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Bitcoin Price

How the value of Bitcoin is determined

By November 13, 2018 No Comments

Who decides on the value of Bitcoin?

In a nutshell, the value of Bitcoin is decided by those that interact with the system. From miners, investors, traders, Bitcoin news and media, financial institutions, to banks and blockchain projects, you name it, they all affect the value. When I say value in this context, I am talking about price. This ‘price’ is based on supply and demand, which moves the Bitcoin price up or down depending on these interactions.

But what does value mean? Does the price value of Bitcoin reflect the true value? And can ‘value’ be defined as something other than price?

In this blog & video, I break down and explain the difference between the price value of bitcoin, and the intrinsic value of bitcoin.

Breaking down the price value of Bitcoin

Value can be defined in many ways. For example, the value of bitcoin as a cryptocurrency on any given day gives us something quantifiable. We know when we look at the price, its value is X on day Y.

This is price value dictated by the free market. It’s the price in dollars which the free market is attributing to an item, which in our case is Bitcoin. This price value is moved up or down based on the economic principles of supply and demand.

Graph depicting how price value of Bitcoin is dictated by a free market, as it relates to determining the value of Bitcoin

The supply of Bitcoin comes from a number of stakeholders that interact with the system. These stakeholders must in some way be increasing or decreasing the supply of bitcoin on exchanges. Consequently, that’s how they influence the price.

The most significant stakeholders are;

  • Bitcoin Miners
  • Blockchain Projects
  • Investors
  • Traders
  • Institutions

Bitcoin Miners

Bitcoin miners are likely the most significant stakeholders when it comes to suppression of the price value of bitcoin. This is because new bitcoin is minted through the mining process and are then sold on exchanges to fund the mining operations. Things like staffing, computers, electricity, internet, rent, insurance, and other costs form part of a miner’s normal overhead.

These miners are the only stakeholders responsible for ‘injecting’ brand new bitcoin into circulation. When we look at the data, there are currently 1,800 new bitcoin mined every day. Many of them are then sold on exchanges fairly quickly so as to avoid volatility.

This constant flood of new bitcoin into the market fills the exchange order books with sell-orders. Basically, more people are selling than buying, and so the price drops. Or, there might even be a similar number of people buying as there is selling. In this case, the price stays about the same.

A pretty good example of this is the period between the 5th of September and the 7th of November 2018. The price of Bitcoin stayed between around $6,200 and $6,500 USD for over a month.

Image of the value of Bitcoin between September and November 2018

Blockchain Projects

This is one stakeholder that is not talked about too often, but I think it plays a big part in Bitcoin’s price. Various Blockchain projects raise funds by taking in Bitcoin or Ethereum from investors during their initial coin offering. Sometimes in huge quantities.

Once the fundraising is over, these projects need to sell this cryptocurrency for working capital. Working capital is really just normal fiat money used to fund business operations.

Projects get fiat money by either selling the bitcoin directly on an exchange or using OTC, which is ‘over the counter’ (basically a private sale with reduced fees). This mechanism of selling bitcoin places downwards pressure on the price.

The value of bitcoin some companies hold is significant. For example, Lisk raised 14,009 BTC, now worth $91,000,000 based on the current price. As of Q2 2018, TenX was holding 3,012 bitcoin, worth $19 million today. Ethereum raised around 3,700 bitcoin back in 2014, and the list goes on.

What this leads to is a constant downward pressure on price from the hundreds (if not thousands) of blockchain projects that are constantly selling bitcoin reserves for cash.

Investors

Next up, we have investors and short-term speculators. I originally thought investors were the most unlikely to be causing downward pressure, but the most likely to cause upward price pressure on the value of bitcoin. Research by Chainalysis, however, describes a different story.

Investors typically have a longer-term outlook. I say typically because the intention or outlook of an investor changes based on the psychology of a market cycle. During very bullish times, irrational exuberance takes place and short-term speculative investors are likely to join.

The longer-term investors are system participants who will buy bitcoin at various prices and will store it with no intention of selling in the short term. They become ‘hodlers of last resort‘, as Trace Mayer calls it, becoming steadfast in their conviction of long-term price appreciation.

These hodlers of last resort have a significant portion of the bitcoin in circulation locked up in deep cold storage. And they are not coming out anytime soon. This leads to scarcity in the market, and in the event of a bear market, helps to keep the price at a reasonable level as demand for bitcoin matches or exceeds supply.

However, the research undertaken by Chainalysis in April 2018 shows around 6m Bitcoin is held by investors. Short-term speculators hold around 5.1m.

Image depicting chart showing how speculators hold smaller amounts of Bitcoin than investors, as it relates to determining the value of Bitcoin

By tracing the movement of bitcoin between wallet addresses, research shows it has significantly changed hands since December 2017. Long-term investors have sold around $30b worth to new speculators.

This rapid transfer of wealth is thought to be the primary cause of the 2018 bear market, as the amount of bitcoin available for trading increased by 60%.

Traders

Now let’s consider the day trader and the swing trader. These two system participants love to ride the rollercoaster of volatility. It’s their goal to exploit every peak and every dip.

Not constricted by the ambitions of long-term value appreciation, traders are buying and selling based on the markets indicators. If the indicators are signaling a buy, traders place buy orders. If the indicators are signaling a sell, traders place sell orders.

Overall, these participants don’t place a significant amount of influence on the supply and demand either way. The thousands if not hundreds of thousands of traders who are active globally keep the order books deep and liquidity moving.

Institutions

Next up we have financial institutions. By institutions, I am referring to major regulated funds and brokerages that serve corporate clients. This might be Bakkt, Fidelity, CBOE, Greyscale, or any other major company that is playing with millions of dollars.

These institutions represent a tricky set of stakeholders to analyse from a price value of bitcoin perspective. The reason is that much of the trading is done via over-the-counter. An OTC provider will connect an institution with a private seller, facilitating large volume trades that are off public exchange order books. Because these trades are not public, there is no immediate flow-on effect like with a demand-driven event.

However, institutions buying OTC are decreasing the known circulating supply. They are essentially becoming hodlers of last resort, further creating scarcity of bitcoin.

This scarcity, although not immediately tangible, could play a profound effect during another market bull run.

Breaking down the intrinsic value of Bitcoin

We’ve covered the price value of bitcoin and its many influences. Now it’s time to break down something more difficult to quantify: Intrinsic value.

What exactly does intrinsic value mean? Here is a great definition provided by Investopedia;

Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, using fundamental analysis. Also called the true value, the intrinsic value may or may not be the same as the current market value.

The above definition is in the context of equities. By using intrinsic value, prospective investors can analyse companies and study their financials to find hidden opportunities. This is a technique commonly used by famous investors such as Warren Buffet. He studies companies, looking for high intrinsic value not yet realised by the market. A good example was Buffet’s investment into CocaCola.

Now, obviously, bitcoin is not a stock, it’s a digital asset. So to understand which factors could be used to analyse its value, we need to examine the Bitcoin network as an entity. By doing this, we can then examine what forces may add or subtract value to it.  These forces include:

  • Energy consumption
  • Network transaction volume
  • Exchange transaction volume
  • Financialisation

Energy consumption

Bitcoins network consumes a tremendous amount of energy. And so it should. Its proof-of-work consensus algorithm forces miners to run complex equations.

Bitcoins proof-of-work system uses Hashcash, (invented by Dr. Adam Back), which is a function that creates a large ‘one-way’ number using SHA256, a cryptographic hash function. Developed by the NSA, SHA256 uses an Elliptic Curve Digital Signature Algorithm to produce the hash. In simpler terms, a very large and random number is created that is feasibly impossible to invert.

Visual representation of an elliptical curve digital signature algorithm as it relates to determining the value of Bitcoin

Source; https://blog.cloudflare.com/a-relatively-easy-to-understand-primer-on-elliptic-curve-cryptography/

When a block is formed on the Bitcoin blockchain, it creates a hash using SHA256 and adds a set number of leading zeroes to it. Miners must then run SHA256 repeatedly to either match the block header (Hash + leading zeroes) or get a number lower than it. The first miner to achieve this out of the global mining pool gets to confirm the block and receives rewards in the form of newly minted bitcoin.

The process design was made intentionally difficult and resource intensive. In essence, the design ensures that the ledger of transactions becomes computationally infeasible to change. It also ensures new bitcoin are created and rewarded as a result of real energy input.

How miners fit in

When more or less miners join the network, the energy input goes up or down. Bitcoin achieves this automatically by adjusting the ‘difficulty’ of mining to ensure blocks are mined every 10 minutes. Honestly, it’s a highly complex subject that deserves its own post. In an attempt to put it in simple terms, energy consumption goes up the more the Bitcoin blockchain grows. Growth in this case being in terms of network participants (miners) joining.

Bitcoin’s total energy consumption is now around 73 Terawatt hours. This is equivalent to Austria’s entire power consumption. The energy consumption by the Bitcoin network is a contentious topic right now, and it’s an interesting point of discussion.

Regardless of the controversy surrounding it, the energy issue reveals one very significant factor. Energy in the form of electrical power is being input into the system. And remember this, this energy is powering a fully decentralised, $110 billion dollar network. Therefore, it must be highly regarded as a significant form of intrinsic value. The more mining participants join the network, the more energy consumption takes place. The less mining participants join the network, the less is consumed.

Energy is definitely an indicator of the intrinsic value of bitcoin.

Network transaction volume

The next major component in evaluating the intrinsic value of Bitcoin is the network transaction volume. This piece of publicly available information tells us right away how much the network is currently in use.

When we define ‘in use‘, we’re referring to the sending and receiving of bitcoin. It might be wallet to wallet, wallet to exchanges, exchanges to wallet, or another type of transfer. This data gives us a window into the daily usage of the Bitcoin network.

Image of chart depicting daily usage of Bitcoin network, as it relates to determining the value of Bitcoin

As we can see, the number of daily bitcoin transactions has drastically increased over the past 5 years. Around 2015, the number of transactions passed 150,000 per day. When we compare the chart to the price of bitcoin over the past 5 years, we can see some correlations between price and transactions.  Image of graph showing how daily Bitcoin transactions have increased in past five years, as it relates to determining the value of Bitcoin

Interestingly, bitcoin’s transaction volume has been going up despite the price remaining steady. One might perceive this as the intrinsic value ‘decoupling’ from price value. A  potentially positive sign for long-term investors.

Exchange transaction volume

Next up we have the exchange transaction volume. This is the dollar amount traded every day on global exchanges. This is an important factor as it shows the activity of traders and investors on any given day. Think of it as the human psychological element to the intrinsic value equation.

Here is a chart of bitcoin’s trading volume in USD over the past 5 years.

Image of chart showing Bitcoin trading volume over the past five years as it relates to determining the value of Bitcoin

As we can see, the chart shows a strong correlation to the price value of bitcoin. However, there has been some decoupling from this correlation during the later months of 2018. Trading volume has gone down while the price remained steady.

This is showing us that short-term trading is dropping off, likely due to poor sentiment. It’s also showing us that the equilibrium point between supply and demand for the price value of bitcoin emerged in late October. One might perceive this as the market nearing the true bottom of the bear market cycle.

On a side note, I am personally fascinated by the study of economic psychology during market cycles. I believe it plays a huge part in valuing and gauging market sentiment.

Financialization

Lastly, we have financialization. When you hear this term, it’s related to the financial products developed around a certain asset. For Bitcoin, this means exchange-traded funds (ETFs), futures contracts, options, and managed funds.

We can measure the quantity and frequency of these products as they move through the approval process within the context of intrinsic value. This value does not come from the products themselves but from the process of their introduction and approval.

For example, when regulatory agencies continually reject ETF applications, it’s a negative intrinsic value. It shows us that Bitcoin is not yet ‘mature’ enough for regulators to approve the fund. However, as we draw closer to an ETF’s approval, the intrinsic value starts to become a positive. The general sentiment for long-term investors is that this ETF will soon see approval. So we know the Bitcoin network has greater long-term intrinsic value as a result. Additionally, we know that this will influence the price value of bitcoin.

Personally, I’m not sure yet whether or not financialization is a positive for Bitcoin. Some products may not need to hold Bitcoin in reserves. Without physically holding some bitcoin, these products may not do anything for the price value of bitcoin. Nor will they help to serve the ecosystem.

But regardless of where I stand, financial products approved for Bitcoin will raise the intrinsic value of bitcoin.

Conclusion

As we can see, there is a huge difference between the price value and the intrinsic value of Bitcoin. But that’s not to say interpreting this data is easy, because it’s not. There is a myriad of factors at play and crypto economic theory is mind-meltingly complex at best.

However, I strongly believe there is enough information to show a clear separation between the two. Clearly, the price of  bitcoin does not always correlate with the network’s usage.

Either way, how incredible is it that we have blockchain technology? We have at our fingertips financial and network data that is live, transparent, trustless, and incredibly dense. To those that can make sense and exploit its capabilities, opportunities are just around the corner.

Beau is the Founder & Chief Editor at Cryptocurrency Australia Media, an educational platform designed to help anyone learn about cryptocurrency investment and blockchain technology. Beau is also the Founder & Principal Consultant of Blockchain Management Solutions, a specialist technical and project management consultancy, is an advisor with Masternode Ventures, a blockchain incubator, and is an advisor with THORChain, a new decentralized exchange protocol.