Three factors driving the bitcoin boom and what could kill it

This looks to be a strong year for bitcoin. But many observers are scratching their head over what is driving the boom. The answer is simpler than you might think.

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(Image via Pixabay)

Bitcoin is setting new records and, despite a slowdown in late January, looks set to continue growing over the course of 2021. From a technical standpoint, this bull-market is following similar patterns to those that have come before. But there is one key difference: institutional investors.

What typically drives bitcoin bull runs?
A large driver of stock markets is fear and greed and this is the same for Bitcoin. The price of BTC will usually rise fairly rapidly as the bitcoin-curious are fearful of missing out (FOMO).

This has been a big factor as bitcoin is not only traded via futures on the Chicago Mercantile Exchange (CME) and Intercontinental Exchange (ICE) but also on crypto-specific exchanges and on retail broker platforms. Both the former (see this) and the latter have seen significant increases in crypto trading.

The trigger behind this rise is usually an announcement of more BTC utility, such as PayPal’s announcement that it would allow its users in the US to buy BTC on its service. This increases the positive exposure of the currency, causes an uptick in purchases, and drives the price of BTC up.

Eventually, the FOMO begins to fade and informed investors begin to sell, often hoping to buy the dip, and the market becomes spooked by sudden price drops, as it did in 2018. However, this is unlikely to happen this time around because of a combination of three factors.

1. Bitcoin’s role as digital gold
Certain crypto enthusiasts will angrily disagree, but bitcoin still has limited utility beyond acting as a store of value. This is important because it means that bitcoin is not a currency (at least not yet). It functions more like an asset, such as gold.

Bitcoin has a limited total supply. Thus, sudden influxes of capital create scarcity. As stronger hands force weak hands to sell, it causes significant upward pressure on price as the supply of BTC is less able to meet new demand. This has always been an important factor in any bitcoin run, but it has become even more important thanks to institutional investment.

2. Institutional capital is forcing significant price pressure
The big change in this bull cycle is the heavy involvement of institutional capital. To date, Greyscale Capital alone has acquired more than $26.6bn in BTC, and a number of other big Wall Street names are piling into the crypto sector. This is significant for two reasons.

The first is that this level of purchasing is unprecedented. Greyscale alone has outbought new BTC supply by around three-fold. The immediate effect of this is a supply squeeze, as more bitcoin is taken off the market the amount of liquid BTC assets will drop significantly, forcing companies and individuals to pay a premium if they want to get in on bitcoin.

The caveat here is that for the moment institutional capital needs to keep flowing. If it begins to tail off then the bull-run may begin to slow down and we’ll see a sustained period of corrections. Of course, other factors could provide a boost to bitcoin.

3. Enhanced utility
In the last 12 months, the utility of bitcoin has begun to broaden. We’ve already mentioned PayPal. But it’s much bigger than this. The growing interest among institutional investors and the advances of decentralized finance have opened up a number of financial instruments based on bitcoin that will make it easier to make creative trades.

Specifically, there is the ability to trade in bitcoin futures and the ability to use wrapped BTC (WBTC) to access flash loans on the Ethereum blockchain. These add more utility to BTC than previously existed, and give it a stronger underlying value, beyond just acting as a store of value.

The ability to stake BTC to lend it is also powerful, as it brings the cryptocurrency one step closer to acting as a decentralized bank.

Could anything bring BTC crashing down?
There are a number of things that could derail bitcoin at this point, some more realistic than others. Most recent anxieties include fear that Tether has artificially inflated the price of BTC, and the (false) double-spending scare spread by Coinbase.

  • Double-Spending Scare

Let’s start with the latter. While a real double-spend would be disastrous for bitcoin, in this case it was simply an example of a higher fee transaction beating out a low fee transaction for the same amount. In other words, it was a sign that the blockchain is working as intended. A key takeaway here is that even the crypto-savvy media is perfectly capable of spreading false information that could negatively impact the price of BTC.

  • Tether

Tether poses a trickier challenge. There are serious concerns surrounding Tether itself, particularly the false statement that it has reserves backed 1:1 by dollars. Additionally, there is an ongoing investigation of the company.

Tether is a major liquidity provider for the market, and if it is shut down, it would have a serious impact on BTC itself. However, there are alternative stablecoins that might limit the damage.

  • Institutional speculation

The bigger challenge may actually come from institutional investors themselves. For the moment, the data appears to show that the majority of investments by companies like Greyscale are speculative. This means there is a very real chance that these big investors decide to sell when they believe BTC has reached its limit.

This could lead to a catastrophic collapse in the price of BTC in the short to medium-term as a string of sell orders are triggered.

The simple fact is that it is exceedingly difficult to predict the future of BTC. It is still a relatively young asset class and it is still considered a speculative investment by the majority of the big money companies.

You should think carefully about your investment and accept that there is still a risk that BTC could go to zero.