ewzyafrsadvx
how is bitcoin valued
Tutorials

What determines the value of bitcoin?

Spread the love

Ever wonder why the price of bitcoin tends to peak when the hype around it is the largest?

Here is a graph of price per bitcoin and Google Trends metric for the word “bitcoin”

Price per bitcoin has a strong correlation with the hype around it

Bitcoin, like everything else, follows the rule of supply and demand. There can only be a finite number of bitcoin in circulation. Unless there is a change in protocol, that number will remain at 21 million. Since there is a fixed supply, we experience an organic increase in price when demand outstrips those willing to sell.

In its philosophy, bitcoin works almost similarly to gold. Gold is an ideal metal to make jewelry and an electroplate to other metals that prevent it from corroding, but it does not have any economic value on its own. You can neither eat gold or make a soup out of it; it only has value because it can be traded for something else that has value.

Gold is a noble metal that does not easily react and corrode. It is extremely time-intensive to mine and rare to find. It also has a shiny surface which makes it stand out. These are among the main reasons why gold was specifically chosen as a metal to store value. Gold has value because people believe it has value. It’s a belief that a specific amount of gold will yield similar goods and services anywhere in the world.

This gold analogy, however, surfaces a broader question.

How does bitcoin have value?

The same concept applies to bitcoin—bitcoin has value because it can be traded with something that has value, like any goods or services people are willing to accept as a method of payment. In addition, what makes bitcoin so sought after is because of its liquidity. Simply put, sending bitcoin is easier than sending gold and much faster than sending fiat currencies for remittances.

What determines the value of bitcoin?

On familiar terms, two things drive the value of anything in the market—scarcity, and utility.

Gold is valued because of its scarcity (limited supply) and it serves as a transfer of value (utility). In the commodity-based economies before the 1950s, money was simply representative of commodities like gold or silver; paper money was  merely a fraction of the commodities (gold or silver) and during certain events like the Californian gold rush, where a vast amount of gold was suddenly discovered, gold lost its value and so did the currencies which were mere representatives of gold.

Now that we have established why gold is valuable, let’s contrast it side by side with bitcoin:

Feature Gold Bitcoin
Scarcity Yes Yes
Utility Yes Yes
Indestructible Yes Yes
Not likely to degenerate or lose the shape of form Yes Yes
Uniformity Yes Yes
Acceptability(Is it accepted all over the world?) Yes Yes
Divisibility(Can be broken into the fraction of proportional value) Yes Yes
Shiny Yes No
Electronic No Yes
Can be sent instantly No Yes

 

As you can see, bitcoin serves all the same purposes as gold. The difference is that it is not shiny but can be sent instantly and is accepted all over the world.

Supply and demand are rather expansive when we try to understand why things like bitcoin have value, as there are a number of factors that affect supply and demand.

How is the price of a bitcoin determined?

The nominal value of gold is proportional to the amount of energy needed to refine and take it out of the ground. The same is true with Bitcoin “mining.” However, the market drives the price to buy and sell bitcoin based on the current supply and demand.

Imagine bitcoin as a lump of gold and each individual bit of gold as an ounce of it. The value of an ounce is determined by the total value of gold divided by the number of ounces. Similar to that, the value of 1 bitcoin is determined by dividing the total market cap with the total number of bitcoin available.

In mathematical terms, the price of a bitcoin or any other cryptocurrency is determined by using this formula:

Price of a single bitcoin = Total Market Cap / Total supply of bitcoin

It is evident that the total market cap is proportional to the price of bitcoin. Therefore, more investment in bitcoin will increase the price and vice versa.

These are the other factors that increase the price of bitcoin

Network Effect:

The Network Effect is a process where a number of new participants improve the value of a good or a service. A fax machine is worthless if you have nobody to send a fax to. If a large number of people have fax machines, however, the value of fax machines increases because there are a lot of people you can fax.

The Internet is one of the most successful examples of the Network Effect. As opposed to just being a communication medium between Universities and the military, the use and scope of the Internet only increased as more people started using it. Now, the Internet is almost as valuable as our basic needs.

More people knowing about bitcoin and entering the Bitcoin network increases the value of it. As more people realize the usefulness of bitcoin, it creates a demand for it and increases the price per bitcoin.

The graph below illustrates how gradual adoption affects the price of a commodity. As you can see, bitcoin is still considered to be in the early adopter’s phase.

A graph that describes the law of diffusion of innovation

Gresham’s Law:

Any currency has two values: the actual commodity value and a nominal value. The commodity value is set based on what makes up the worth of the money, which could be determined by whether or not the coin is made of silver or paper money of the same value or the electrical power cost being used to mine bitcoin. This value is always independent of the nominal value (set value) of the currency.

The currency that has better commodity value is considered to be good money and the one with lesser commodity value is bad. So a gold coin is a good money and fiat paper notes—not so much. Gresham’s Law states that if the currency is allowed an independent existence, the bad money will wipe out the good money because people will always spend the bad money and hold good money (i.e. spend fiat and save gold). Because paper has no commodity value, people are likely to still opt in for fiat and hold onto bitcoin. This will make bitcoin more scarce and ultimately increase the value of it.

Market Adoption

The bitcoin maximalists and core enthusiasts like to believe in Metcalfe’s Law, which states that the effect of a telecommunications network is proportional to the square of the number of connected users of the system (n2); but a recent study showed that these are just early days of bitcoin and the law may not necessarily hold true. However, there is a big chance that this may be applicable in the future.


The first “crash” of bitcoin can be accredited to a flock of people who were driven by the fear of missing out on a hot commodity. They bought into the narrative that bitcoin is the currency of the future or that they should buy it immediately lest they miss the wave. While the former is true, the growth was not natural and many expected the price to fall, as people had unrealistic expectations while buying bitcoin.

Reminder: cryptocurrencies are still a new and hyper-volatile asset class, and could drop to near-zero at any time. Don’t put in more money than you can afford to lose. If you’re trying to figure out where to store your life savings, traditional assets are still your safest bet.— Vitalik Non-giver of Ether (@VitalikButerin) February 17, 2018

A tweet from Vitalik Buterin– Founder of Ethereum

A similar effect was observed with Ethereum and various altcoins when people got into a frenzy and began investing more than they could afford. A gradual and natural market adoption will eliminate volatility and increase the price of bitcoin. Market adoption is only increasing for bitcoin, as its gaining more mainstream popularity.

Now the people who followed the hype have come and gone, bitcoin has a better opportunity to slowly expand. It’s highly unlikely the same old frenzy of pumpers and dumpers will enter the scene again. The right kind of adoption among the masses will create a higher demand for bitcoin and thereby alter the prices. Despite the hype that’s been created over the past few years, Bitcoin is still a small market and even fewer people use it the way it was designed to be used—as a peer to peer payment system. But if more people come to find out about the network and use it for what it is, it will spike up the price of a bitcoin.

Block Halving

Block Halvings happen every 21000 blocks which are roughly every 4 years. Bitcoin miners currently receive 12.5 BTC for mining every block as a reward for securing the network but it is all going to change in the year 2020. In May next year, this reward will be reduced to 6.5 BTC per block. 

This increases the scarcity of bitcoin because the rate of supply has been halved. As evident from the

Graph from the last halving, courtesy of Forbes

last halving, there would be a circulation of news around the time it happens and it generally ends up skyrocketing the price at least momentarily or otherwise. 

 

What decreases the value of bitcoin?

Hard Forks:

A hard fork is “a change of the Bitcoin protocol that is not backward compatible with the older versions. All participants must upgrade to continue participating and validating new transactions. Those who didn’t upgrade would be separated from the network and cannot participate in new transactions. This results in a permanent deviation in the blockchain. However, as long as there is support in both chains, these will simultaneously exist.”

Wethecryptos

In such a case, those who had parent cryptocurrency usually also end up having an equal number of newer ones. The uncertainty caused by the market stirs it up and you never know how the market is going to respond. This situation is not helped by greedy whales (people or organizations that own a large amount of cryptocurrency) and dolphins (private traders who deal in large volumes).

These two groups of people, when they find out the fork is going to happen, use their skills and contacts to buy as much digital currency as possible, knowing they will get an equivalent amount of new forked coin. This causes the price of the digital currencies to be highly inflated and when the price is high, they tend to sell on any exchange they can find. Eventually, balance is restored after their “pump and dump” scheme is over, but they cause uncertainty in the market and drive people away from it, essentially decreasing the value of the currency.

Fear of Missing Out(FOMO)

The price of bitcoin usually has little to do with the evolving technology or market adoption and is more influenced by human emotions. As discussed above, for a fixed supply,  the higher the market cap, the higher is the price of bitcoin. If people are driven away from the Bitcoin ecosystem, which can cause them to sell their valued digital assets, it effectively reduces the price of bitcoin.

Mainstream media has been a major culprit for causing FUD towards bitcoin. Even though the technology behind Bitcoin is robust and has so many advantages, the public perception towards it can be swayed by many external factors. Nobody wants to lose their hard-earned money and people do not want to take a chance with their investments—this causes people to exit the digital currency ecosystem and effectively reduces the price of bitcoin.

Now that you know how it is valued, buy bitcoins to get started. 

Leave a Reply

Your email address will not be published. Required fields are marked *