As the price of bitcoin pumps to all-time highs and crashes down from those highs only months later, one can’t help but wonder “Who decides the price of bitcoin?” and “Where does the price of bitcoin come from?”. The answer is as simple as “supply and demand” but who or what controls both the supply of bitcoin and the demand for bitcoin?
Understanding The Price Of Bitcoin
When you wake up in the morning and check the price of bitcoin on your favorite app or bitcoin exchange, have you ever stopped and asked yourself what is involved in deciding the price of bitcoin? It’s a good question and one that more people should be asking. The answer is simple but it does take some time to fully understand how it all works. Let’s start with the short answer.
The price of bitcoin is the intersection of offers from people selling bitcoin (supply) and people buying bitcoin (demand).
These offers, called orders, are placed on bitcoin exchanges by individuals and businesses from all over the world. Some of these orders are entities selling bitcoin for the local fiat currency while others are buying bitcoin with their local fiat currency. Bitcoin also trades against multiple altcoins on crypto exchanges all around the world.
Supply Meets Demand: The Price Of Bitcoin
Supply and demand is a term that gets thrown around a lot in economics, finance, and in the bitcoin industry as well but what does it really mean? To fully understand how the supply and demand surrounding bitcoin works, I will do my best to break things down to make them as easy to understand as possible.
As you are reading this right now, there are people all around the world who have bitcoin and want to exchange it for fiat currency. They have a supply of bitcoin but they want fiat currency more than their bitcoin.
There are also people all around the world who have fiat currency and they want to exchange it for bitcoin. They have a supply of fiat currency but they want bitcoin more than their fiat currency.
In order for either of these people to exchange what they have for what they want, they will need to use a bitcoin exchange to make a trade. They can both place a buy or sell order for whatever price they would like to pay for the price of bitcoin. When there is both a buy order and a sell order at the same price, a trade takes place and thus we’ve discovered the market price of bitcoin.
Now that you have a basic understanding of where the price of bitcoin comes from, let’s dive a little deeper into some of the ways that works.
The Bitcoin Supply
One of the most important and fascinating aspects of bitcoin is the discovery of digital scarcity. Up until the creation of Bitcoin, there was no way to create something in the digital world that was limited or scarce. All digital bits of information were unlimited and could be infinitely copied at little to no cost at all. All of that changed when we discovered the formula for a system that enabled absolute digital scarcity.
There are several key components of the Bitcoin supply that are important to understand because they all work together to ensure that bitcoin is the most absolutely scarce asset in the entire world. The total hard-capped supply of 21 million bitcoin, the slowing supply via the halving every ~4 years, and the consistent increase via the difficulty adjustment every ~2 weeks all regulate the Bitcoin supply. Let’s look at each one in a bit more detail.
Total Supply: 21 Million
The total supply of bitcoin is hard-capped at 21 million bitcoin. This is one of the consensus rules that govern Bitcoin. This rule ensures that there will never be more than 21 million bitcoin …EVER and is probably the leading reason why Bitcoin has value. If bitcoin could simply be mined forever, it wouldn’t be scarce and there wouldn’t be any reason to hodl bitcoin long into the future because it would be just like fiat which can be infinitely printed.
Bitcoin’s hard cap of 21 million bitcoin is what makes bitcoin the most scarce asset known to humankind. This scarcity has a direct effect on the price of bitcoin.
Circulating Supply: The Halving
In order to ensure that Bitcoin’s inflation slows down over time (the supply of new bitcoin), Satoshi Nakamoto added an incredibly important mechanism to slowly cut the supply of new bitcoin in half on a fixed schedule of every 210,000 blocks (approximately 4 years). This event is commonly known as The Halving and it ensures that Bitcoin’s inflation rate is reduced by 50% at a consistent rate over time. Without the halving, all of the 21 million bitcoin would have already been mined and in circulation.
After the final satoshi is mined around the year 2140, there will not be any more halvings and all of the bitcoin that will ever exist will be in circulation.
Consistent Supply: Difficulty Adjustment
In order to prevent all of the bitcoin blocks from being mined too quickly, Satoshi also integrated an incredibly important feature known as the difficulty adjustment which is a built-in feature that regulates the mining process and ensures that new bitcoin is generated and added to the blockchain on a consistent basis of approximately every 10 minutes.
Without the difficulty adjustment, the total supply of bitcoin would have been mined a long time ago and all of the bitcoin would potentially be in the hands of a very small group of miners with access to computational power.
Self Enforcing Rules
The total supply of bitcoin is hard-capped at 21 million, with a predictable and verifiable decrease in new bitcoin every 210,000 blocks, while the difficulty of mining is adjusted every 2016 blocks to maintain a ~10-minute interval for new bitcoin produced. All of these elements working together ensure that and that the total supply of bitcoin is limited, new supply is slowing down, and the rate of increase is consistent. Once you truly understand all of these elements and how they all work together, it’s only a matter of time until you realize that the price of bitcoin is designed to increase over time …forever.
Demand For Bitcoin
While all of the factors that determine the supply of Bitcoin are transparent and easy to measure, the demand for bitcoin is not as straightforward. Factors that can influence the demand for Bitcoin include the fundamentals of Bitcoin, overall market sentiment, news and events related to Bitcoin, regulatory developments, macroeconomic conditions, technological advancements, investor sentiment, education of bitcoin users, and even market manipulation.
Discovering The Price Of Bitcoin
In order for the market to discover the price of bitcoin, there needs to be a place that people can come together to buy and sell bitcoin. Whatever price people agree on is the price of bitcoin known as the spot price but how people all decide and agree on the price requires a few steps.
Let’s look at each one in some detail with an example using our favorite people, Alice, Bob, and some of their friends.
Limit Orders
A limit order is when you place an order to buy or sell bitcoin at a certain price. It means that someone wants to buy/sell when the price reaches a certain limit.
To illustrate this, let’s create an imaginary example.
Let’s say that Alice wants to buy some bitcoin so Alice sets some limit orders to buy 1 Bitcoin at $100, 2 bitcoin at $99, 3 bitcoin at $98, 4 bitcoin at $97, and 5 bitcoin at $96.
Now let’s say that Bob has some bitcoin that he wants to sell so Bob places some sell orders. 1 bitcoin for sale at $100, 2 at $101, 3 at $102, 4 at $103, and 5 at $104.
Let’s also say that Dave has 8 bitcoin that he wants to sell for $110 each but he also wants to buy 8 bitcoin for $95 each so he places both buy and sell limit orders at those prices.
This is what the order book will look like after Alice, Bob, and Dave all place their limit orders. In this example, since both Alice and Bob have orders placed at $100, a trade is executed and we’ve discovered the price of bitcoin.
Now, their friend, Carol would like to buy some bitcoin by placing a $1000 limit order at $103. When she places this order, she will buy $1000 worth of the bitcoin at any price up to a limit of $103 (inclusive) or she runs out of USD.
First, Bob’s order for $101 is filled and the price of bitcoin rises to $101 but Carol’s limit order is not done being filled because she still has USD left and Carol’s price limit hasn’t been met yet.
Next, Carol fill’s Bob’s sell orders at $102 for 2 Bitcoin and the price of bitcoin rises to $102 but Carol still has USD left and her limit of $103 still hasn’t been filled.
Finally, Carol’s fills Bob’s sell orders at $103 so now the price of bitcoin is $103 but not any higher. Even if Carol had more USD to buy bitcoin, she wouldn’t fill any additional sell orders above $103 because she set a limit of just $103.
This process that Carol just completed is known as buying up the book because she bought a bunch of bitcoin which caused the price of bitcoin to go up as she filled orders. If Carol wanted to get more bitcoin for her USD, she could have placed limit orders at a lower price and waited until someone filled her orders.
Naturally, things are a bit more complex than this on an actual bitcoin exchange but this serves as a basic example of where the the price of bitcoin comes from. Now that you have a basic understanding of how limit orders work, let’s look at the other common type of order.
Market Orders
Market orders work a bit differently than limit orders. Instead of creating an order to buy or sell bitcoin at a certain price and wait for it to get filled in the future, market orders are completed at the current price of bitcoin. Market orders are best used when you simply want to buy or sell some bitcoin right now and you’re not concerned about the price. If you use a service to buy bitcoin like Cash App, Swan, or Relai, etc. chances are that they just buy from a bitcoin exchange order book or custodian with a market order and charge you a small fee for facilitating the purchase.
Using the same imaginary order book as above, let’s say that Alice wants to buy some bitcoin but she doesn’t want to wait for a limit order to get filled at a specific price. She just wants to buy more bitcoin right now without a limit so she needs to fill whatever open orders are available at the current price.
In this instance, Alice will need to make a market order. When she places a market order with $312 USD, she will fill all of the open sell orders at the current market price. Then she will fill all of the open orders at the next highest price. This will continue until Alice has no more USD to buy bitcoin because she didn’t set a limit on her order price. She is just buying bitcoin until her market order is completely filled.
When Alice places a market buy order for $312 at the spot price of $104, she will fill open orders until all of her USD is gone. In our scenario, she bought 3 bitcoin at $104 but she doesn’t have enough USD to fill enough orders to push the price above $104.
Final Thoughts
Understanding how the supply of bitcoin works is relatively straightforward but there is no way to measure the demand for bitcoin because it is influenced by countless factors. Knowing how both limit orders and market orders can help you to better understand how the price of bitcoin fluctuates and how or when you might decide to buy bitcoin.
Now, the next time you find yourself asking the question “Where does the price of bitcoin come from?”, you know that the answer. The price of bitcoin is decided by a collection of individuals and business all around the world who are buying and selling bitcoin at any given point in time. Wherever the highest purchase price meets the lowest sell price and an exchange takes place, the price of bitcoin is discovered.
Simply put, the price of Bitcoin is determined by every single person who engages in buying and selling globally, at any given moment. Therefore, whenever you stack sats, you are just one of countless individuals who impact the price on a global scale.
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