which might have the knock-on effect of creating a herd mentality. Also, these factors are not mutually exclusive; they are all in play at the same time, making it difficult to assign a price increase or drop to any single factor. Nevertheless, analysing these trends can give an insight into particular price moves. Being able to predict them is the objective of any experienced investor.