What's going on with Bitcoin?

The following is not investment advice and should not be taken as such. It also does not take into account local regulatory considerations that may apply.

The latter part of 2020 and beginning of 2021 has seen the price of 1 Bitcoin (BTC) rise from about $10k to $34k at the time of writing this (roughly a 300% increase). Lots of people are asking me what’s driving this and whether it’s another bubble like in 2017, when the price crashed rapidly after reaching an all time high of about $19k. There’s a lot of information out there, perhaps too much to make sense of, so I thought I’d write this short post to try and present the key factors in layman’s terms for those of you that are interested.

What is Bitcoin?

It’s probably worth starting with a refresher on what Bitcoin actually is. Bitcoin is a type of cryptocurrency that is secured by cryptography. It runs on a decentralised global network of computers maintaining a blockchain (immutable ledger of transactions) which is enforced by a type of algorithm known as Proof of Work. There are plenty of resources to help you understand more about this and there is a pretty good one here to start.

Supply and Demand

So what's driving the price up? In essence, supply and demand economics apply to Bitcoin (and other cryptocurrencies) in the same way as other assets. When demand outstrips supply, the price goes up. I'll pick up the supply end of the equation first.

Bitcoin supply is finite. There will only ever be 21 million coins produced and this is built into the source code. In theory this is one of it's advantages over fiat currency or, say, gold which can be created by central banks or mined from the ground. In the words of it's founder, Satoshi Nakamoto, it should ultimately be “completely inflation free”, making it a far better store of wealth than assets whose real value declines over time. At the time of writing, there are about 18.5 million Bitcoins in circulation. The last will be mined in or around 2140.

But there's another unusual factor impacting supply - a large portion of the Bitcoin in circulation is not liquid. A significant number of owners have chosen to hold their investment for long term appreciation and store of wealth (up to about 11.5 million coins). There is also a portion of 'lost' Bitcoin where users have lost their cryptographic keys (up to about 3 million coins). So the number of Bitcoin actually available for buying and selling is much lower.

Demand is a little more complex. The way I see it there are two primary factors driving high demand - 1) Institutional players entering the space; and 2) Infrastructure improvements.

Institutional players

Many high profile institutional investors are allocating assets to Bitcoin. Hedge funds (e.g. Tudor Investments, Guggenheim and Fidelity), Insurance companies (e.g. MassMutual), Pension funds (e.g. Fairfax) and Public company treasurers (e.g. Microstrategy and Square) are investing $billions in Bitcoin and at the moment their demand far exceeds the supply. About 900 new bitcoin are mined each day, and just three market participants alone - PayPal, Square, and Grayscale Bitcoin Trust - purchase considerably more than that because of high investor demand.

The interest from institutional investors seems largely driven by the global macroeconomic environment - namely the stimulus being (or likely to be) pumped into global economies to aid recovery. This stimulus is likely to cause inflation and Bitcoin is being seen as a hedge against this and a good store of value.

The other thing to consider is the availability of traditional instruments for investors to access Bitcoin (as opposed to buying and holding it directly). Funds and investment vehicles are cropping up in many jurisdictions and we’ve even seen corporates issue fixed income bonds to raise capital to invest in Bitcoin (Microstrategy being the most notable). This is making it easier and more familiar for institutions to access Bitcoin opportunities.

Improved infrastructure

The other factor that these investors are taking into account is what I'm referring to as an improved infrastructure surrounding Bitcoin - specifically 1) security; and 2) regulated entities.

Security. One of the triggers for the big Bitcoin price crash we saw in 2018 was a number of high profile security breaches at exchanges where many users lost their Bitcoins and investments. Retail investors (who had up to that point driven the price up) became concerned and the resulting sell off contributed to the price crash. This emphasised one of the major risks with cryptocurrencies around the safe keeping of 'private keys' - in short whoever has the private keys has the ability to transact the Bitcoins. And therefore if these keys are centralised / controlled by exchanges without adequate security, the Bitcoins themselves are vulnerable to attack / loss.

Since then we’ve seen a significant improvement in the options available to secure keys, either through self custody (e.g. Casa) or regulated custody solutions from the likes of Gemini and Fidelity. There is also a much greater awareness of the potential risks and how to mitigate them. The combination of these has increased the confidence of institutions to invest large amounts of capital.

Regulation. We’ve also seen a lot more clarity where regulation is concerned and in particular many regulated entities operating in the space, which in turn increases confidence. For example, cryptocurrency exchanges like Coinbase and investment vehicles like the Grayscale Bitcoin Trust now provide regulated services to investors.

What’s next?

The outstripping of supply with demand means Bitcoin is a scarce asset and this scarcity is driving prices upwards. This is likely to continue in the short term in my view - macroeconomic conditions aren’t going to change and neither is supply. As for what the market top price will be (or whether it crashes again) that is difficult to say but here are a couple of thoughts on things that might impact it:

1) Entry from a big public company like Apple would likely drive the price up significantly. They could invest treasury assets in Bitcoin like Microstrategy has done, or maybe equip their iPhones with hardware wallets to store cryptocurrency, driving retail investors hitherto concerned about security. Either way the confidence created in Bitcoin by a move like this would be game changing.

2) It may also be interesting to see how regulators react in 2021. We’re already seeing emerging regulations concerning Know Your Customer requirements for private wallets and other types of cryptocurrency which could dampen demand (although one would imagine this isn’t a huge problem for institutional investors). It’s also possible that we see more countries trying to ban the holding and use of Bitcoin which could have a similar effect.

If you want to know more on the topic there is a lot of great information out there - some of my favorite podcasts are What Bitcoin Did and We Study Billionaires which attract some great guests and produce really useful insights.