In-depth Analysis

What drives the price of bitcoin?

Traders of bitcoin are used to sharp price action, like the one experienced during the first weekend of this month, when the digital currency lost around 20% of its value. Such drops in value would normally see investors pulling hair out of their heads, but many holders of cryptos barely care, believing that regardless of everything else, the asset will eventually recover and continue to reach for virtually limitless heights. Such investors are driven by an almost messianic faith in bitcoin’s significance and potential, seeing in it as an encapsulation of several virtues, which include holding the key to a fairer and more transparent future and, unlike the much maligned fiat money, being immune to the influence of obscure powerful forces.

Considering its popular appeal and legions of fans, many will be surprised to learn that 95% of all available coins are held by only 2% of the existing wallets and, despite the spectacular price-action of the last 12 months, less than 20% of existing bitcoins were traded during that period. Another peculiarity of this market is the large number of exchanges where trading occurs, creating a fragmented market that is conducive to amplifying volatility; meaning a relatively small movement in one such venue can trigger a significant price oscillation across the entire system. Finally, the large number of derivatives contracts, allowing the use of leverage, which are based on the prices of the underlying asset, in this case bitcoin, account for a number of transactions five times larger than those placed on the coin itself.

However, despite the idiosyncrasies of this marketplace, in essence, the value fluctuations of cryptos tend, to a large extent, to be determined by dynamics similar to those that move more established markets. The events of December 3rd provide a good illustration: the price of bitcoin dropped around 20% of its value, a movement that mirrored (on a greater scale, due to the reasons highlighted in the previous paragraph) a generalised switch to risk-aversion in the financial markets – the Nasdaq index lost 2% on that same day –  following the release of US employment data.

As the unemployment rate dropped to 4%, the lowest level since the beginning of the pandemic, expectations that the American Federal Reserve will hike interest rates earlier than previously expected took over the sentiment of investors. The result was a decline in the demand for risky assets, which affected tech stocks but had a particularly strong effect on crypto currencies. This dynamic was intensified by the emergence of Omicron, a new variant of the coronavirus that saw investors seeking the protection of safe-haven assets, fearing new lockdowns and the halting of the economic recovery coinciding with the withdrawal of monetary stimulus.

Volatility both attracts and repels traders, depending on their profile and risk appetite. Still, as industry heavyweights become increasingly involved in the cryptos’ market, volatility will tend to decrease. Also, authorities around the globe started looking at this asset class with more attention, meaning that in the medium to long term enhanced regulation will also contribute to greater price stability. But, in the meantime, with the withdrawal of central banks’ stimulus looming ever closer in the horizon (remember 2013 and the taper tantrum?), volatility is likely to remain high and crypto traders may be in for an abundance of trading opportunities.

 

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