What Determines Bitcoin's Price?

Bitcoin 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 is used to prove 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.

Key Takeaways

  • Purchasing stocks grants you ownership in a company, whereas purchasing bitcoin grants you ownership of that cryptocurrency.
  • Bitcoin is neither issued nor regulated by a central government and therefore is not subject to governmental monetary policies.
  • Bitcoin prices are primarily affected by its supply, the market's demand for it, availability, and competing cryptocurrencies.
  • As of December 2020, approximately 88.5% of the total bitcoin supply had been mined.

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. Contrarily, 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
  • The exchanges it trades on
  • Regulations governing its sale
  • Its internal governance

Supply and Demand

Countries without fixed foreign exchange rates can partially control how much of their currency circulates by adjusting the discount rate, changing reserve requirements, or engaging in open-market operations. With these options, a central bank can potentially impact a currency’s exchange rate.

The supply of bitcoin is impacted in two different ways. First, the bitcoin protocol allows new bitcoins to be created at a fixed rate. New bitcoins are introduced into the market when miners process blocks of transactions, and the rate at which new coins are introduced is designed to slow over time. For example, growth slowed from 6.9% (2016), to 4.4% (2017) to 4.0% (2018). This can create scenarios in which the demand for bitcoins increases at a faster rate than the supply increases, which can drive up the price. The slowing of bitcoin circulation growth is due to the halving of block rewards offered to bitcoin miners and can be thought of as artificial inflation for the cryptocurrency ecosystem.

Secondly, supply may also be impacted by the number of bitcoins the system allows to exist. This number is capped at 21 million, where once this number is reached, mining activities will no longer create new bitcoins. For example, the supply of bitcoin reached 18.587 million in December 2020, representing 88.5% of the supply of bitcoin that will ultimately be made available. Once 21 million bitcoins are in circulation, prices depend on whether it is considered practical (readily usable in transactions), legal, and in demand, which is determined by the popularity of other cryptocurrencies.

El Salvador made Bitcoin legal tender on June 9, 2021. 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 artificial inflation mechanism of the halving of block rewards will no longer have an impact on the price of the cryptocurrency. However, at the current rate of adjustment of block rewards, the last bitcoin is not set to be mined until the year 2140 or so.

Competition

While bitcoin may be the most well-known cryptocurrency, there are hundreds of other tokens vying for user attention. While bitcoin is still the dominant option concerning market capitalization, altcoins including Ethereum (ETH), Tether (USDT), Binance Coin (BNB), Cardano (ADA), and Polkadot (DOT) are among its closest competitors as of March 2021. Further, new initial coin offerings (ICOs) are constantly on the horizon due to the relatively few barriers to entry. The crowded field is good news for investors because the widespread competition keeps prices down. Fortunately for bitcoin, its high visibility gives it an edge over its competitors.

Cost of Production

While bitcoins are virtual, they are nonetheless produced products and incur a real cost of production—with electricity consumption being the most important factor by far. Bitcoin "mining" as it is called, relies on a complicated cryptographic math problem that miners all compete to solve—the first one to do so is rewarded with a block of newly minted bitcoins and any transaction fees that have been accumulated since the last block was found.

What is unique about bitcoin production is that unlike other produced goods, bitcoin's algorithm only allows for one block of bitcoins to be found, on average, once every ten minutes. That means the more producers (miners) that join in the competition for solving the math problem only have the effect of making that problem more difficult—and thus more expensive—to solve in order to preserve that ten-minute interval.

Research has shown that bitcoin's market price is closely related to its marginal cost of production.

Availability on Currency Exchanges

Just as equity investors trade stocks over indexes like the NYSE, Nasdaq, and the FTSE, cryptocurrency investors trade cryptocurrencies over Coinbase, GDAX, and other exchanges. Similar to traditional currency exchanges, these platforms let investors trade cryptocurrency/currency pairs (e.g. BTC/USD or bitcoin/U.S. dollar).

The more popular an exchange becomes, the easier it may draw in additional participants to create a network effect. And by capitalizing on its market clout, it may set rules governing how other currencies are added. For example, the release of the Simple Agreement for Future Tokens (SAFT) framework seeks to define how ICOs could comply with securities regulations. Bitcoin’s presence on these exchanges implies a level of regulatory compliance, regardless of the legal gray area in which cryptocurrencies operate.

Regulations and Legal Matters

The rapid rise in the popularity of bitcoin and other cryptocurrencies has caused regulators to debate how to classify such digital assets. While the Securities and Exchange Commission (SEC) classifies cryptocurrencies as securities, the U.S. Commodity Futures Trading Commission (CFTC) considers bitcoin to be a commodity. This confusion over which regulator will set the rules for cryptocurrencies has created uncertainty—despite the surging market capitalizations.

Furthermore, the market has witnessed the rollout of many financial products that use bitcoin as an underlying asset, such as exchange-traded funds (ETFs), futures, and other derivatives.

This can impact prices in two ways. First, it provides bitcoin access to investors who cannot afford to purchase an actual bitcoin, thus increasing demand. Second, it can reduce price volatility by allowing institutional investors who believe bitcoin futures are overvalued or undervalued, to use their substantial resources to make bets that bitcoin’s price will move in the opposite direction.

Forks and Governance Stability

Because bitcoin is not governed by a central authority, it relies on developers and miners to process transactions and keep the blockchain secure. Software changes are consensus-driven, which tends to frustrate the bitcoin community, as fundamental issues typically take a long time to resolve.

The issue of scalability has been a particular pain point. The number of transactions that can be processed depends on the size of blocks, and bitcoin software is currently only able to process approximately three transactions per second. While this wasn’t a concern when there was little demand for cryptocurrencies, many worry that slow transaction speeds will push investors towards competitive cryptocurrencies.

The community is divided over the best way to increase the number of transactions. Changes to the rules governing the use of the underlying software are called “forks.” “Soft forks” pertain to rule changes that do not result in the creation of a new cryptocurrency, while “hard fork” software changes result in new cryptocurrencies. Past bitcoin hard forks have included bitcoin cash and bitcoin gold.

What Gives Bitcoin Value FAQs

How Is Bitcoin Value Calculated?

Bitcoin's value is largely dependent on its supply and the market's demand for it. Its value is also attributed to other factors, such as alternative digital currencies—including their supply and price—availability, and rewards for mining. Intrinsic value 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 the mining difficulty.

How Does Bitcoin Increase in Value?

As bitcoin nears its maximum limit, demand for it increases. The increased demand and limited supply push the price per bitcoin upward. Also, more institutions are investing in bitcoin and accepting it as a form of payment, thereby increasing its utility and making it a preferred medium of exchange among consumers.

Bitcoin is relatively safe due to cryptography and robust protocols and readily available through several exchanges. Also, you need not purchase a full bitcoin to have ownership of it. Fractional shares are available, increasing its attractiveness and value.

How Does Bitcoin Make Money?

Unlike stock, bitcoin does not represent ownership in a company or entity. Owning bitcoin is owning digital currency, much like owning US$1 is owning paper currency. Bitcoin miners earn rewards for completing blocks of verified transactions, and owners of bitcoin make money as the price per coin increases. For example, if you purchased 100 coins at $65.52 (100 x $65.52 = $6,552) on July 5, 2013 (bitcoin's record low) and held it until its all-time high of $61,683.86 on March 13, 2021, you would have $6,168,386.

Why Is Bitcoin So Valuable?

The demand for bitcoin is increasing, whereas the availability of new supply is shrinking, with the size of each block reduced by half, on average, every four years and the final bitcoin to be mined somewhere around the year 2140. Indeed, unlike most other produced goods, the rate of supply of new bitcoins cannot increase in response to spikes in demand.

A supply and demand imbalance results in increased prices. Some consumers, companies, and investors favor bitcoin for this and the potential ability to hedge inflation. The resulting popularity contributes to increased demand, and thus an increased price.

What Makes Bitcoin Prices Go Up and Down?

Bitcoin's price fluctuates for various reasons, including media coverage, speculation, and availability. With negative press, some bitcoin owners panic and sell their shares, driving down the price. Vice versa with positive press. Also, when the volume of bitcoin sold on the market increases, the price decreases. As more institutions adopt bitcoin as an investment and medium of exchange, its price increases.

Also, many people have eroded confidence in their fiat currency and seek alternative sources to store their money. Because bitcoin is decentralized and unregulated, it is a favorable alternative, thus driving up its price.

Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author does not own bitcoin.