The Financial Times received an email in 2014 regarding a $50,000 valuation for bitcoin. There general response was,
“While the eMail pointing to a $50,000 bitcoin is imprecise to say the least, It’s a starting point. A more rigorous mathematical model integrating demand projections with probabilities of certain make-or-break contingencies isn’t just possible – it already exists, in various versions, across various investors’ hard drives.”
Essentially, the Financial Times was emphasizing the need to understand the bitcoin’s price drivers. What follows here are the major factors that affect bitcoin price.
1. Transaction Volume
Transaction volume is a measure of the total amount of bitcoin being moved around in the system. The market price of bitcoin must be able to support total transaction volume.
While we generally know how many Bitcoins have been “released”, this number only provides an upper bound on supply. Realistically, there are “lost coins”, emanating from people who forget their wallet’s address, and “hoarded coins”, which are coins that are being held no matter what.
3. Expectations of Future Value
Generally, expectations of an increase in future value will cause the price to go up (and vice versa for a decrease in expected future value).
4. Uncertainty of Future Value
The uncertainty of future value is represented by present-day volatility. Generally, the more volatile a currency is, the more likely it is to have a lower price since investors cannot have a lower chance of receiving their expected return. Volatility has been a major issue for Bitcoin, and an analysis of bitcoin’s volatility is presented in the Volatility section.
It is generally assumed that positive news will increase prices and negative news will decrease prices. Although a general correlation between the positivity of news and and an increase in bitcoin’s price does seem to exits, the correlation seems quite weak, as evidenced by the graphic below.
Bitcoin price history against major news events
Velocity is the number of times a single unit of the currency is used over a specified period of time. So, how many times does a single, specific bitcoin change hands over the course of, say, a day. Generally, a high velocity corresponds to a lower price.
Liquidity is a measure of how easy it is to buy, sell, or exchange the currency. A liquid currency can very easily be used as a medium of exchange, while an illiquid currency is much harder to use and loses its advantages as a currency. Generally, a more illiquid currency should be priced higher because there will be the risk that you cannot exchange it when you want. Bitcoin is more illiquid due to people that hoard it, effectively reducing the supply of available bitcoin’s for exchange.
8. Cost of Mining
A huge part of the bitcoin network is related to the concept of “miners”. Mining is essentially the process of validating a transaction. Going back to the idea that bitcoin is decentralized, we know longer have an intermediary such as a bank to validate transactions. Thus, miner’s instead validate transactions in “blocks” by essentially continuously guessing numbers until they find the number that validates the transaction. The miner that finds this number is rewarded with a certain amount of bitcoins, along with any transaction fee that that people issuing transactions decide is reasonable. Thus, another constraint on price is that at the least is must make sense for a miner to mine; that is, the total reward needs to be equal to (cost of mining) * (expected amount of time to find a block).
9. Human Emotion
Finally, we must remember that while with all of these price drivers people will try to develop accurate models, there is always a level of variability due to human emotion.