The price mechanism of cryptocurrencies differs from commodities. Supply and demand are not creating an equilibrium; Bitcoin is a bet on technological development.
With Bitcoin breaking through the $5,000 mark, crypto enthusiasts have declared the start of the “Crypto Spring.” After more than a year-long crypto bear market, everyone is hungry for good news and some light at the end of the tunnel.
This month, Bitcoin crossed over the $5,000 mark after going below that floor last December. The market has been “bearish” since the end of 2017 when Bitcoin’s bubble burst. Prior to that, it reached a peak of $19,500.
The market, however, can be cruel. And that’s even more true for crypto markets, as high volatility makes it hard to distinguish between short term price hikes and long-term upwards trends. So, let’s look at the bigger picture.
Bitcoin’s supply and demand mechanism differs from commodities
Supply and demand determine the price of most tradeable assets. If there is higher demand, prices will go up. If the cost increases, supply increases as well. If, for instance, the price of crude oil increases, there will be an incentive for oil companies to re-activate wells that have previously been unprofitable. With increasing supply, prices should come down again. As a result of this process, there will be a so-called “equilibrium,” at which the price will stabilize.
This supply/demand mechanism is somewhat disabled when it comes to Bitcoin, as the price of Bitcoin has almost no impact on supply. Bitcoin supply is determined by the Bitcoin protocol, which allows new bitcoins to be created at a fixed rate. Thus, an increase in demand will lead to a rise in price, without the correcting mechanism of a potential increase in supply.
One could argue, that as demand goes up, so do the transaction fees that miners can charge when processing transactions. Higher transaction fees should, therefore, result in higher supply and thus lower prices.
However, the other effect of increasing transaction fees is that more miners will join the network, which does not only increase supply but also improves network security. This, in turn, should bolster buyer confidence and result in increasing demand and rising prices.
Long-term value proposition: means of payment and apolitical store of value
If there is no self-correcting price mechanism, does that mean Bitcoin is either going to zero or the moon?
If we look at Bitcoin as a commodity, it should trade around its fair value, which is its break-even point. However, it’s difficult to determine a break-even-point, because the cost of mining is ever-changing and reacts to the prevailing market conditions.
A better way to look at Bitcoin’s valuation is to look at its value proposition. Firstly, Bitcoin is a bet on technological adoption of cryptocurrencies. Currently, there are about 35 million active wallets worldwide, not a lot compared to a population of 7.6 billion. If, however, Bitcoin will ever reach mass adoption, its value will stem from its ability to be a means of payment and a store of value
Secondly, Bitcoin is a decentralized currency, meaning it’s independent of political price manipulation. In a similar fashion to gold, Bitcoin can protect value from inflation and political instability.
The Bitcoin price will thus depend on how users price this value proposition. At this point, Bitcoin volumes are low, and infrastructure is still primitive, which leads to high skepticism and thus high price volatility. However, as the underlying technology improves and adoption increases, volatility will smooth, and Bitcoin’s fundamental characteristics will increasingly predominate investment decisions.
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