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Bitcoin Price: How is it Determined and Why is it So Volatile?

Liz Louw
12 October 2018

The tremendous price drop of bitcoin and the overall cryptocurrency market in early 2018 was brutal. While we do believe that worthwhile crypto projects will bounce back in time, we should recognise that the now infamous price move was no accident or simply due to bad luck. To the contrary, the 2017 cryptocurrency price boom was vastly out of sync with the growth of essential value metrics; factors such as ecosystem development, user adoption, and dedicated capital investments. In fact, Michael Hudson argues that the real boom in the underlying value of the crypto ecosystem only occurred later in 2018, while crypto prices found themselves under constant pressure.

In hindsight the discrepancy between price and value is clear. Yet many an unwary investor found themselves swept up in the drama of the boom and subsequently at a loss when the price bubble popped. If unjustifiable and dangerous investment behaviour is to be countered, it is essential that investors focus on educating themselves on the primary driving factors behind crypto prices.

How the Bitcoin Price is Determined

In one of Bistocks’s most read blogs, Vee Tardrew warned readers, “Do not confuse the price of bitcoin with its value. They are not one and the same.”  

While we have said much about the fundamentals of cryptocurrency valuation and have published several blogs and an ebook on how to find the best cryptocurrency for investment, let’s take a moment to consider the factors that determine and influence the market price of cryptos.

Willing-Buyer, Willing-Seller Model

Similarly to the stock market, we could say that cryptocurrencies are sold on auction where transactions occur when a willing-buyer meets a willing-seller. Not only do parties have to agree on the type and amount of an asset to be exchanged before a successful transaction can take place, but they also have to agree on the exchange rate between these assets.

The Price Impact of Bitcoin Supply and Demand Ratio

The laws of supply and demand are also at play: as the demand for an asset rises in comparison to the available supply, competition increases and higher prices are likely to be offered.

Independent Exchange Platforms, Independent Pricing

Since cryptocurrency as an asset class is still in its nascent stages, it does not yet have a universally accepted price index. Instead, it is crypto exchanges that provide the pound/dollar/euro price of an asset on their platform to reflect the rate or price at which the last transaction took place. These price points are therefore highly contextual and should not a universal standard or objective measure.

Multiple Bitcoin Marketplaces, Multiple Bitcoin Prices

In fact, this is one of the ways in which the cryptocurrency market differs from the stock market: there are numerous crypto marketplaces in existence, each listing the price of assets according to the last successful transactions on their specific platform. Due to the exchange-specific pricing, price discrepancies often develop providing traders the opportunity to buy an asset on one exchange and almost instantaneously selling it on at a higher on another exchange. This process, called arbitrage, is quite common within the cryptocurrency industry, and some see it as a risk-free way to profit.

Factors that Contribute to the Volatility of the Bitcoin Price

Other factors that differentiate crypto markets from stock markets is that it operates 24/7 and that it is accessible to retail investors regardless of their financial expertise or economic position. These aspects lead into the topic of the extreme volatility of the crypto market. With price swings that far exceed that of any other asset class concerning speed and margin of change, it is fair to wonder what gives.

As a market that operates non-stop, without putting trading on hold over weekends or after-hours or based on any one time zone, activity is prone to emotional build up without pause and reflection. Pare this continuous operation with the non-existent entry barriers, and you get a considerable proportion of the market which, at a lack of education trade according to hype and speculation instead. With this vulnerable group already at risk, media hype and baseless speculation often wreak havoc. In a recent conversation with Bitstocks Portfolio Manager, Adam Norrie linked some of the considerable crypto price fluctuations we have seen in the past year to speculators’ fierce reaction (even, overreaction) to media reports. Even when news reports turned out to be misleading or ‘fake news’, it tends to have a stupendous impact on markets.

Blockchain Mark Consultant, Michael K. Spencer, describes the situation as follows:

“The media on Bitcoin is basically a circus show. You cannot trust alarming headlines nor can you totally trust Bitcoin purists and zealots of crypto. This means speculations on the price of cryptocurrencies are, for the most part, just that.”

It is vital to keep in mind that cryptocurrency exchanges, like stock exchanges, profit from trading activity whether the trade was profitable for the user or not. Whether a news report is valid or not, overreacted or underplayed, it does not matter as long as it encourages people to trade and them to charge their fee on each trade. And so, even news headlines promoted by technologically-sound crypto exchanges should be considered with scepticism instead of blind faith.

With this volatile landscape at play, a situation emerges where day traders do their best to profit off of price swings while investors risk getting fleeced during pump-and-dump schemes.  At present, speculation has become the dominant driver of market activity. A promising, yet unconfirmed, news headline out of the USA could fuel a rise in price one moment, just for a rumour out of China to trigger a price dump the very next.

Why the Current Bitcoin Price Does Not Matter

The speculative volatility of the cryptocurrency markets poses a frightening trap for the uninformed, or inexperienced investor. Investing in cryptocurrency is not a get-rich-quick scheme, and any gambit that promises you otherwise should be viewed with extreme scepticism. At Bitstocks, the City of London’s first Cryptocurrency Investment Firm, we view cryptocurrency as a long-term value proposition, which is why the Bitcoin price right now does not matter.

Our investment strategy is to seek out valuable gems at an early stage and hold our position for the long-term. If you would like to learn more about Bitstocks’ philosophy, do get in touch to schedule a consultation with one of our portfolio managers.

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