The economics of BitCoin price formation

Introduction:

Since its appearance, Bitcoin has managed to gain more and more popularity in a short time. People are beginning to accept Bitcoin as a means of exchange because it allows them to better deal with the vagaries of financial markets, thus avoiding inflationary pressures. Existing literature suggests that Bitcoin is likely to be a speculative bubble for five major reasons. 

First, its high volatility and limited supply that can lead to deflationary biases. Second, its use is not yet accepted as a medium of exchange. Third, Bitcoin does not have an underlying value derived from either consumption or the production process such as gold. Fourth, bitcoin stems from the lack of legal certainty hence it seems vulnerable to excessive cyber-attacks. Finally, Bitcoin price fluctuations are driven by the level of investor attractiveness (Kristoufek, 2014).

Problem :

This article seeks to answer the following question:

“Is Bitcoin business income, log-term promise or “a speculative bubble?”

Objective :

• Empirically verify that the number of merchants accepting Bitcoin is very low.
•   Evaluate, on the one hand, the relationship between transactions and the price of Bitcoin and, on the other hand, the link between investor interest and the price of Bitcoin.

Literature review

• Ciaian et al (2014) confirm that Bitcoin users can affect Bitcoin prices in the short and long term, which is why investors should be concerned about the evolution of Bitcoin.
•  Similarly, Glaser et al. (2014) show that the motivation of bitcoin investors and their intention to collect correct and useful information about bitcoin have a significant impact on the trading volume of bitcoin as well as its price.
•  Kristoufek (2013) indicates that if the price of Bitcoin increases the attractiveness increases as well. This is explained as Bitcoin buyers seek to make more profits based on the volatility of Bitcoin.
• Bouiyour and Selmi (2014) show that Bitcoin is a speculative bubble
•  Palanbizio and Morris (2012) study the impact of macroeconomic and financial indicators on Bitcoin price formation. They find that the price of oil and the exchange rate positively affect the price of Bitcoin.
•  While Ciaian et al (2014) find that the price of oil has no influence on the price of Bitcoin. However, supply and demand play an important role in explaining the price formation of Bitcoin.

Model :

To assess the causal link between Bitcoin price and transactions and the relationship between attractiveness and Bitcoin price, Bouiyour and Selmi (2014) present three models:

Results :

According to Bouiyour and Selmi (2014), the price of Bitcoin plays an important role in explaining trade transactions, i.e. the use of Bitcoin in transactions affects its price. In other words, if the demand increases the price of Bitcoin increases as well. 

However, if the price of Bitcoin is determined by speculation, this implies a high level of uncertainty about its price which can lead to an unexpected relationship. The result does not change by adding the Chinese market index and the hash rate. This means that the two variables do not have an influence on the link between Bitcoin price and transactions. 

Regarding the relationship between the attractiveness and the price of Bitcoin, Bouiyour and Selmi (2014) find that investors interested in Bitcoin positively affect its price. In other words, most investors seek to invest in this new crypto-currency for a speculative purpose (to benefit from more money) so their attractiveness increases, as well as the price of Bitcoin. 

Bouiyour and Selmi (2014) add the hash rate and the Chinese market index. They find that these two variables, this time, change the relationship between the attractiveness and the price of Bitcoin. They find that the Chinese market plays a key role in explaining the causal link between Bitcoin's attractiveness and price. Indeed, the Chinese market has experienced several adverse events that lead to a decrease in the attractiveness as well as the price of Bitcoin. For this reason Chinese banks have banned the use of Bitcoin in the market.

 Generally, most of the investors lack the necessary computer and mathematical skills for Bitcoin mining. For this, the hash rate, which represents the difficulty of the calculation, negatively affects the attractiveness of investors.

Conclusion : 

Bitcoin is attracting the attention of several investors. Unfortunately, its volatility reduces its acceptance as a means of payment. Thus, Bitcoin is tied to mathematical algorithms and majorities of investors do not have the necessary skills in computer science and mathematics, hence the ecosystem of Bitcoin is uncertain.