Bitcoin is a cryptocurrency based on specifications outlined by Satoshi Nakamoto in 2009. Transactions are recorded in a blockchain, which shows the entire transaction history for each unit and is used to prove ownership. Processing transactions requires miners using computers to process blocks of transactions, which are the core components of the blockchain.
What Determines Bitcoin Price?
Buying a bitcoin is not the same as buying a stock or bond. Bitcoin is not a corporation, so there are no corporate balance sheets or Form 10-Ks to review, and no costs, revenues, or profits to create a baseline against other cryptocurrencies.
It is also unlike investing in a traditional currency, as it is not issued by a central bank or backed by a government. As such, the monetary policy, inflation rates, and economic growth measurements that typically influence the value of a currency do not apply. This can make understanding why the price of bitcoin goes up or down confusing. Several factors can influence the price:
- the supply of bitcoin and market demand for it
- the number of competing cryptocurrencies
- the exchanges it is traded on
- regulations governing its sale
- its internal governance.
Supply and Demand
Countries that do not have a fixed foreign exchange rate are able to partially control how much of their currency is circulating by adjusting the discount rate, changing reserve requirements, or engaging in open-market operations. These options allow the central bank to potentially impact a currency’s exchange rate.
The supply of bitcoin is impacted 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: growth has slowed from 9.8% (2015) to 6.9% (2016) to 4.3% (2017). This can create a scenario in which the demand for bitcoins increases at a faster rate than the supply increases, which can drive up the price.
The second way that supply is impacted is by the number of bitcoins that the system allows to exist. This number is capped at 21 million, meaning that once this number is reached, mining activities will no longer create new bitcoin. At this point, mining activities are likely to be supported by transaction fees. The supply of bitcoin reached 16.8 million in late January 2017, representing 80% of the supply of bitcoin that will ultimately be made available. (See also: Only 20 Percent Of Total Bitcoins Remain To Be Mined.)
Once 21 million bitcoin are in circulation, prices will depend on whether it is considered practical (can be readily used in transactions), legal, and in demand. The latter factor will depend on the popularity of other cryptocurrencies.
While bitcoin may be the most well-known cryptocurrency, there are hundreds of cryptocurrencies that investors can also choose from. These include ethereum and litecoin, which are also traded on the Coinbase exchange, as well as options such as Dogecoin and Peercoin.
Monitoring new initial coin offerings (ICOs) can give investors an idea of the number of companies that are interested in entering the market in the coming years. There are a relatively low number of barriers to entry in the market.
Generally, the presence of many competitors should keep the value of an investment in check. It is likely that the value of the U.S. dollar would be different if there weren’t strong alternatives, such as the euro, yen, or pound, or the value of a share of ExxonMobil stock had Chevron, Royal Dutch Shell, or BP not existed.
The speculative nature and quasi-legal status of cryptocurrencies, however, makes it difficult to understand how the rules of competition will affect pricing. This makes other factors, such as being well-known, a major advantage for bitcoin.
Availability on Currency Exchanges
Just as equity investors are familiar with indexes like the NYSE, Nasdaq, and the FTSE, cryptocurrency investors know Coinbase and GDAX. For a fee, these exchanges allow investors to buy and sell bitcoin, ethereum, and litecoin using different order types (market, limit, stop). They function very similarly to traditional currency exchanges, and allow investors to trade cryptocurrency/currency pairs (e.g. BTC/USD or bitcoin/U.S. dollar).
The more popular exchanges become, the easier it is for them to draw in additional participants, creating a network effect. This allows them to use their market clout to set rules for how other currencies are added, which in turn makes currencies available on the exchanges more popular.
The recent release of the Simple Agreement for Future Tokens (SAFT) framework, for example, 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. This gives it a leg up on currencies not offered on Coinbase and GDAX, which may be perceived as less safe.
Regulations and Legal Matters
The rapid rise in the popularity of bitcoin and other cryptocurrencies caught regulators off guard. It took until December 2017 for the Securities and Exchange Commission (SEC) to weigh in on when digital assets, specifically the DAO token, were to be considered securities. (See also: How Do You Invest in the DAO?)
The U.S. Commodity Futures Trading Commission (CFTC) considers bitcoin a commodity. This confusion – which regulator will set the rules for which cryptocurrency – has created substantial uncertainty, even if this is not evident in the surging market capitalizations.
Receiving regulatory approval has allowed the creation of financial products that use bitcoin as the underlying asset. Bitcoin could be used in an exchange traded fund (ETF), futures, and other derivatives. (See also: How to Invest in Bitcoin Futures.)
This can impact prices in two ways. First, it opens up bitcoin to investors who cannot afford to purchase an actual bitcoin, increasing demand. Second, it can reduce price volatility by allowing institutional investors who think that 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
Bitcoin is not governed by a central authority, and relies upon developers and miners to process transactions and keep the blockchain secure. Changes to software are reached by consensus. This consensus-driven ethos can cause friction when the members of the bitcoin community feel that fundamental issues are taking too long to resolve.
The issue of scalability has been one of the largest sources of friction in the bitcoin community. The number of transactions that can be processed is dependent on the size of blocks, with the bitcoin software able to process approximately 3 transactions per second.
In the first several years after bitcoin was launched this wasn’t a major concern, as demand for cryptocurrencies was not substantial and thus didn’t result in large transaction volumes. As interest in bitcoin increased, however, some in the community worried that slow transaction speed would push investors to use other cryptocurrencies instead.
The community was divided over how to increase the number of transactions. Changes to the rules that the underlying software uses are called “forks,” with “soft forks” involving rule changes that do not result in the creation of a new cryptocurrency.
Changing the software itself is referred to as a “hard fork,” which results in a new cryptocurrency. Past bitcoin hard forks include bitcoin cash and bitcoin gold. Investors may ultimately decide that the new currency is not as valuable, resulting in these currencies not appreciating in value as much as bitcoin.
Should You Invest in Bitcoin?
The rapid appreciation of bitcoin and other cryptocurrencies has led to comparisons with the speculative bubble created by Tulip mania in the Netherlands in the 17th century. While it is broadly important for regulators to step in to ensure that investors are protected, it will likely be years before the global impact of cryptocurrencies can be fully understood. In the meantime, as with all investments, past performance is no guarantee of future results.
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 incryptocurrencies 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.