As it is very usual for people to keep tabs on the current price of bitcoin, only a few of these people actually understand how the price is determined.
What really affects Bitcoin’s price?
How is the price of Bitcoin determined?
Is it demand and supply?
Are there other determining factors?
In this article, I will be answering these questions as simple as possible, so that even a newbie would understand.
Firstly, we need to understand that Bitcoin is different from assets such as shares, stocks, and commodities.
So, therefore, there are a few surprising but interesting determinants to be considered when calculating the price of bitcoin.
Price of Bitcoin Explained
When discussing bitcoin price, people are mostly referring to either the USD price of bitcoin on common leading exchanges like Binance, Bitfinex etc. or an average price gotten from multiple exchanges as provided on sites like coinmarketcap.
One interesting fact worthy of note is that there is no single bitcoin price. This is due to the fact that Bitcoin is a decentralized asset that is traded on hundreds of exchanges and between countless individuals all over the world.
As for the Bitcoin price on exchanges, it refers to the price of the last transaction that took place on that particular exchange. So, let’s say the bitcoin price on Binance is $7000/BTC, this only means that the last trade on Binance was concluded at $7000. This price will be adjusted accordingly once a new trade has been conducted and concluded.
This means each exchange would have a slightly different bitcoin, although these prices are very similar. Later in this article, we would learn how these prices are been synchronized together.
Definition of Terms
Before diving into the breakdown of Bitcoin price determination, here is the definition of some keywords you should take note of.
- Order book; not a book in real sense but a page displaying information relating to buy and sell orders execution.
- Buy orders;also known as bids are a list of all standing and pending orders to purchase bitcoin at a certain price.
- Sell orders;also known as asks are a list of all the available offers and orders to sell Bitcoin at a certain price.
- Spread;this is the difference between the best bid and best ask prices on a given exchange.
- The taker; is the side that is desperate enough to pay the spread in order to immediately execute the trade.
- The maker; is the other side, meaning the individual that made or initially started the trade.
Bitcoin Price Discovery
Price discovery is simply the process through which buyers and sellers meet on an exchange or elsewhere to agree on the price at which they will trade.
By default, buyers want to pay as little as possible for as many coins as possible. Sellers, on the other hand, want to sell a few coins for as much money as possible.
Two conflicting interests, right? Interestingly, they both have to reach a consensus on a certain price for any trade to take place.
As explained earlier, the Bitcoin price on any exchange is just the most recent price that a buyer and seller have agreed upon. The buyer and sellers constitute the first determinant of bitcoin price which is; Demand and Supply.
Let’s now analyse how Demand and Supply i.e. buyers and sellers determine prices at which they agree to commence trading activities.
The Order Book
The interface in any standard exchange always has what is known as the order book. This has two sides; the buy orders side also known as bids and the sell orders side also known as asks. Also on display are recent trades in lists or chart format.
Asks are listed showing the price at which the seller would be willing to sell and the number of coins he would want to sell at that particular price. Bids are also listed in the hierarchy of the closest to the asking price and the number of coins the buyer can afford at that price.
Makers and Takers
This is where the demand and supply determinants come into play.
Makers set the price they want to buy or sell at. Takers do the actual “buying from” or “selling to’ the maker.
Demand and supply pricing can be explained thus; if there are more buyers than sellers the price rises or the other way round it falls.
Practically, this is not true in bitcoin price determination because it takes two parties to close a trade. This implies that if someone bought bitcoin, someone else must have sold it to him.
What really causes the price to move up and down is market aggressiveness. This refers to the side that is more desperate in “crossing the spread”.
Whichever side is more motivated will pay for the spread to execute the trade immediately; making him the ‘taker’ and the other side is the ‘maker’.
How Takers Use the Spread to Drive the Price
In an assumption that the current price is $14000 and aggregate buyers predict that price will hit $15000 in the next two days, the buyers would be motivated to act as takers because they would profit by buying under $15000.
This makes them more aggressive to pay the spread to buy up as many coins as possible offered at $14000. With this move, they expect to make $1000 gain minus the spread.
If buying becomes aggressive, sellers are very quick to notice and start increasing their ask prices. This goes on until buying pressure is at its peak, at which the whole process would reverse.
Over time, these impulses drive the bitcoin and crypto market price up and down.
As rightly observed by Jen Wieczner of Fortune magazine, Bitcoin and crypto price is also affected by hype, be it personal or institutional hype.
Other traditional assets are not generally influenced by that.
What the hype actually does is to suddenly attract a group of investors, which drives up the stock price of bitcoin up rapidly.
This attracts even more crowd of investors until reaching such an extent that the price has been overinflated and by default adjusts itself.
- Leading Exchanges
Finally, the effect of market-leading exchanges on Bitcoin price is really worthy of note. Those which have the highest trade volume [i.e. the highest number of crypto traded] are considered to have a more “official” price.
Assuming Ethereum price spikes on a leading exchange like Bitfinex or Binance– and also across several major exchanges at the same time then it will most times certainly cause all other exchanges to have higher Ethereum prices too.
The reason for this trend is simply because most traders pay rapt attention to prices on major exchanges.
They expect that prices on leading exchanges will surely filter through and affect minor exchanges through arbitrage trading strategy and belief that traders would follow suit. This leading exchange trend can also be witnessed across exchanges that make use of different base currencies.
Global Price Synchronization
As of now, we have learnt that price discovery occurs across all Bitcoin trading avenues. This process as described above is going on continually across hundreds of crypto exchanges around the world. Due to this, there is no official bitcoin price as every exchange has a slightly different price for bitcoin.
What keeps these prices more or less similar and synchronized is what is referred to as the process of arbitrage trading. This simply refers to a trading strategy which involves taking advantage of price differences between trading avenues. Assuming bitcoin is cheap on luno and expensive on binance, traders can make a low-risk profit by trading between these two avenues. The after effects of arbitrage trading are what keep bitcoin and crypto prices more or less aligned and similar across these avenues.
As there is no single ‘official’ bitcoin price, despite the synchronization of prices as explained above, some avenues usually make available a composite ‘index price’.
This price is arrived at by weighting the price of various leading currencies by trade volume and then using them as an average.
Index pricing can be a very useful pricing mechanism as it eliminates any unusual effect of any uncommon trading activity on a single exchange.
While bitcoin and crypto price have been known to be mostly determined by the forces of demand and supply, the effects of social hype and trends from leading exchanges cannot be overlooked.
Also, the effects of arbitrage trading and the use of index pricing have really gone a long way to keep these prices in check and create a more uniform and synchronized ‘official’ price for bitcoin and cryptos generally.