The price of the cryptocurrency Bitcoin is determined by some combination of a small number of very large trades, the issuance of Tether, a so-called stablecoin, and organic supply and demand. Finding out what caused a particular price movement requires examination of all three factors.
Bitcoin, a digital asset, was originally seen as a new type of currency. But its growing popularity has exposed its limitations as money while vastly increasing its price, making many of its early adopters millionaires. As a result, it is now primarily seen as a speculative investment (Baur et al, 2018).
The price of Bitcoin is highly volatile, and it often makes the news for dramatic rises and falls. On 9 November 2021, it reached a high of $67,562 for one Bitcoin, but in the nine weeks since, it has fallen by 37% to $42,723.
Figure 1: Price of Bitcoin (US dollars), January 2019 - January 2022
Note: Data accurate from 12 January 2022
What is driving these price movements? To answer this, we first need to look at what the Bitcoin price reported in the media actually is.
How is the Bitcoin price calculated?
There is no ‘official’ price for Bitcoin, so most news organisations use an average of the prices offered on the largest exchanges for transactions in the cryptocurrency. Since Bitcoin is a global phenomenon, it trades against many other currencies. For simplicity, its price is usually reported in US dollars. But the dominant currency for buying or selling Bitcoin is not the dollar, but Tether, a private digital currency or ‘stablecoin’ that usually trades one-for-one against the dollar. Technically, it would be more accurate to report the price of Bitcoin in Tether.
Since the one-for-one peg between Tether and the dollar has thus far been sustained, the distinction between the Tether price and the dollar price has been unimportant to investors up to now. But when investigating the causes of Bitcoin’s price movements, Tether’s dominance of the Bitcoin market becomes important.
Prices are determined not just by the supply and demand for the asset, but by the supply and demand for the money used to buy them. An increase in the money supply often leads to an increase in prices – this is thought to be one of the main causes of inflation. The price of Bitcoin is thus determined not just by the supply/demand of Bitcoin, but by the supply/demand of Tether used to buy it.
The supply of Tether has continually increased over time. In January 2021, there were 21 billion outstanding Tether; as of 26 November 2021, there are 73.6 billion. Most of these are not backed by dollars: in a May 2021 attestation, the Tether Corporation stated that only 6.8% were backed by cash or cash equivalents. The activities of the Tether Corporation therefore substantially increase the money supply within the world of cryptocurrencies.
When prices rise across the real economy, one of the first things that economists investigate is whether there has been a rise in the money supply. Might the expansion in the supply of Tether be responsible for the rise in the price of Bitcoin?
Is the Bitcoin price driven by Tether issuance?
The relationship between Tether issuance and the price of Bitcoin has been investigated by Griffin and Shams (2020). They find that during the 2017 boom in Bitcoin, price increases were often driven by a small number of large Tether-denominated purchases following the issuance of new unbacked Tether. The study concludes that this practice was responsible for at least half of the rise in the Bitcoin price in the year from March 2017.
Since then, the scale of Tether issuance has increased enormously. In the ten months covered by Griffin and Shams’ study, 2.2 billion Tether were issued; in the past ten months, there have been 52.6 billion issued.
The world of cryptocurrencies evolves quickly, so it is difficult to say for certain that this is still the primary driver of prices. But Bitcoin’s blockchain, which records every transaction involving the cryptocurrency, shows that a $5,000 increase in its price on 6 October 2021 was attributable to a single $1.6 billion purchase of Bitcoin with Tether. It is reasonable to assume that Tether issuance is still a significant determinant of Bitcoin price movements.
What else affects the price of Bitcoin?
It is not clear whether the $1.6 billion purchase was made using newly issued Tether; it is theoretically possible that it was an investment from an extremely wealthy individual. This relates to another criticism often levelled at cryptocurrency markets: that a small number of ‘whales’ who control large amounts of Bitcoin manipulate the market to make money at the expense of ordinary investors.
The market is well known to be highly concentrated: as of November 2020, 2% of accounts controlled approximately 95% of Bitcoin. The price experiences ‘jumps’ more frequently than a typical financial asset, suggesting that the price is disproportionately driven by a small number of large trades (Shen et al, 2019).
These trades could be in response to news, but they may also be an attempt to generate large sudden price movements. These movements can force ‘margin traders’, who use borrowed money to bet on the Bitcoin price, to liquidate, allowing whales to buy or sell back for a profit. Large price increases can also be used to attract publicity, as price movements tend to be reported uncritically by the news media. This coverage leads to increased investment by members of the public, allowing large holders to cash out some part of their Bitcoin holdings.
The final factor determining the price of Bitcoin is the level of interest among the general public. The Bitcoin price has been shown to respond to increased news coverage and increased discussion of cryptocurrencies on social media (Kraiijeveld and De Smelt, 2020; Rognone et al, 2020). This mechanism is straightforward: when Bitcoin is in the news, new buyers enter the market and the price rises.
Why does this matter?
Inexperienced investors in cryptocurrencies generally view the Bitcoin price as a direct function of interest in the asset. If they expect more people to enter the market in the future, they buy Bitcoin and when they feel that the market is saturated, they sell.
In reality, investing in Bitcoin is also implicitly taking a position on the other factors determining its price. If Tether can continue to be issued while remaining pegged to the dollar, the Bitcoin price will be likely to rise.
But the Tether Corporation has been sanctioned by the State of New York and the Commodity Futures Trading Commission, and Bloomberg has reported that Tether executives are under investigation for bank fraud. If regulators dismantle Tether directly, or if their actions lead to a run on Tether, this could cause the dollar price of Bitcoin to crash.
The future price is also a function of future large trades, so buying or selling Bitcoin is also a bet on what whales will do next. This puts retail traders at a clear informational disadvantage relative to large holders.
For authorities and the news media, it is important to understand that a change in the price of Bitcoin is not necessarily a signal about interest in the cryptocurrency, economic fundamentals or Bitcoin’s long-term viability as a currency or asset. In many cases, it is not a signal of anything important at all.
Where can I find out more?
- Are Bitcoin and other digital currencies the future of money? A discussion of the status of digital currencies and the possible barriers to their widespread adoption as money.
- Anyone seen Tether's billions? A Bloomberg investigation into the Tether Corporation, its legal difficulties, and its effects on cryptocurrency markets.
- Blockchain Analysis of the Bitcoin Market: A recent National Bureau of Economic Research working paper by Igor Makarov and Antoinette Schoar that examines Bitcoin’s transaction patterns and ownership structure.
Who are the experts on this question?
- Frances Coppola
- John M. Griffin
- John Paul Koning
- Amin Shams
- Andrew Urquhart