What Determines the Price of Bitcoin? (Or any Other Cryptocurrency)

Last updated on May 8th, 2018 at 02:24 am

While many people follow Bitcoin’s price, not everyone knows exactly how this price is determined. Bitcoin is unlike traditional assets such as stocks or commodities, so there are some surprising differences in the way its price is calculated.

What the term “Bitcoin price” really means

When talking about Bitcoin’s price, people are usually referring to either the USD price on a leading exchange (such as Bitfinex, Binance, or Bitstamp) or a composite price made from the average of multiple exchanges’ prices (e.g., CoinMarketCap).

When people talk about the price on a certain exchange, they mean the price of the last transaction made on that specific exchange. So for example, if the price of Bitcoin on Bitstamp is $10,000, this means that the last trade made on Bitstamp was closed at $10,000. Once a new trade is conducted, the price will be updated accordingly.

As Bitcoin is a decentralized asset that trades on hundreds of exchanges and between countless individuals around the world, there is, in fact, no singular Bitcoin price. Each exchange has its own price for Bitcoin, although these prices are usually quite similar. Later in this guide, we discuss what keeps all these different prices roughly synchronized.

Let’s start with a quick rundown on how price is determined on a single exchange.

Price Discovery in Action

Price discovery describes the process by which buyers and sellers meet on a crypto exchange (or elsewhere) to reach agreement on the price at which they’ll trade. Buyers want to pay as little as possible for their Bitcoin. Sellers want to sell Bitcoin for as much as possible. Both must compromise upon a certain price before any trading can occur.

As we’ve mentioned before, the current price of Bitcoin, on any exchange, is simply the most recent price a buyer and seller have agreed to.

Let’s take a closer look at how buyers and sellers on a crypto exchange reach an agreement.

The Order Book

The trading interface on any standard crypto exchange features what’s known as the “order book.” It’s not a real book of course—rather the display page for market information that relates to the execution of buy and sell orders.

On the buy side of the book are listed all the standing offers to buy Bitcoin at a certain price—also known as “bids.” On the sell side are all the offers to sell Bitcoin at a certain price—also known as “asks.”

Recent trades are often displayed too, in list and/or chart format.

Here’s an example of BitStamp’s real-time order book, as displayed via the interface of BitcoinWisdom.com:

BitStamp order book

Asks are listed at the top right; showing the price the seller wants for their coin and the number of coins they are willing to sell. More asks than these are present in BitStamp’s order book, but only the dozen or so asks closest to the last price are visible here. Below are the closest bids, showing the price and number of coins the buyer wants.

At the bottom is the trade history, which shows how many coins were traded and at what price. The most recent trade will be the one that set the last price. This last price reflects the current valuation of Bitcoin on the exchange—in other words, the current Bitcoin price. It will change only as further trading occurs.

Makers and Takers

Bitcoin’s price movements are often explained away as more buyers than sellers, or vice versa. In practice, this isn’t really true since it always takes two parties to trade (if someone bought Bitcoin, someone else sold it to him).

What really drives the price up or down is the side that’s more aggressive in “crossing the spread.” The spread is simply the difference between the best bid and best ask price. In our Bitstamp example, the best bid (i.e., buying price) is $9,350, and the best ask (i.e., selling price) is $9,400, so the spread is $50.

Whichever side is more motivated to trade will pay the $50 spread cost in order to execute the trade immediately. This side is known as “the taker,” as it’s taking the offer listed in the order book by “the maker” (the person who created the trade).

How Takers Drive Price

Let’s say that aggregate buyers, convinced that price will hit $10,000 by Friday, are acting as takers. Buyers believe they’ll profit by buying below $10,000. This makes them more likely to pay the spread to buy up all the coins on offer at $9,400—they expect to make $600 minus the $50 spread. Once buyers have absorbed all the coins offered at $9,400, the next best ask then becomes coins offered at $9,450—and after that, coins offered at $9,500, and so on, up the ask list.

If buying is aggressive, sellers soon realize it and start raising the prices of their asks. This continues until buying pressure is exhausted, at which point the process will reverse. Over time, these impulses drive the price up or down.

Price Across Exchanges

Of course, price discovery happens across all Bitcoin trading venues (not just BitStamp). The process described above is happening, more or less continually, across the hundreds of Bitcoin exchanges around the world. As such, there is no official Bitcoin price, as each exchange has a different price for Bitcoin.

What keeps prices more or less synchronized across exchanges is the process of arbitrage, the trading strategy that takes advantage of the price differences between trading venues. For example, if Bitcoin is cheap on BitStamp but expensive on Coinbase, then traders (or their bots) will make low-risk profits by trading between the two. The effects of arbitrage are what keep prices aligned across exchanges.

Leading Exchanges

Finally, it’s worth noting the effect of market-leading exchanges. Those with the highest volumes (i.e., the highest number of coins traded) tend to be considered as having the more “official” price. For example, if Bitcoin’s price spikes on a major exchange such as Bitfinex, Binance, or Bitstamp—and especially across several major exchanges at once—then it will almost certainly lead all other global exchanges to have higher prices too.

The reason for this leading exchange(s) phenomenon is simply that most traders pay close attention to major exchange prices. Traders have the expectation that prices on major exchanges will filter through to minor exchanges due to the effect of arbitrage effects and the belief that others traders will act accordingly.

This leading exchange effect occurs even across exchanges that use different currencies. For example, if Bitcoin that’s being traded in a high-volume country such as Japan, where it’s priced in JPY, starts dipping below the average international price, that’s likely to act as a drag on prices in USD, EUR, and other markets too.

Index Prices

As there’s no official price, despite the synchronization effects described above, certain sites and companies make a composite index price available. This price is calculated by weighting the prices of various leading currencies by volume and combining them as an average. For example, the Bitcoin Liquid Index price on BraveNewCoin is composed of USD, CNY, and EUR prices across nine high-volume exchanges.

These indexes can be useful pricing mechanisms because they smooth out the effect of any unusual trading activity on a single exchange. For example, say a large trader decides to sell 25,000 BTC on Bitfinex. The price will be greatly suppressed on that exchange and take some time to recover back to the international average price. An index price will show less of this localized disturbance over its duration.

See original article here
Author: Steven Hay”