Bitcoin’s volatile pricing is well documented. The cryptocurrency soared to nearly $20,000 per coin at the end of 2017 and then fell slowly throughout 2018. It’s like a roller coaster and one that is hard for Bitcoin watchers to predict.
Influences on Bitcoin price
There are lots of factors but here are eight of the most important. Every time price changes for Bitcoin and other cryptocurrencies:
Supply and demand
The most basic principle governing the pricing of anything is supply and demand. When the 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, the 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.
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. Price discovery takes into account supply and demand and things beyond that. For example 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 close to an accurate price. Anyway 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.
One of the fundamental principles behind Bitcoin and other cryptocurrencies is that they are decentralized and therefore not controlled by any one body, like a central bank or a government. However it operates in the financial services sector, due to this cryptocurrencies have been gaining 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 rised immediately after Japan announced that it would consider Bitcoin to be legal tender.
It’s a key factor in determining any purchasing decisions. For example when you buy a product you read the 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 behavior. A report that a major retailer is accepting Bitcoin will drive purchasing and boost the price. An interview with a major influencer, who warns that cryptocurrency is a bubble, could see people sell, driving prices down. For example, 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.
Political and economic instability
One of the advantages of a decentralized currency is that it is insulated, to an extent, from the political and economic instability that can affect a nation’s currency. For example the British Brexit vote in 2016, the value of the pound fell sharply. It’s very hard to prove a link between these factors, but it is certainly possible that investors are seeing Bitcoin as a safeguard against political and economic problems in particular countries.
Bitcoin might be decentralized, but it still has its own rules and governance procedures. For example Miners receive a small number 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 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.
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, analyzing these trends can give an insight into particular price moves. Being able to predict them is the objective of an experienced investor.