Bitcoin Economics 102
How the Governments, Altcoins, and Investors affect Bitcoin price
Till 2012 Bitcoin was the leading cryptocurrency, but soon several competitors such as NameCoin, Zcoin, and Ethereum were introduced in the crypto market. All these other cryptocurrencies (excluding Bitcoin) are collectively known as Altcoins and each of them has its own set of advantages and disadvantages over Bitcoin. However, neither of them managed to gain the popularity that Bitcoin enjoyed. People around the world began using Bitcoin for several purposes such as online shopping, purchasing goods in the physical market and malls and also for making transactions to friends.
From early 2017, Bitcoin’s price began rising steadily. The volume of daily transactions surged as more and more people joined the network. People began trusting the system for keeping their money safe and managing their transactions effectively.
Around this time, Bitcoin caught the eye of many governments around the world. Governments saw the shift in people’s behavior towards using the digital currency rather than fiat currency and responded differently. While some governments such as those in Mexico, Zimbabwe, South Africa, and the United States made it legal to use the platform, others such as those in India, Bangladesh, Nepal, and China banned people from making any kind of transaction on the platform. They made policies to restrict how people interacted with the platform. For example, China allowed people to do mining on the platform but prevented them from making new transactions. On the other hand, governments in India and Bangladesh banned any kind of interaction with cryptocurrency be it mining or making new transactions.
Severe penalties were imposed on people for violating government rules. These policies discouraged people from making transactions on the platform and reduced the user base of the platform. Thus, the demand for Bitcoin dropped in many of the countries around the world. This is one of the reasons for the observed drop in the price of Bitcoin around the start of 2018.
Note: Bitcoin is a currency that is not backed by any kind of reserve and its price is majorly decided by the demand of people (as discussed in detail in the previous blog). Government policies, which discouraged people from joining the network, were a direct hit to the demand for the digital currency in many countries.
Governments argue that it is extremely difficult to collect taxes and counter criminal activities such as money laundering and extortion on a decentralized anonymous network such as Bitcoin. But there is another side to this story. Some people say the governments fear that if digital currencies such as Bitcoin gained popularity, then they might lose control over fiat currency and thus countries’ economic activities. They might not be able to capitalize on markets or make policies in their interests. So, to protect their power, governments discourage people from using such digital payment platforms. Whether or not the government must have control over currency is an extremely complex topic for our discussion but we have seen some points on both sides of the story.
So it is fair to say that to a certain extent, centralized authorities such as governments do play a role in determining the price of Bitcoin which was supposed to be completely decentralized and controlled by no advisory whatsoever. One must understand that though governments discourage people from participating in the Bitcoin network, they are not against the blockchain technology. Many governments such as those in China, India, and Japan are developing national cryptocurrencies on blockchain technology which people could use in parallel to using fiat currencies. These cryptocurrencies will not be as anonymous as Bitcoin, to enable the government to track criminal activities on the network and collect taxes from individuals.
ALTCOINS AFFECTING BITCOIN PRICE
Apart from governments, Altcoins also affect the price of Bitcoin. With new altcoins being introduced in the market, people have a wider range of coins to choose from. The market share gets divided each time a new cryptocurrency is introduced. As of early 2020, there are more than 5,000 altcoins which account for 34% of the total cryptocurrency market. New altcoins sell themselves as better alternatives to Bitcoin and try to attract people to invest in their platform. This reduces the share of prospective investors in Bitcoin, which affects the user base and thus, demand takes a blow.
INVESTORS AND BITCOIN PRICE
People often see Bitcoin as an investment opportunity. Many people invest in Bitcoin hoping for the price to soar making them huge profits in a short time. Since early 2017, when the value of Bitcoin started climbing, this investment ideology has been gaining popularity. Sadly, people do not realize that holding Bitcoins in reserve is a hit to the currency. Bitcoins held as reserve go out of circulation and are unavailable for making new transactions. The availability of Bitcoins reduces which forces people to pay higher prices for coins thus increasing the price of Bitcoin. Though this might seem a good sign for an investor, it might not be so. If the barriers to entry in the platform are high due to soaring prices, not many people might be able to join the network. This will reduce the demand for the network, affecting its price.
Let’s dive into a simple economic model to understand demand-to-price equation.
Let,
S = Supply of BTC (not including BTC held as long-term investments)
P = Price of BTC
T = Total transaction value mediated via BTC (per second). This represents the demand for Bitcoin.
D = Duration that BTC is needed by a transaction, in seconds. (Time from when the payer buys the Bitcoin to till the time the receiver sells them to get fiat currency)
So,
(S/D) Bitcoins are made available per second
(T/P) Bitcoins are needed per second
Ideally, (in an equilibrium state)
(S/D) = (T/P)
=> P = (TD/S)
If D (time to complete a transaction) and S (Supply of Bitcoin) does not change, then the demand for Bitcoin is directly proportional to the price of the Bitcoin. Thus, if investors reduce the supply of Bitcoin, the price of Bitcoins increase and the demand decreases, which pulls the price down to maintain equilibrium.
To quickly summarize this blog,
- Some governments support whereas others restrict how people interact with the Bitcoin platform. Government policies restricting the use of Bitcoin affects the demand for the Bitcoin.
- Altcoins provide people an opportunity to choose from multiple coins. This creates competition, often reducing the number of participants on the Bitcoin platform, which decreases demand.
- Investors holding Bitcoins as a reserve, hoping for profits, deplete the supply of Bitcoins in the market and thus reduce the number of people who might join the network. Thus, reduce the demand on the platform.
Additional note: Bitcoin would not be replaced anytime soon by the fiat currency again, as the banks can not compete with Bitcoin on transaction costs. Where banks charge up to 2% for validating a transaction, Bitcoin transactions are validated for free. Though, to support the miners, transaction fees (which will still be much less than what the banks charge) might soon be made compulsory.
