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Ask CryptoVantage: How Does Bitcoin Derive Its Value?
Unlike fiat currencies such as the US dollar, Bitcoin is a decentralized digital currency that is not associated with any government. Therefore, its value is not predetermined by a central entity but by supply and demand as well as other market factors.
To understand how bitcoin derives its value in the market, it is important to first understand how fiat currencies get their value. The value of a fiat currency such as the US dollar is derived from several factors such as exchange rate, purchasing power, and demand relative to other national currencies as well as the prevailing political climate. In a way, Bitcoin similarly derives its value by being compared to other currencies and commodities, however, there are many differences.
For instance, there is no regulating body that sets a standard value for Bitcoin as is the case with most fiat currencies. As such, trading volume and demand largely determine Bitcoin’s worth. In this article, we will investigate some of the main factors that determine bitcoin’s value apart from what people are willing to pay for it.
Public Perception
To kick us off, one factor that has affected the rise and fall in Bitcoin’s value as witnessed over the years is the public’s perception. Perceptions are mostly shaped by news headlines.
For the most part, when the media focuses on Bitcoin’s volatility with talks of events such as China Central Bank’s recent crackdown on cryptocurrencies, the market panics. A negative perception prevails and the price of bitcoin falls as people panic sell.
In like manner, when the media talks about how Bitcoin millionaires are on the rise, the market booms, and demand soars. Therefore, what the media broadcasts about bitcoin has an impact on its price and therefore its overall valuation.
Demand for Bitcoin
As is the case with most commodities, an increase in demand will cause its value to rise. What determines the demand for bitcoin is a bit tricky, but one factor that remains relevant is how many people want it relative to other assets.
For instance, while gold was once in high demand due to its status as the ultimate store of value, demand has since decreased over time with the rise of digital assets such as Bitcoin that mimic gold’s characteristics.
In like manner, Bitcoin’s demand and therefore its value is driven by a need in the market for a decentralized autonomous currency that offers more control when compared to fiat alternatives. After all, Bitcoin emerged during the 2008 financial crisis as a technology that allows anyone to be their bank free from the control of third parties.
While many cryptocurrencies offer similar features, Bitcoin remains the most tried and tested cryptocurrency and therefore the one with the most demand. For this reason, Bitcoin boasts the biggest market valuation in the crypto space.
Bitcoin’s Deflationary Supply
Similarly, the supply of bitcoin relative to how much it is being demanded will have an impact on its valuation. Bitcoins are finite in supply as their total supply is capped at 21 million coins. Therefore, as more people demand bitcoin and move away from the tyranny of fiat currencies, the price increases because there are simply fewer units for them to buy.
For example, if a person was willing to buy 0.1 bitcoins at $100 and then another person came along and wanted to buy that same amount, the price would most likely rise because there is simply not enough volume of bitcoin for both of them. Bitcoin also features a deflationary supply system built into its infrastructure.
Given that new bitcoins are produced and first distributed to miners as a reward for their work, the next batch of bitcoin rewards gets halved every 210,000 blocks mined which are roughly every four years. This deflationary mechanism reduces bitcoin’s supply over time thereby increasing its price.
Production Costs
Bitcoin’s production costs also have an impact on valuation. Given that miners are responsible for safeguarding the network, through clearing transactions, they bear much of the cost of producing new bitcoins in circulation. As bitcoin is a proof of work blockchain, this production process is energy-intensive.
The cost of electricity determines the availability of miners on the Bitcoin network. With more miners in the network, Bitcoin’s hash rate or computing power increases. This makes the network more stable and with stability confidence in Bitcoin among the general public increases. This leads to a rise in price and valuation. With increased production costs, fewer miners are willing to participate and therefore the network becomes less stable.
Escalating mining costs have led to a few notable events in recent months where Bitcoin’s hash rate and price decreased on China’s announcement to ban everything crypto-related.
Regulation
Bitcoin’s price is also impacted by the idea of whether a government will legalize and regulate bitcoin or ban it. Regulation impacts its valuation in that new regulations provide a sense of security to new investors who then climb into the market for fear of missing out on an opportunity.
Similarly, when regulators issue blanket bans over the crypto industry, Bitcoin’s price and valuation are affected as the market panics and sells their positions.
Bottom Line: It All Leads to Supply and Demand
As with many assets, the value of Bitcoin comes down to supply and demand. As people move away from fiat systems in favor of decentralized cryptocurrencies, bitcoin demand and valuation will increase.
The supply remains limited due to the protocol’s strict conditions governing how many bitcoins can be mined. Furthermore, production costs are high and increase over time, leading to fewer miners participating. Plus, with increases in the difficulty required to mine new blocks on the blockchain, only miners with the most sophisticated equipment will be able to participate in the network.
