The value of a fiat currency is usually defined by a central bank. This is the case for the Euro as well as for the US-Dollar. With Bitcoin, things are different since there is no centralized entity that is regulating its monetary policy. Everything is determined by Bitcoins protocol. There are also very simple but effective external factors in play when it comes down to determining the price for a single Bitcoin.
How is the price for Bitcoin determined and which mechanisms other than the protocol come into play?
Supply and Demand
The basic rules which apply to Bitcoin and determine BTC’s price are very simple. Supply and demand are correlating with each other. If there is a lot of supply available and no demand, then the price will go down. Should the supply get tighter or the demand should increase drastically, then the price goes up.
Sure, this is a basic description of how a market works, but with Bitcoin, this has a greater weight than with other assets. The reason for that is also simple. Bitcoins protocol limits the amount of BTC to roughly 21 million that will ever come into existence.
This means that unlike fiat currencies Bitcoin follows strict rules that won’t allow to increase or decrease the amount of BTC that is flowing on the market. Therefore, changes in supply or demand have a bigger impact on the market and therefore on the price. Of course, the total supply is always the same, but the available supply on the market can change over the course of time. If investors chose to hold onto their BTC the supply will be more affected than with currencies that can be inflated. On the other hand, should they choose to sell BTC then there is only a fixed amount that could exercise pressure on the price until it is theoretically all sold.
Why is the Bitcoin price so volatile?
Bitcoin is not only the first cryptocurrency but also the most dominant according to its market cap. This may leave the impression that BTC is indeed a very big deal. The truth is that Bitcoin is still a relatively small asset when comparing it to others that are more established like gold.
With a market cap that is still small, Bitcoins price can be influenced more easily. It is believed that the volatility will vanish once the market cap has reached a more significant size. This theory is supported by the fact that the volatility has already tightened throughout the last couple of years.
BTC is still making large price moves and is considered to be volatile at its current market cap. Once it is going to reach a market cap that is similar to or bigger than gold this behavior may adapt and show a similar pattern to assets of the same size.
Can the Bitcoin price go to zero?
Yes, it absolutely can. Even though the probability is very low, the Bitcoin price could drop down to zero. The only reason that keeps the Bitcoin price up is the perception of the investors and why they attribute value to BTC.
Some people believe that Bitcoin has better properties than gold and will act as a digital store of value. Others think that because of these properties BTC is the best inflation hedge. It is very scarce after all. But if investors would stop believing in these things, then Bitcoin would become a mere collectible and it would most likely only retain value in price because of a few collectors.
This is also why the Bitcoin price is sometimes determined by the news. In May 2021 the Chinese government banned Bitcoin mining through a new policy. Within a short timeframe, the hash rate of the network dropped, and along did the price.
To most professionals in the industry, it was clear that this would only be temporary because it would still be highly attractive to mine Bitcoin. Still, the broader got scared by the news and started a sell-off. A few months later the hash rate and the price recovered and Bitcoin even reached an all-time high in November 2021.
This is a prime example of much impact the public perception has on the Bitcoin price. The good news is that this effect also works in the other direction and to the benefit of Bitcoin.
Production costs and the Bitcoin price
As the example of the Chinese mining ban in 2021 already hints, the production of Bitcoin comes at a cost. Miners have to invest in hardware as well as the energy cost for running the equipment. Personnel and renting the sites represent only a fraction of the cost.
This is a very typical picture for a commodity and the production costs are associated with the Bitcoin price. Miners can only maintain their businesses when the Bitcoin price is sufficiently high. If the price drops and miners have no or only a little bit of liquidity set aside, they can only carry on for a certain time.
After the run of funds, the so-called miner capitulation sets in which means that they have to sell anything in their possession and go out of business. Therefore, the circumstances of the mining industry can have an impact on the Bitcoin price.
Is it possible to predict the Bitcoin price?
In short: No. It is not possible to foresee the future and predict a price level for Bitcoin. What is possible is to gather enough data and do market research to speculate on the Bitcoin price development. The price can either go up or down, which is a binary choice if we rule out the possibility of sidewards movement for the sake of the example. Apart from luck, technical and fundamental analysis of the market is helping to predict outcome. Please note that even professionals don’t enjoy the certainty of the outcome of their trades. Instead, they rely on strategies and complex financial instruments like options or derivatives to beat the odds even if the trade goes in the wrong direction.