The Microeconomics of Cryptocurrencies: Can a cryptocurrency become a global currency?

by Jitasha Bahl

INTRODUCTION

Bitcoin is a cryptocurrency that operates on blockchain technology. In a white paper published in 2008, Satoshi Nakamoto, a pseudonym for a computer programmer or group of programmers, introduced Bitcoin as an open source, peer-to-peer digital currency (Nakamoto 2008, 2). Bitcoins have no intrinsic worth and are not backed by a government, rather, their value is determined solely by supply and demand.  It is a one-of-a-kind asset that combines the characteristics of a traditional financial asset with those of a speculative asset. Since the cryptocurrency has grown and a wider public became aware of it, its price dynamics have been a contentious topic. Unlike traditional government-backed fiat currencies such as the dollar and euro, Bitcoin is created independently of an underlying economy or issuing organisation, suggesting that it is not influenced by macroeconomic fundamentals. The figure 1 shown below presents the total number of Bitcoins in circulation (dotted line, left axis) and the market capitalization in million USD (solid line, right axis) from 2009 to 2020.  Figure 1 presents the development of the total number of Bitcoins tradeable and the market capitalization (Baur and Dimpfl 2021). Market volatility with such large price swings is unusual for traditional currencies, implying that there must be other price formation variables unique to digital currencies. This paper looks at the impact of these market forces of supply and demand on the price of Bitcoin. The main objective of this research is to determine what factors influence the price of the world’s first decentralized cryptocurrency, Bitcoin and thereby evaluate whether it is fit to be adopted as a global currency.

Fig.1. Total Number of Bitcoins and Market Capitalization (Baur and Dimpfl 2021).

FACTORS AFFECTING BITCOIN’S PRICE

Supply and demand, investor and user sentiments, government laws, and media frenzy all influence the price of Bitcoin. Price volatility is determined by the interplay of all of these factors. Most commodities’ prices are influenced by supply and demand more than any other reason. The number of coins in circulation and the amount individuals are prepared to pay determine Bitcoin’s market value. The following factors affect the price of bitcoin:

1.) Inelastic Supply

The operation’s difficulty, and the pace at which new Bitcoins are generated, is automatically configured to maintain a constant, predefined rate. To keep inflation under control by restricting the total amount of Bitcoins in circulation, the rate at which new coins are created will be halved every four years, ensuring that the total number of Bitcoins in circulation never exceeds twenty-one million. As a result, the network is now maintained only by the generation of new Bitcoins. This, however, will not be the case indefinitely. As the total number of Bitcoins approaches the maximum limit of twenty-one million, the rate of Bitcoin generation will decelerate and eventually stop around 2040 (Turpin 2014, 341). The number of Bitcoins in circulation will never exceed 21 million, as per its protocol. So, when the demand for Bitcoin increases, there is only one variable that can change to ensure the demand and supply of Bitcoin are in equilibrium, and that’s price. While absolute scarcity is what makes Bitcoin so valuable, it’s the same property that tends to make its price volatile. Thus, since the percentage change in supply of Bitcoin is less than its percentage change in price, it is said to have inelastic supply. No matter how much energy is put into mining Bitcoin, it’s issuance rate and hard-capped supply remains the same. Figure 2 shows the vertical supply curve of Bitcoin, since its supply is perfectly inelastic. The uncertainty of Bitcoin’s market price is a consequence of the Bitcoin supply schedule’s lack of flexibility.

Fig.2. Supply and Demand of Bitcoin: Case of a Vertical Supply Curve (Iwamura et. al 2008, 31)

Market forces of Bitcoin Supply and Demand

The price of Bitcoin is determined by its supply and demand. The price of Bitcoins rises when there is more demand, and falls when there is less demand. Demand must keep up with inflation to preserve price stability since there are a finite quantity of Bitcoins in circulation and new Bitcoins are generated at a known and diminishing rate. Since Bitcoin is still a niche market compared to what it could be, it doesn’t take a significant amount to influence the market price up or down, making the price of a Bitcoin incredibly volatile. The virtual currency’s supply is exogenous and therefore plays only a limited role in the price formation. In the long-run, Bitcoin will increase indefinitely due to its capped supply and an ever-growing demand. If demand rises and supply does not rise correspondingly, then prices will rise until demand is curbed (Goczek, Łukasz, and Ivan 2019, 6). Investing in Bitcoin will remain interesting, challenging, and volatile, because while Bitcoin’s ultimate supply is known and its rate of added supply is also known, demand is still the main variable that will move prices in the future. 

3.) Investment Attractiveness

Cryptocurrency is a type of digital money that may be used as a store of value as well as a medium of exchange. While it is only now gaining traction as a legitimate payment method, it has already established itself as a new asset class during the last decade. Since Bitcoin has been created relatively recently, there are a number of unique elements that influence investment demand for Bitcoins, in addition to standard currency price determinants like market supply and demand. The popularity of Bitcoin is one of the possible drivers of its price. Simply put, rising interest in a currency, coupled with a convenient means to invest in it, leads to rising demand and, as a result, higher pricing. This is a typical market response to an apparent profit opportunity that is easily accessible which is why, as an asset, it is attractive to investors. The steadily increasing price of Bitcoin is enticing to new users, and as a result, more people are becoming miners over time, positively influencing its price (Ciaian, Miroslava, and d’Artis 2016, 1813).

4.) Easy accessibility to the public

The block chain stores all information about the Bitcoin money supply, which anyone can check and utilise in real time. Since the Bitcoin protocol is cryptographically secure, no individual or organisation can alter or control it. As a result, the Bitcoin core can be relied upon to be entirely neutral and transparent. Moreover, we cannot rule out the possibility that investor speculation is influencing Bitcoin’s price. As a result, speculative Bitcoin trading is not inherently a negative phenomenon, as it can provide benefits such as absorbing excess risk from risk averse individuals and providing liquidity to the Bitcoin market. Short-term speculative investing has the potential to increase market volatility and produce price bubbles. As a result, Bitcoin’s success is dependent on its capacity to decrease the negative consequences of such speculations while also expanding its use in trade and business (Ciaian, Miroslava, and d’Artis 2016, 1814).

The high price volatility of Bitcoin could also be explained by certain behavioural biases. When people learn about Bitcoins and their soaring prices, they begin to buy them as financial instruments or even as speculative investments based on what other people are doing. A trailing behaviour is when you invest in an asset that you don’t understand because you are following or being influenced by someone else. Celebrity endorsements by public figures are examples of how third parties can affect decision-making.

The security that the Bitcoin system delivers to its holders and when utilised in exchanges is a big part of Bitcoin’s credibility. Since Bitcoin transactions are conducted entirely over the Internet, cyber-security is the primary concern. Cyber-attacks have the potential to disrupt the entire Bitcoin system, resulting in its eventual collapse. Bitcoin is more susceptible to cyber-attacks than traditional currencies because it is a digital currency. In the past, attacks like this have been common in the Bitcoin system. Its attractiveness to investors is reduced by negative news about system security, like cyber-attacks on Bitcoin exchanges. Positive news about the security of the system, such as an upgrade to safer network software, on the other hand, makes it more appealing to investors (Ciaian, Miroslava, and d’Artis 2016, 1803). Overall, more investment attractiveness may exert upward pressure on Bitcoin price, whereas lower attractiveness may result in lower Bitcoin demand and price.

AUTHOR’S ANALYSIS

A currency must have low volatility in order to be viable, as it is difficult to value products and services when the currency fluctuates a lot. A legitimate currency serves as a means of exchange, a store of value, and a unit of account, but bitcoin falls short on all three counts. Its volatility is far higher than that of commonly used currencies, posing a significant short-term risk to consumers. Excessive volatility that is more akin to that of a speculative investment than a currency. The value of Bitcoin can be extremely volatile, for instance, it peaks at a high amount at a certain point of time and plummets to less than half of that amount two months later. If bitcoin becomes immensely prevalent and displaces sovereign fiat currencies, the economy will experience deflation since the money supply will not rise in tandem with economic development due to its inelastic supply. Moreover, crypto-assets can be used to launder ill-gotten gains, fund terrorism, and escape taxes if adequate anti-money laundering and counter-terrorist financing measures are not in place. The financial system, fiscal balance, and partnerships with foreign countries and correspondent banks might all be jeopardised as a result. Therefore, Bitcoin, though the most popular cryptocurrency, due to its high price fluctuation, it is not fit to be used as a currency. It has the characteristics of an investment and a virtual payment system but not of a currency.

CONCLUSION

First, despite the fact that Bitcoin is generally regarded as a highly speculative asset, we find that typical fundamental parameters such as trading, money supply, and price level all influence Bitcoin price over time. The demand-side forces, such as the size of the Bitcoin economy, have a significant impact on the price of Bitcoin. Given that Bitcoin supply is exogenous, the development of demand-side variables will most certainly continue to be one of the most important determinants of Bitcoin pricing in the future. In the long run, Bitcoin follows normal economic theory, notably the quantity theory of money, but it is susceptible to price increases that might lead to potential bubbles and increased demand for the currency at exchanges in the short run (Kristoufek L 2015). The International Monetary Fund has also warned that adopting crypto assets as national currencies, such as Bitcoin, can have a negative influence on a country’s financial stability. Ahead of El Salvador, a Central American country, officially embracing Bitcoin as legal tender, the fund called the move an “inadvisable shortcut,” adding that banks and other financial institutions will be exposed to the tremendous instability and volatility that bitcoin assets experience (Adrian and Weeks-Brown 2021). In the path of adopting Bitcoin as a global currency, the several risks outweigh the potential benefits. Paper currency will eventually be outdated, as virtual currencies begin to take over in the future. However, in my opinion, Bitcoin is not ideally positioned to do so due to the factors that affect its price which have been stated above.


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s