On 10 Jan 2024, 15 years after the genesis block was mined, The U.S. Securities and Exchange Commission approved the first Bitcoin exchange-traded funds. Likewise, the Hong Kong government showed support to the development of Web3 technologies and applications, licensing the two cryptocurrency exchanges, OSL and Hashkey, in Aug 2023. As central banks are facing credibility threats especially after the pandemic, crypto currencies are standing out as an alternative asset class and those events signal Bitcoin has fully joined the financial system it was built to challenge.
Then the question comes: What drives the price movement of crypto currency?
To begin with, the supply and demand rule applies to crypto assets. From the demand side, investors’ growing appetite for alternative assets to diversify from current risk spectrum and the speculative motive fuel their cravings for crypto assets. From the supply side, Bitcoin’s halving events (which reduce new supply) are seen by many observers as favourable for the price.
Second, macro factors such as interest rates, liquidity and risk preference also play critical roles. High interest rates may squeeze the liquidity out of the market and push investors away from high-risk investments like crypto while the lower rates environment will be beneficial for cryptocurrencies price.
In addition, trading sentiment is inextricably linked to cryptocurrencies price. The rollout of new regulation, news about comparable cryptocurrencies and crypto exchanges or even comments from big shots will affect the trading sentiment hence the cryptocurrencies prices.
Picture 1: The price of Bitcoin
Source: crypto.com
Next question is, how do we value the cryptocurrencies? Here we look at bitcoin, which dominates 46% of the total market capitalization of the crypto asset market by June 2023. According to CFA Institute Research and Policy Center, there are four most-discussed models: the addressable market approach, the stock-to-flow model, Metcalfe’s law, and the cost of production model.
1. Addressable market approach
In total addressable market approach, Bitcoin is deemed as a store of value or a medium of exchange which could disrupt the traditional “value transfer” market such as M2, gold, global remittance and so on. The higher the penetration rate of Bitcoin in those addressable markets, the higher the value of Bitcoin has.
Exhibit 1: Value of Bitcoin at Different Levels of Addressable Market Penetration
Source: CFA Institute Research and Policy Centre
However, this method assumes bitcoin can take the role of one or more of these markets as an accepted store of value, which is an assumption that is yet to be proven. It does not count the competition from other cryptocurrencies either.
2. Stock-to-Flow Model
Treating Bitcoin as comparable to commodities and precious metals such as gold, The stock-to-flow model is based on the ratio between “stock”: the current amount of bitcoin in circulation, and “flow”: the yearly production (mining of new coins) of bitcoin. The underlying logic to make this comparison is that significantly increasing precious metals supply is difficult, so do the Bitcoin. In addition. both can be deemed as a store of value.
The higher the stock to flow ratio, the more valuable the asset. A high stock-to-flow ratio, such as 50 or greater, suggests intense relative scarcity, implying that values will also increase.
Picture 2: The stock-to-flow ratio of Bitcoin (USD)
Source: glassnode
3. Metcalfe’s Law: Bitcoin as a network
Metcalfe’s law treats Bitcoin as a network, stating that the value of Bitcoin as a network is proportional to the square of the number of nodes (n2), or members. In this valuation method, the value of bitcoin equals the square of its number of users, where the number of active addresses is being used as a proxy for the number of users.
4. Marginal Cost of Production
The marginal cost should be equal to the marginal product (new bitcoin) of mining in a perfectly competitive market. The primary cost for mining bitcoin is electricity, measured in dollars per kWh ($/kWh). The marginal cost of mining is a function of electricity price, hardware energy efficiency and the computational power of the miner. The dollar value of the marginal product of mining per day is represented by the marginal cost of mining/ the expected level of daily bitcoin production.
References
What Is Bitcoin’s Price? A Short History
https://crypto.com/university/short-history-of-bitcoin-price
Valuation of Cryptoassets: A Guide for Investment Professionals
Understanding The Bitcoin Stock-to-Flow Model
https://www.forbes.com/advisor/investing/cryptocurrency/bitcoin-stock-to-flow-model/
Glassnode: Bitcoin: Number of Active Addresses
https://studio.glassnode.com/metrics?a=BTC&category=&m=addresses.ActiveCount.
Metcalfe’s Mirror: Complexity in networks