Bitcoin price drivers: what moves the long-term price of bitcoin?

*Such is the nature of cryptocurrency investment. When I began to write this post bitcoin was trading at $900. It’s now past $1100 and may well break its ath soon. If you’re deciding whether to invest now, I’d say go for it – but only in small amounts, and only with a weekly or monthly schedule of dollar-cost averaging. The bitcoin price goes through boom and bust cycles, tied as it is to human psychology and irrationality, but I’m more of a believer than ever. Imho, anything above $2K is a bubble which will inevitably burst, as it has many times through its entertaining and volatile history. Buyer beware!

Bought my first bitcoin in 2013. Down the rabbit hole I went: obsessively checking the price tens or hundreds of times a day, scanning every new item posted to the crypto subreddits, reading more whitepapers than I ever had in school, devouring every analysis and essay I could google. And like every investor who has put far too much of their net worth into cryptocurrency, I’ve developed some strong – and always changing – views on what moves the long-term price. It’s impossible to consistently and accurately forecast short term price fluctuations, subject as they are to peoples’ whims, but I have a strong conviction that cryptocurrency will be one of the greatest wealth creation opportunities that we’ve witnessed in the Internet age.

Software is eating the world, and it is finally eating money.

So the below explanations aren’t factors that move the price every day. The daily price is more influenced by factors like technical analysis and slippage and popular press. Rather, the below arguments are the fundamentals, the pillars, that drove bitcoin from a fledgling technology to a $15B market cap today, and will still be relevant when cryptocurrencies as an asset class are worth $100, something I believe will happen within ten years.

Here they are:

  • Bitcoin’s intrinsic value as a payment technology without a central authority
  • Bitcoin as an increasingly attractive asset for institutional investors and professionally managed money
  • Bitcoin as the new and better Gold
  • Bitcoin as a relatively safe and accessible currency
  • Bitcoin as an increasingly legitimate asset with government recognition and regulation
  • Bitcoin as perhaps the best speculation vehicle the world has yet seen

If you have evidence that flat out contradicts any of the below, I’d love to hear from you. As an investor it pays to be right. It doesn’t matter, really, how you arrive at the answer.

While I sometimes mention cryptocurrencies as an asset class, I try not to discuss specific coins besides bitcoin. The market of altcoins and appcoins is somewhat correlated – and the precise correlation between them is a fascinating piece of potential research that I’ve yet see. So ethereum’s success will bode well, to a degree, for bitcoin. And vice-versa. But my commentary below will try to focus on bitcoin alone, because that is the biggest market and the most stable asset. The success or failure of cryptocurrencies will depend, to an important degree, on bitcoin.

At a very high level…

The growth of adoption of Bitcoin and therefore bitcoin price is following an S-Curve of Technological Adoption, which is itself characterized by fractally repeating, exponentially increasing Gartner Hype Cycles. This theory represents an overarching long-term fundamental factor that dwarfs the effects of other fundamentals such as: exchange hackings, government regulatory announcements, changes in economic policy and further technological advancement of the protocol.

That’s a fancy way of saying we’ll see a lot of price swings in the years to come, even as the price and market cap grow.

Now onto the arguments. They’re arranged roughly in order from most to least important.

bitcoin’s intrinsic value is Bitcoin

A diminishing number of critics like to argue that bitcoin has no intrinsic value. And for the longest time I sorta agreed with them. What is the intrinsic value of something that you can’t see or hold, that has no government backing, and is simply the result of some fancy math problems?

The problem is that we are confusing Bitcoin’s forest for its trees. Bitcoin is many things, and one of the most important, and the source of its intrinsic value, is its use as a payment network. In Naval Ravikant’s wise words, “the Internet allows any two individuals to transfer data without permission from any central authority. Bitcoin does the same for value.”

In other words, what Bitcoin the payment network allows me to do is send you money no matter where you are in the world, as long as you have an internet connection. And we can do this without the help or approval for any intermediary.

Now what generates the confusion is that Bitcoin is also a currency. We call that currency bitcoin with a lower-case b. So you could think of the system as Bitcoin+bitcoin. The payment network + the currency. Or in the words of a Chicago Federal Reserve economist, “Bitcoin is a system for securely and verifiably transferring bitcoins”.

Now what’s generating all the excitement and hyperbole is bitcoin the currency, a finite accounting unit currently trading around $1000 USD.

Bitcoin is both a payment system and a money. The payment system is the source of value, while the accounting unit merely expresses that value in terms of price.

The intrinsic value is the payment network. But you can’t separate it from the currency, because bitcoin the money is the oil that makes this engine run. The currency pays the computers to solve tough math problems to secure the network. The currency allows us to transact and trade and spend. The currency is the network’s native unit of account and medium of exchange and for these reasons, it has become a store of value.

What’s important in Naval’s earlier quote is the keyword “value”. He specifically said value, not money, because the Bitcoin network can do much more than transfer money. It can send anything of value that can be encoded digitally, like a smart contract, or a property title.

This is how Bitcoin+bitcoin differs from gold: while gold has intrinsic value because you can wear a gold necklace around your neck and we can use gold in limited industrial applications, gold is just gold. The currency bitcoin’s value lies in its utility for Bitcoin the payment network, which itself is valuable for all the reasons stated earlier.

Bitcoin+bitcoin is the first time in history where the payment system and the currency are tied together in this way.

Think about government fiat: the US dollar is a currency, but the payment system relies on banks, on tellers, on the physical action of swapping money.

Gold and oil are currencies, in a way, but neither commodity can ship itself around the world, securely and in ten minutes, for a very low transaction fee.

So the biggest and perhaps most fundamental factor in bitcoin’s price – what gave a price at all, in fact, and what will continue to drive its growth and adoption – is its usefulness as a value-transfer network that can exist without the approval of any government or central authority.

As a result of this ability to transfer value without a central authority comes the ability to do things that governments dislike: activities like buying drugs and gambling online. Bitcoin+bitcoin gives users access to what people call the dark markets or shadow markets. Silk Road, a famous and now defunct dark market, at its peak accounted for as much as 10% of bitcoin’s price. This is known as regulatory arbitrage – the ability to take advantage of different regulations – or none at all – through the use of bitcoin and cryptocurrencies. And for a subset of users, this is their most important feature. A conservative bet is that at least 10% of the world economy is in this shadow economy, if not much more. Illegal drugs alone – both online and offline – is a $360B market. Given the worldwide government war on cash, cryptocurrencies could grow to 1/3 of this market. That alone would reach my $100B prediction. The proliferation of privacy-focused altcoins like Monero and Zcash only confirms this utility.

Money exhibits a strong network effect, and research shows a strong correlation between Bitcoin’s userbase, its transaction volume, and its price appreciation. So Bitcoin+bitcoin’s utility will grow exponentially as more people use it. Both scalability and privacy are problems today, but there are several solutions in the works, and many competing cryptocurrencies – from Ethereum to Monero – that solve address these concerns.

Outside of the dark markets, Bitcoin as a payment network is useful today but not yet indispensable. For much of 2014, merchant adoption was portrayed by the media as a major catalyst in bitcoin’s growth. But the data has proved otherwise. Merchant adoption rates are slowing, and there is little usage of bitcoin the currency for buying regular, everyday goods. For shopping on Amazon and at Target, cash and credit cards are good enough. And while there are many additional use cases for Bitcoin’s platform for value-transfer – from remittances to capital flight, from serving the underbanked to smart contracts – none of these have become, by themselves, large or fast growing pieces of the Bitcoin economy.

The argument that best captures the reason why bitcoin the currency rises appreciates in value as Bitcoin the network grows in utility is USV’s fat protocols thesis. In a nutshell: the protocols on which the Internet was built – like SMTP and HTTP and TCP/IP – were far less commercially valuable than the applications and websites which employed them – like Yahoo and Google. But Bitcoin and cryptocurrencies represent a class of protocols where a lion’s share of the value will go directly to investors in the protocol’s tokens, like bitcoin and Zcash.

Institutional investors at the gate

The second big driver of bitcoin’s value is an increasing interest among institutional investors and high net worth individuals. Granted, they’ve always been an essential part of bitcoin’s growth. Guys like Tim Draper and Chamath Palihapitiya and Wences Casares gave vocal and passionate support to its fledgling community. But there are a number of signs now that professionally managed money – from pension funds to hedge funds, from Wall Street to the Square Mile – is getting into bitcoin in a meaningful and sustained way.

Saying Wall Street money is coming into bitcoin is a little like saying global warming’s here: each year it gets a little warmer, but its almost impossible to convince a skeptic, since there’s rarely a smoking gun, a single notable domino.

One collection of signals is a growing number of cryptocurrency products marketed to institutional investors. Two US-based ETFs applying for SEC approval: the COIN ETF from the Winklevoss Brothers and the XBTC ETF from SolidX, to be listed on BATS and the NYSE Arca, respectively. I’ve read both S-1 registration statements and will have an analysis for you later. General consensus is that approval of these ETFs will be a major boost for bitcoin’s price, and that at least one ETF will be approved in 2017. But don’t hold your breath – the first equity ETF took the SEC more than 4 years to approve, and the Winklevoss twins filed for the COIN ETF in July 2013. The upside? When Gold ETFs were first introduced in the mid 2000s, the gold spot price tripled over the next 5 years.

These ETFs are just the latest and biggest entrants in a growing market of bitcoin products that facilitate professional money’s desire to gain bitcoin and cryptocurrency exposure. Products like Grayscale’s Bitcoin Investment Trust GBTC and Global Advisor’s European exchange listed funds COINXBT and COINXBE. There’s even a US bitcoin IRA now. At its peak GBTC traded at a 60% price premium over bitcoin, just one indicator that a class of investors seek bitcoin exposure but either can’t or don’t want to buy bitcoin directly.

There are many reasons for institutional interest. The simplest is bitcoin’s outstanding performance. Volatility – once one of the biggest concerns about bitcoin as an investment – has decreased to the level of a small cap US equity. And research indicates bitcoin’s price movement exhibits no correlation with major asset classes including equities, bonds, real estate, and commodities. This is huge for portfolios that seek asset diversification while also participating in bitcoin’s upside. In recent months Acatis became possibly the first European investment fund to publicly add bitcoin exposure to their portfolio, through a stake in COINXBT.

Our first buy was conducted on October 7, 2016. Since then the price has appreciated 35.49 percent. This alone gave our funds, as a whole, a return of 1.06 percent and we gained more than €1 million with bitcoin’s price rise. This is quite good and ranks in the top 20 percent of the quality of our assets.

Bitcoin as Gold 2.0

For many investors, bitcoin is the new gold. More divisible and transportable. Easier to spend and easier to store (if not necessarily safer). And Bitcoin’s perceived waste of electricity to power its mining is minuscule when compared to the cost and pollution of gold mining. In 2013 it was estimated that the total electricity cost of bitcoin mining in a 24-hour period was $1.5M, or about $500M a year. The average cost to mine an ounce of gold is $1000, and about 80M ounces are mined each year. That’s $80B dollars, or 160x more costly than bitcoin, without taking into account the added expenses of refining, storing, securing, and transporting gold.

Needham research estimates 75% of bitcoin purchases are as a store of value, which is also the primary reason people buy gold. This is confirmed by other experts in the space including Wences Casares, CEO of Xapo.

In a world of money supply inflation, people buy commodities like gold to preserve their wealth. Bitcoin is becoming another option because, among other reasons, its inflation rate is known and decreasing and its long term supply is fixed at 21M bitcoins – or 21 trillion bits. There will never be more bitcoin than that. This rule only applies to bitcoin, not other cryptocurrencies, and only in its present form. In each of the last two halvings which occurred on November 2012 and July 2016 – when inflation rate of bitcoin supply dropped by half – bitcoin’s price went on a run price some 4-6 months after. The next halving will occur in mid-2020. This may not be a real pattern, as research shows at best a weak relationship between bitcoin’s price and its supply.

Money as its traditionally known serves three functions – a store of value, a medium of exchange, and a unit of account. Right now the bulk of money coming into bitcoin, especially from the developed world and from big investors, seems to be for its attractiveness as a store of value. Gold 2.0. Bitcoin as a medium of exchange is developing, but slowly and largely in speculation markets. And it’s still too early – and bitcoin too volatile – to be considered a reliable useful unit of account, although my view is that as the world of altcoins and blockchain tokens grow, bitcoin will be seen more and more as the unit of account for this new world of digital assets.

Bitcoin drives out the bad currencies

On a related note, more a subset than a separate thought from the above, bitcoin is becoming an exit plan and safe haven for citizens living in countries suffering from high inflation (like Venezuela) and geopolitical risk (like Britain and Greece). Research showed a link between the 2012-2013 Greek-Cypriot crisis and increased demand for bitcoin. In the aftermath of UK’s Brexit referendum, bitcoin was – alongside gold, the US dollar, and the Japanese yen – one of the few assets to appreciate in price.

Gresham’s Law states that bad money drives out the good. The theory goes as follows: in a free market economy, if you hold two currencies – let’s say the stable US dollar and the crumbling Venezuelan bolivar – you are likely to hoard the dollar and spend your bolivar. If everyone does this, eventually only bolivars will circulate in the economy and their value depreciation will accelerate and concurrently the demand for dollars will rise as a safe and stable asset. Vinny Lingham has a great essay on how people around the world are starting to use bitcoin as a hedge against weaker currencies.

…the recent fed rate hike which puts pressure on emerging market currencies, strengthens the dollar and in turn creates a surge in the forex/BTC trading price. This in turn creates additional foreign buying and demand for Bitcoin as a forex hedge, particularly outside the US, because the price of Bitcoin in that country is rising quickly.

Are regulators friendly, are they not. Are regulators friendly, are they not

Government regulations are another important factor in bitcoin’s long-term price performance. The drivers I’ve mentioned earlier – Bitcoin’s intrinsic utility, rising institutional interest, and bitcoin as the new gold – generally increase bitcoin’s price. Regulations go both ways. Long-term, it’s arguably good for bitcoin to have a clear set of regulations no matter how restrictive they are (save, perhaps, for an outright ban on bitcoin trading and mining). But the more regulations that exist, the more friction there will be in bitcoin investment and cryptocurrency innovation. One need look no further than New York’s BitLicense.

The multi-billion dollar question here is how China and America will regulate bitcoin. China has been cautious with bitcoin, officially banning banks from dealing with bitcoin exchanges, lately they’ve issued some supportive statements and taken steps to explore blockchain technology. Because a majority of Bitcoin mining activity and exchange trading are located in China, a wholesale ban could mean a large drop in bitcoin’s price although this will not lead to its demise. But such a move grows less likely by the day, and in fact recent signs are that the Chinese government is warming to digital assets.

The US has a patchwork of federal and state regulations for bitcoin and its ilk. Today federal regulations by the CFTC treat bitcoin as a commodity, the IRS treats bitcoin as property, and the US Treasury calls it a “convertible decentralized virtual currency”. President-elect Donald Trump appointed Mick Mulvaney, nicknamed the Bitcoin Congressman, as his budget chief. So clarity is emerging, and signs are positive, that regulation will at the least not be a huge roadblock for growing bitcoin adoption and innovation in the States.

Another trend that should positive impact bitcoin’s price is the worldwide government war on cash. India recently banned all 500 and 1000 rupee bills. As the world continues to move – voluntarily and through coercion – to digital money, bitcoin will benefit. The network is nowhere near as anonymous as some people think, despite its usage for dark market transactions. Bitcoin is at best pseudonymous. Research has shown that perhaps as much as a majority of on-blockchain transactions can be identified to a reasonable level of certainty. Everything on Bitcoin’s public blockchain – I mean everything – is public and linkable and source-able to the beginning of that blockchain’s existence. Just have a look at the Big Bang visualization from Elliptic, a company that helps law enforcement identify illegal blockchain activity.

For this reason and others, I believe regulatory risk is low. A clear regulatory environment is better than no rules at all. In business, knowledge is better than hope. Smart governments are starting to realize that money moving to public blockchains is actually aligned with their goals of consumer protection and law enforcement. This is why everyone from the US Federal Reserve to the Swedish Financial Authority are actively studying cryptocurrencies and their underlying technology. A problem – indeed perhaps a cause – of the 2008 financial crisis was the difficulty in determining who owned what complex assets, when, and in what amounts. Blockchain technologies is no panacea, but it would help fight this growing financial complexity and uncertainty.

In fact I think more than governments, it is private companies that will fight bitcoin and its brethren. Some will see it as a competitor instead of what it really is: a foundational technology that anyone can employ to operate better, faster, and more cheaply.

Speculation in a bottle

Finally, we have speculation to thank for helping to make bitcoin what it is today. This factor will decrease in importance, perhaps, as the market matures and volatility decreases and regulation grows, but to date it’s been hard to think of a better speculative asset than bitcoin. A digital borderless asset that operates in a global 24/7 market where trades are executed quickly and settled just as quickly, performing like a small-cap stock with mid-cap liquidity. And easily the best performing world currency since its inception. Never a dull moment for traders. There’s even a link between the number of Wikipedia views of the bitcoin entry and its price!

While it can be a hassle to buy your first bitcoin, once you have a purchase process established, it’s remarkably easy to fund cryptocurrency exchanges with bitcoin to invest in the growing world of altcoins and blockchain tokens.

For example, when I first setup an account with the Poloniex exchange, I funded my account with bitcoin and was able to buy the Monero altcoin (XMR) within an hour. Try doing that with stocks, bonds, or gold. Establishing an account with an online broker like Fidelity takes days, primarily because funding the account requires a standard US bank transfer.

If you get bored of bitcoin itself, there is a Cambrian explosion of other math-based currencies and digital tokens that can be traded on the same exchanges. At latest count there were 642 such cryptocurrencies with sufficient liquidity, from privacy centered coins like Zcash to permissioned networks like Ripple. Beyond altcoins, there are now tens and eventually hundreds of what are interchangeably called blockchain tokens and ICOs and appcoins that will see similar investor interest.

I would go so far as to venture that while bitcoin is not yet a true medium of exchange and unit of account in the same way the US dollar functions in our traditional economy, bitcoin increasingly serves those two functions for cryptocurrencies as an asset class. It is far easier to fund my Poloniex account and buy altcoins using bitcoin as my medium of exchange than trying to do the same through the US dollar and the standard banking system. Increasingly I see altcoin and appcoin prices denominated and reported in terms of bitcoin and ethereum, another leading cryptocurrency.

Derivatives and futures and other financial instruments have entered this space. This will only accelerate. CME Group runs one of the world’s largest options and futures exchanges. They recently added a bitcoin reference rate which many see as a precursor to launching derivative products for bitcoin. We’re just at the beginning, and all of these innovations and layers will only add money and fuel to the cryptocurrency economy.

Known unknowns

Finally, I’d like to briefly address two important questions about Bitcoin’s long-term future.

One is the likelihood of more hacks and malicious attacks against the Bitcoin ecosystem. While the protocol has never been successfully attacked (although this is not impossible), the apps and services that interact with the Bitcoin blockchain have been attacked successfully. Investors have lost money – more than $500M with Mt. Gox and $72 million with Bitfinex and lots of others besides – and will continue to do so if they aren’t careful and lucky to a degree about how they secure their bitcoin.

Because bitcoin is a purely digital asset that lives only in code and computers, and because the ecosystem has and always will be complex, with billions of dollars at stake, you can bet there will be more security incidents that cause some investors to lose confidence and temporary dips in price. That is pretty much table stakes, even though the trend is toward fewer and less damaging such incidents as the ecosystem matures.

And the final question (and my greatest gratitude for your patience, I hope it was worthwhile!) is how long Bitcoin can maintain its #1 position? It was the first cryptocurrency that has since launched a thousand digital currency ships. But Facebook wasn’t the first social network, Linux wasn’t the first open source operating system, and the US dollar was definitely not the first currency.

Bitcoin has to date held onto its top ranking, but there is more and more good and smart innovation. Despite strong network effects and first mover advantage, I believe bitcoin will incrementally lose market share. Its price will still rise, and rise a lot, if for no other reason than a surging tide lifts all boats. Within its use cases as a payment network and a store of value, I can’t see a challenger supplanting bitcoin in the next five years. But many other currencies will flourish alongside and the ecosystem will thrive.

It’s been a fun journey and the rollercoaster’s only getting faster. Strap in and buckle up! (or is it “buckle up and strap in”?)

Sources

There were many sources that I used to compose this essay. Not all of them receive attribution. The ones that are referenced – that I can remember – are listed below. I prefer to minimize in-line links because they seem to detract from a focused and clean reading experience.

Coinmarketcap – a great place to check coin prices and statistics on the cryptocurrency asset class

Why Bitcoin as both a young technology and its price are subject to repeated cycles and swings [Medium]

Vinny’s essay on bitcoin’s late 2016 price rise and his predictions for 2017 [Vinny Lingham]

Equity research shop Needham’s thorough and well-written report on bitcoin. I shared notes in an earlier post [Needham & Co]

A great description of how Bitcoin is both a payment network AND a currency (what I refer to as Bitcoin+bitcoin). This was the essay that finally put to rest my doubts about Bitcoin’s intrinsic value [FEE]

A GREAT if somewhat dated research paper on the factors that move bitcoin’s price, which I reference throughout this essay [Arxiv], and this paper which confirms the Wikipedia-price correlation

USV does it again – a simple must read essay for any serious investors in the cryptocurrency and blockchain tokens space [USV blog]