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How Bitcoin Prices Are Set

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Since it first launched in 2009, the price of Bitcoin has soared to incredible highs and plummeted to disappointing lows. Is there a logical explanation for these fluctuations?

To people just starting with cryptocurrency, it may seem as though Bitcoin’s price is a puzzling, completely unpredictable value. Nevertheless, several known factors influence the price of Bitcoin. 

In this article, I will try to demystify the shift in Bitcoin prices, look into the elements that shape it, and explore the possibility of predicting trends in cryptocurrency worth.

The factors influencing the price of Bitcoin

Here are some of the critical factors that influence how Bitcoin prices are set:

Supply vs. demand

With traditional currencies, the government and central banks can control, although imperfectly, the amount of currency in circulation and the exchange rate.

However, Bitcoin supply works differently. The creation of new bitcoins happens through a process known as mining, during which miners process transaction blocks. The total amount of bitcoins in the world is finite, with a maximum of 21 million bitcoins encoded into the cryptocurrency’s source protocol, and mining gradually slows down over time.

This gradual, pre-programmed increase in the difficulty of Bitcoin mining was supposed to imitate the extraction process of precious natural substances.

Because of the limited total amount of Bitcoin and the ensuing artificial scarcity, the demand for bitcoins can be potentially much higher than the supply, leading to a price increase. In this sense, Bitcoin is the digital equivalent of gold and other valuable metals and minerals.

Bitcoin mining

Bitcoin mining is a process in which a user’s computer solves complex algorithms to earn rewards in the form of new bitcoins and transaction fees. The newly mined bitcoin is known as the “block reward” – the number of bitcoins a miner gains after completing a blockchain block. In the early years of Bitcoin, the block reward was 50 BTC, and mining was comparatively easy.

The current block reward equals 6.25 bitcoin, and this amount halves every four years. This means that, with time, gaining Bitcoin becomes more and more difficult for miners. The next Bitcoin halving will occur in 2024.

When miners gain new bitcoins, they can hold it, but many Bitcoin mining operations trade their cryptocurrency, thus increasing market supply. A major release of new bitcoin into the market could drive the price down.

Bitcoin production costs

Although Bitcoin is a virtual currency, its cost of production is very real. Electricity is the primary resource used in mining Bitcoin.

Mining is an energy-intensive task that requires powerful computer equipment with high electricity needs. Various experts state that the amount of electricity used for Bitcoin mining alone is higher than certain countries consume in a year.

Because Bitcoin mining requires so much electricity, energy costs affect Bitcoin price. When the price of electricity is low, miners can obtain higher profits from Bitcoin. However, if the cost of electricity climbs up, Bitcoin mining can become financially unsustainable, and mining operations may quit.

Often, to offset production costs, Bitcoin miners operate in countries where electricity is cheaper – which unfortunately may mean using nonrenewable coal-based energy sources. This practice has prompted increasing concerns regarding the effect of Bitcoin mining on the environment.

As the amount of Bitcoin yet to be mined is decreasing, the mining difficulty increases, demanding more advanced equipment and more energy. Higher production costs drive up Bitcoin’s market price.

Competition

Although Bitcoin is currently the leading worldwide cryptocurrency, the digital currency market is constantly growing and now features over 4,000 existing cryptocurrencies. Some of the better-known ones include Ethereum, Litecoin, and Cardano.

At the moment, Bitcoin enjoys the advantages of high visibility, popularity, and worldwide acceptance, which give it an edge over competing virtual currencies. However, in the future, other cryptocurrencies may gain popularity and become serious competitors of Bitcoin.

Availability on virtual currency exchanges

Crypto investors use exchanges such as Coinbase and GDAX for Bitcoin trade. Exchange platforms allow investors to trade Bitcoin for fiat currencies or other cryptocurrencies.

Although Bitcoin doesn’t depend directly on governments and central banks, exchanges facilitate a major part of Bitcoin transactions. As popular crypto exchanges become widely acknowledged, they are likely to comply more consistently with global cryptocurrency regulations, which could influence Bitcoin market interactions.

Government regulations

Until now, cryptocurrency has largely been a legal gray area, often called the “digital Wild West.” This position appears to be changing as U.S. lawmakers introduce a new bill meant to make crypto regulations clearer and better enforced.

The new legislation is supposed to look into crypto asset custody, cybersecurity, private key management, and fraud prevention. It should also examine ways to improve crypto-asset market integrity, transparency, efficiency, and fairness.

So far, the present ambiguity of all the aforementioned elements has deterred many conservative investors from holding and trading in cryptocurrency. Once Bitcoin and other crypto-assets become more secure and better regulated, they will continue to gain more widespread acceptance, which could positively influence their prices.

Of course, some may say that government intervention contradicts the concept of cryptocurrency as a free and independent global asset. Others may warn that possible tax regulations and the requirement for increasingly transparent trader identification could drive certain investors away from Bitcoin.

Who decides how much Bitcoin is worth?

How Bitcoin Prices Are Set - Everything You Need To Know - Who decides how much Bitcoin is worth

Since Bitcoin is a decentralized, independent currency, it works like a global commodity, meaning that the market sets its price, which fluctuates constantly.

Bitcoin’s current price depends on how much investors are willing to pay for this asset at the moment. It works the same way for precious metals and minerals. Diamonds are only valuable because people are willing to pay for them. Bitcoin price follows the same principle.

Like other commodities, Bitcoin conforms to the supply and demand formula. More demand and less supply drive prices up, while higher supply and lower demand bring prices down.

To make matters more complex, Bitcoin prices vary according to crypto exchanges. If you check two different crypto exchanges at any given moment, you’ll see slightly different Bitcoin values. Each exchange sets its average price depending on ongoing transactions.

This doesn’t mean, however, that exchanges set the price of Bitcoin. Rather, the traders buying and selling Bitcoin on this particular exchange determine the current price.

Traders must comply with the current market price too, of course. If a trader prices their bitcoins too high, they will get no buyers. They will have to either conform to the acceptable market price or forego the transaction.

Bitcoin liquidity

One major reason why Bitcoin prices can rise and plummet so quickly is the inherently limited, narrow amount of bitcoins on the global market. Compared to conventional currencies like the U.S. dollar or the euro, Bitcoin is a tiny stream. Because of this, a comparatively small number of transactions is enough to start or divert a trend.

The total amount of Bitcoin isn’t distributed equally. Large amounts are concentrated in the hands of individual investors, who hold a lot of power over Bitcoin prices if they decide to sell or trade a high volume of their cryptocurrency. Allegedly, Satoshi Nakamoto, the legendary Bitcoin creator, owns over a million bitcoins. Crypto holders who possess large Bitcoin amounts are known as “whales.”

In contrast, over 99% of Bitcoin wallets have a balance totaling less than one bitcoin. Because a tiny percentage of holders possess a disproportionately high Bitcoin balance, they could manipulate the Bitcoin market price.

Fiat currency values fluctuate too, of course, but a much higher trade volume would be necessary to cause a dramatic surge or fall in conventional currencies compared to Bitcoin. That’s why we usually see slow, gradual changes in the value of the U.S. dollar, British pound, or euro, while Bitcoin has displayed some cataclysmic shifts in recent years.

Is it possible to predict Bitcoin price fluctuations?

Glowing forecasts predict that the value of one bitcoin will eventually reach $500,000. On the other hand, more pessimistic authorities warn of the possibility of a major Bitcoin crash and “crypto winter” that will cause stagnation and major losses for Bitcoin investors.

It isn’t easy to make an accurate prediction of Bitcoin price trends. Cryptocurrency doesn’t act like traditional investments such as stocks, bonds, or hard assets. The price leap Bitcoin took in the first quarter of 2021 – doubling its price from the starting point of $29,000 – was a complete surprise to most financial experts. 

A crypto investor would do well to remember the zigzagging graph of Bitcoin prices over the years. So far, we have seen that downfall has followed every peak in Bitcoin value – but also that the world’s leading cryptocurrency had eventually rallied each time, even though the process could take years.

Overall, the best strategy would probably be not to panic and sell Bitcoin during a sharp decline, but to hold tight and wait for positive trends.

The future of Bitcoin

How Bitcoin Prices Are Set - Everything You Need To Know - The future of Bitcoin

Bitcoin is going more and more mainstream. Leading institutions now recognize Bitcoin as a viable currency, giving rise to its wider acceptance.

Financial giants such as PayPal and Visa are now facilitating Bitcoin transactions, and even central banks in several countries acknowledge the potential of cryptocurrencies. One example is Morgan Stanley, a major U.S. bank that offered some of its investors an opportunity to use Bitcoin funds. Shortly after, Elon Musk announced that it is now possible to purchase Tesla cars with bitcoins.

With Bitcoin’s rising popularity, cryptocurrency investment is looking increasingly attractive right now.

Many crypto users wonder what will happen to Bitcoin once all 21 million bitcoins are in circulation. The actual number is, in fact, lower than 21 million because of private key loss and people dying without passing on their private keys.

Although the limited supply of Bitcoin will eventually mean fewer incentives for Bitcoin miners, the cryptocurrency will likely retain value in the future.

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