How is bitcoin price determined?
In Bitcoin (BTC), there are no company balance sheets to examine, no fund performance to compare or other traditional tools to choose an investment.
Simply put, the price of bitcoin goes up when the demand for bitcoin increases, and the price goes down when the demand for bitcoin decreases. Demand depends on a number of factors, such as global events, including declines and increases in stock and bond prices, and global economic events.
However, unlike the monetary policy of countries with fiat currencies, which is subject to change based on political and economic events, the bitcoin ecosystem is a completely decentralised monetary system. No central authority regulates the monetary base, which is why the creation of Bitcoin follows detailed rules in a very strict protocol, which we have detailed for you below.
Find out what influences the price of bitcoin so you can make more informed decisions about your choice as an investment.
How is bitcoin price determined?
Bitcoin is not issued by a central bank or backed by a government, so the monetary policy tools, inflation rates and measures of economic growth that typically influence the value of a currency do not apply to Bitcoin. Bitcoin acts more like a commodity that is used to store value, so the following factors influence its price:
- Supply and demand for Bitcoin in the market
- The cost of producing bitcoin through the mining process
- Competing cryptocurrencies
- Media and news
Supply and demand for cryptocurrencies
The value of cryptocurrencies is determined by supply and demand, just like anything else people want. If demand increases faster than supply, the price goes up. For example, if there is a drought, the price of grain and produce goes up if demand does not change. The same principle of supply and demand applies to cryptocurrencies.
A cryptocurrency gains value when demand exceeds supply. The supply of an asset plays a significant role in determining its price. An asset in short supply is more likely to have high prices, while an asset in abundance will have low prices. The supply of bitcoins is generally well publicised, as only 21 million will be produced and only a certain amount will be created per year.
The bitcoin protocol only allows new bitcoins to be created at a fixed rate and this rate is designed to slow down over time. The supply of bitcoins increases by a fixed amount with each new block mined on the blockchain. Consequently, the increase in supply is not so fixed. Demand can also increase when bitcoin acquires a new utility, for example. The wider adoption of a cryptocurrency as an investment also increases demand, effectively limiting the supply in circulation.
For example, when institutional investors began buying and holding Bitcoin in early 2021, the price of Bitcoin increased significantly as demand exceeded the rate of new coin creation, effectively reducing the total available supply of Bitcoin.
Bitcoin production through mining
For bitcoin, production costs are roughly the sum of the direct fixed costs of the infrastructure and electricity required to mine the cryptocurrency and the indirect costs associated with the difficulty level of the algorithm. Bitcoin mining consists of a network of miners competing to solve a crypto number – the first miner to succeed wins a prize of freshly mined bitcoins and all transaction fees accrued from the discovery of the last block.
New cryptocurrency tokens are produced through a process called mining. Cryptocurrency mining involves the use of hardware to verify the next block on the blockchain.
The decentralised network of miners is what allows cryptocurrencies to function in this way. In return, the protocol produces remuneration in the form of cryptocurrency tokens, in addition to the fees paid by the miners. Blockchain verification requires computing power. Participants invest in expensive equipment and electricity to mine cryptocurrencies.
In a proof-of-work system like Bitcoin, the more competition there is to mine a given cryptocurrency, the harder it is to mine it. This is because miners are essentially competing with each other in solving a complex mathematical problem to verify a block. Thus, the cost of mining increases because more powerful equipment is needed to perform it successfully.
As the cost of mining increases, so does the value of the cryptocurrency. Miners will not mine if the price of bitcoin is not high enough to offset their costs. And since miners are essential to the functioning of the blockchain, as long as there is demand to use the blockchain, the price will have to increase.
How competition affects the price of bitcoin
Although bitcoin is the best-known cryptocurrency, hundreds of other tokens are vying for investment. As of 2022. Bitcoin dominates trading in the cryptocurrency markets. But over time, its dominance has diminished. In 2017, Bitcoin accounted for more than 80 per cent of the total capitalisation of the cryptocurrency market. By 2022, that share had shrunk to less than 50 per cent.
The main reason for this is the increase in awareness and opportunities for alternative currencies.
For example, Ethereum has become a serious competitor to Bitcoin thanks to the boom in decentralised finance (DeFi).
Ether accounts for about 20% of the total market capitalisation of cryptocurrencies. Other cryptocurrencies that continue to be introduced are gaining in popularity. BNB, XRP, ADA and Solana are some other coins that are taking over the bitcoin market. There are thousands of different cryptocurrencies, with new projects and tokens being released every day.
The barrier to entry is relatively low for new entrants, but creating a profitable cryptocurrency also depends on building a network of users for that cryptocurrency. A useful application in a blockchain can quickly build a network, especially if it improves a limitation of a competing application. If a new entrant gains momentum, it takes value away from the existing competition, driving down the price of the incumbent while the new entrant’s token sees its price rise.
Regulations – a factor determining the price of bitcoin
There is some confusion about who should regulate cryptocurrency exchanges. The US Securities and Exchange Commission (SEC) says cryptocurrencies are securities like stocks and bonds, while the Commodity Futures Trading Commission (CFTC) says they are commodities like coffee or gold. Neither can claim regulatory authority over cryptocurrency exchanges.
A final solution could provide more clarity and improve the value of cryptocurrencies, while opening the door to more widely traded cryptocurrency-related financial products.
Bitcoin regulations are needed to allow easier ways to trade cryptocurrencies. Products such as ETFs or futures contracts offer investors greater access to cryptocurrencies, increasing their value. In addition, regulation may allow investors to take short positions or bet against the price of cryptocurrencies with futures contracts or options. This should lead to better price discovery and reduce the volatility of cryptocurrency prices.
Regulations could also have a negative impact on the demand for cryptocurrencies. If a governing body changes the rules to the detriment of cryptocurrency investment or use, it could cause a drop in cryptocurrency prices. Another example is the ban on bitcoin trading and transactions in China in September 2021, which affected the supply and demand of the cryptocurrency.
Mining companies in China were forced to pack up and move to mining-friendly countries. Prices dropped from around $50,000 at the beginning of September to around $40,000 at the end of the month, only to quickly recover and exceed previous price levels as operations resumed. The development of a regulatory framework is only a matter of time and its impact on the bitcoin price is unknown.
The media, news and its impact
In an effort to inform investors, the media and news are working both for and against the bitcoin price. Any change in any of the previously discussed factors is quickly published and disseminated to the masses. As a result, good news for cryptocurrency investors usually leads to an increase in the price of bitcoin, while bad news lowers it.
The combination of supply, demand, production costs, competition, regulatory changes and subsequent media coverage influences investors’ outlook, which is one of the most significant factors affecting cryptocurrency prices.
Can the price of bitcoin fall to zero?
More on the topic: Can bitcoin go to zero?
The short answer is: yes. Fiat currencies that are no longer in use are worthless, except to collectors who will probably still pay good money for a 100-year-old paper or coin.
The value of a currency is based on its perceived value. It is worth noting that currencies no longer in use usually fail due to the introduction of successors or events such as hyperinflation.
Such events usually lead to a significant depreciation of the currencies concerned. In the case of bitcoin, hyperinflation is not possible, as bitcoin cannot be created at random and its production is fixed at a certain quantity.
Ultimately, the possible realistic causes of a bitcoin price collapse are: political pressures, technological failures and any media publication under the general term FUD: any kind of news that can spread ‘fear, uncertainty and doubt’. Until bitcoin truly reaches the majority of the world, we can continue to expect both significant price increases and significant price decreases – for now, volatility rules.
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Author: Marcin Woźniak
In 2018, Marcin first encountered blockchain technology and Bitcoin, which instantly captivated his interest. He possesses a profound passion for technological innovation and the ongoing digitalization of the financial sector. Marcin eagerly anticipates the transformative potential of blockchain on a global scale and is enthusiastic about contributing to this revolutionary movement.