Where does Bitcoin’s price come from?

• Bitcoin's price: supply & demand
• Bitcoin's fixed supply
• The Kimchi Premium
• What's influences demand for Bitcoin?

Though Bitcoin is increasingly being used to address real world problems, like the high cost of international remittance, or as an alternative to weak national currencies, most people hear about Bitcoin for the first time through eye-catching headlines about price. Whether it's because it's reached an all time high, or fallen dramatically, price captures people’s attention, but where does Bitcoin’s price come from?

Bitcoin’s price & the law of supply and demand

Bitcoin isn’t a product with a team behind it deciding its price. It is a new form of money with no central authority that is traded like a commodity. So even though it is a very novel idea, its price movement is no different to that of commodities bought and sold two thousand years ago; it simply responds to changes in supply and demand.

Demand is literally the amount of people wanting to buy something, and supply is those willing to sell it. Where the two meet, a price is formed. 

So Bitcoin’s price comes from the interaction of buyers and sellers. That interaction happens at websites called cryptocurrency exchanges. As the name suggests they facilitate the exchange - buying and selling - of cryptocurrencies like bitcoin. As we now know, where buyers and sellers come together, price is formed. 

So if you Google “What is the price of Bitcoin?’ you’ll get a result like this.

The result shows the price of one Bitcoin expressed in Euros. Bitcoin’s price comes from Coinbase.com which is one of the world’s largest cryptocurrency exchanges.

There are of course many more exchanges than Coinbase, each of them with their own customers expressing their demand to either buy or sell bitcoin. So there is no one official source of the price for Bitcoin, but prices wherever it is exchanged. 

You can of course average the price across the largest exchanges, which is what websites like Coinmarketcap or Coingecko do. Here’s the source of their price CMC:

What’s interesting here is that price varies by only a few dollars across the top eight exchanges, which is what you’d expect. If I want to sell and there is a much higher price available on a different exchange, I’ll go and sell there or conversely buy at a lower price if it was available. But the price at Bithumb is almost $2,000 higher. How can that be?

The Kimchi Premium

Bithumb is a Korean Exchange, you can see that from the Currency Pair (BTC/KRW) expressing the price of one bitcoin in Korean Won. Obviously if holders of Korean Won could buy from any of the other eight exchanges, they would, and get Bitcoin at a much cheaper price but the regulations in Korea around move both traditional currencies and crypto make that very difficult to accomplish. 

The specific supply and demand conditions for Bitcoin in Korea - a combination of the popularity of Bitcoin trading and tight laws of money movement - results in a higher price for Bitcoin, which has become known as the ‘Kimchi Premium’.

So understanding that Bitcoin’s price comes from the interaction of supply and demand, is only part of the puzzle, the bigger question is what drives supply and demand? 

In Korea demand is higher, because of the unique conditions. Elsewhere in the world there are different conditions that also drive up demand. Venezuela, Nigeria, Argentina and Turkey all suffer from hyperinflation - their local currencies are continually losing purchasing power - so they want to put their wealth into a different currency that doesn’t lose its value but are also restricted by tight controls on money movement; the result is a growing demand for Bitcoin which trades at a premium in those countries.

But if we go back to our basic principle of supply and demand, rising demand is normally met with a proportionate increase in supply. If people are eating more apples, apple growers will try to meet the increasing demand by increasing production. It might take a while, but once the supply increases, the price should come down, so long as the cost of producing those extra apples isn’t any different from before.

Bitcoin’s fixed supply 

So why doesn’t the supply of bitcoin just go up? This is what makes Bitcoin so special, and can help explain price movement, given the simple knowledge that price emerges from supply and demand. Bitcoin’s total supply is fixed and the rate at which that total supply is reached is also fixed.

Bitcoin’s supply schedule - how many/when new bitcoin are created - is dictated by a set of rules called the Bitcoin Protocol, which computers on the Bitcoin network run as a piece of software. 

That set of rules says that there will only ever be a maximum of 21 million bitcoin, with a fixed number of bitcoin created every 10 minutes towards that total, generated as a reward for special network users called Miners, when they confirm new bitcoin transactions in blocks of data that are added to an historical chain -  hence the term blockchain. 

The first block was mined in January 2009, at which time the reward was 50 bitcoin. So 50 new bitcoin were added to the supply every 10 minutes. Once 210,000 blocks have been created that reward is cut in half, which happens roughly every four years and is commonly known as a halving or halvening.

Bitcoin has gone through three halvings:

• Nov. 28, 2012 - reward halved to 25 bitcoin
• July 9, 2016 - reward halved to 12.5 bitcoin
• May 11, 2020 - reward halved to 6.25 bitcoin

This process will continue until the magic number of 21 million bitcoin is reached, estimated to be around 2140. So the Bitcoin Protocol programs the creation of bitcoin at a fixed rate to a known maximum supply with no exception. 

In the language of economists this is called inelastic supply, which you also see with things like art, antiques or collectibles, because you cannot go back in time and ask Leonardo Da Vinci to knock up a few more Mona Lisa’s.

So if Bitcoin’s price is determined by the interaction of demand and supply, and we now know that supply is fixed, price movement must simply come down to demand. So our journey of price discovery now moves to what influences demand for Bitcoin?

What influences the demand for Bitcoin?

Speculation

The biggest influence on the price of Bitcoin is speculation. People buying it as a tradable asset that hope will appreciate. That speculation is an aggregate of all the factors listed below plus the way that different market participants behave under uncertainty. Skittish inexperienced retail investors and heavily leveraged professional traders can feed into cycles of extreme volatility.

Network Effects

One of the important factors around Bitcoin adoption is that the value of each new user isn't equal. Bitcoin is a monetary network and the value of networks grows exponentially with each new user, not linearly. There is no one metric that tells us how fast the Bitcoin user network is growing, but once it passes a tipping point price will react. 

Hashrate

Bitcoin's strength comes from the aggregate power of the computers supporting the network through Mining. That is measured by Hashrate, which is known to track price closely.

FUD

FUD stands for Fear Uncertainty and Denial and is shorthand for themes that are intended to undermine Bitcoin's legitimacy, often without much basis in fact. Some of the most common are

• Environmental concerns around mining
• the idea that Quantum Computing will break its cryptography
  
• the suggestion that demand comes from Stablecoin printing
• People claiming to be Satoshi Nakamoto

As certain FUD themes gain traction this can increase negativity in the market and drag down price. We summarised the most popular misconceptions around Bitcoin in our TLDR section.

The Halving Cycle

We now that Bitcoin's supply follows a fixed schedule, with key changes in the amount of new bitcoin created every four years. This halving cycle is associated with changes in demand as people preempt the change as well as respond after the change.

Failing Fiat Currencies

Bitcoin’s fixed supply is in contrast to all modern currencies, which have unlimited supply. In some countries that leads to hyperinflation, and the flight to other currencies - as mentioned above in Venezuela, Turkey, Nigeria etc. So where existing currencies fail, demand grows for better alternatives. There is even a rule for this called Gresham’s Law.

Censorship Resistance

Though much of Bitcoin's demand relates to speculation, a certain level of activity is specific to the problems it solves, one of which is censorship resistance. Any industry or organisation that faces restrictions imposed by the current financial system may turn to Bitcoin given how resistant it is to censorship.

Regulation

We’ve already mentioned how price can be influenced by controls on the movement of money. This can have a negative impact where governments try and protect their powers over money, against the threat of Bitcoin. China reiterating its historical stance against Bitcoin reduced confidence and price; regulatory pressure from other influential countries will do the same.

Conversely, countries deciding that they think Bitcoin should be legal tender - such as El Salvador - will move the needle in the other direction.

Hodlers

Money is often described as a social convention. Much of the demand for Bitcoin comes from the conviction of its hodlers - a term used to described longterm holders. The field of on-chain analytics can measure this effect, with stats at the time or writing showing that 85% of Bitcoin's supply hasn't moved.

Competition

Money is an evolving concept. It is hard for us to appreciate that because it rarely happens within a generation, which is why Bitcoin is considered such an important technological milestone. Within a few years Satoshi Nakamoto's idea inspired thousands of copycats and variations. Each of those projects has its own believers, diverting potential value away from Bitcoin, measured by a metric called Bitcoin Dominance. That competition also includes governments who are adapting to create something called Central Bank Digital Currencies. They represent a threat to Bitcoin by maintaining the status quo.

So Bitcoin's price emerges from the convergence of a melting pot of competing ideas around the uncertainty of future use and the certainties of its fixed supply. Long term holders have so far been proved correct, but as past performance doesn't influencer future success price will always be the biggest point of discussion around Bitcoin.