At-a-glance
  • The recent de-risking of portfolios may not be the best explanation of bitcoin’s recent selloff
  • Rising miner revenue per transaction may have signalled past bitcoin selloffs
  • Movement sideways in the number of bitcoin transactions may indicate a lack of growth in its user community

In between its low points set on March 2020 and April 2021, bitcoin prices advanced 1,557%. They have struggled since. By late July bitcoin fell 55% from its high. It then staged a second rally, gaining 133% by early November, hitting a new record high, before falling by as much as 52% over the past three months.

Bitcoin’s most recent decline coincided with turbulence in the equity market, which also corrected in the first month of 2022. However, the idea that bitcoin’s recent decline is primarily a result of portfolio de-risking may be focusing too much on bitcoin’s positive, but rather weak, correlation with U.S. equities. Over the 12 months to early February 2022, bitcoin had a +0.29 correlation with the S&P 500® (Figure 1). This implies that movements in the equity market explain only about 9% (the square of the correlation coefficient) in the daily price movements of bitcoin.

Figure 1: Bitcoin has weak correlations with traditional financial instruments

A more convincing explanation of bitcoin’s recent selloff lies within the bitcoin market itself, and it relies on two factors: miner revenue per transaction and the number of transactions.

The Role of Miner Revenue Per Transaction

Bitcoin’s two recent 50%-plus bear markets are not its first. Since its inception in 2009, the currency has experienced a number of even larger declines, three of which saw the currency fall by over 80%:

  • A 93% decline between June and November 2011
  • An 86% decline between November 2013 and January 2015
  • An 84% decline between December 2017 and December 2018

The most recent back-to-back 50%-plus declines in bitcoin prices share one thing in common with these previous three periods: bitcoin’s miner revenue per transaction rose sharply in the months before the declines began (Figure 2). Blockchain.info defines cost per transaction as total miner revenue divided by the number of transactions. As such, it’s a comprehensive measure of the cost of trading bitcoin on the various spot crypto exchanges. 

Figure 2: Spikes in miner revenue per transaction in crypto exchanges preceded past sell offs

By contrast, bitcoin’s bull markets have usually been preceded by long periods of reduced miner revenue per transaction. It seems that miners charging less to match trades was a prerequisite to bitcoin sustaining rallies in past bull markets. The open question now is, if the miner revenue per transaction is in fact an indicator of future trends, have bitcoin’s miner revenue per transaction fallen enough and stayed low enough for long enough to engender a new rally?

The Number of Transactions

Bitcoin’s supply is fixed by the crypto asset’s algorithm. Currently, of the 21 million coins that could exist by 2140, 18.946 million have already been created. This means that over the next 118 years only 2.05 million new coins can come into existence (Figure 3). Bitcoin’s scarcity goes a long way towards explaining why investors have come to value it so highly. Even after its recent correction, as of early February it is still trading at over $40,000 per coin. Moreover, the complete inelasticity of its supply explains the currency’s volatility.

Figure 3: Bitcoin’s scarcity helps to explain its value, its supply inelasticity helps to explain its volatility

While the supply side of bitcoin is extremely transparent, the demand for bitcoin can be relatively opaque. Blockchain.info produces a useful series with regard to demand: the number of bitcoin transactions per day on the various crypto exchanges. This number can be seen as a proxy for bitcoin demand. The surprise for bitcoin has been that, by this measure, demand has been stagnating for five years after a period of exponential growth. In 2009 there were, on average, about 100 transactions per day in bitcoin. That had reached 1,000 by the end of 2010, 10,000 by 2011 and 100,000 by 2015. By 2016 volume had stopped growing and has been stuck in a range of around 275,000 transactions per day. When one looks closely at the series, it does appear that rising number of transactions tend to precede bitcoin rallies, and falling number of transactions appear to precede bitcoin selloffs (Figure 4). Movement sideways in the number of transactions suggests that bitcoin demand hasn’t moved far since 2017 and that price gains may be best attributed to the slowing pace of bitcoin creation, which dropped in half at the start of 2020 and, by the rules of the algorithm, will likely halve again in early 2024.

Figure 4: Stagnating transaction volumes may indicate a lack of growth in the user community

Finally, we look at the degree of difficulty in creating bitcoin. Since bitcoin was created, the number of calculations needed to solve for a new coin has risen from less than 10 in early 2010 to around 26 trillion today. The strongest growth in difficulty occurred before 2014 and coincided with the exponential growth in the number of daily transactions. Since then, growth in difficulty has slowed, especially since early 2019. Now the main driver of bitcoin’s growth may be the quadrennial halving of the number of new bitcoin to be minted each year (Figure 5).

Figure 5: Does the rising difficulty of mining new coins put a floor under prices?

To the extent that bitcoin can be seen as a commodity, its mining difficulty could be viewed as its cost of production. In many commodity markets, it is commonly assumed that a commodity’s price cannot stay below its cost of production for long. The fact that miners have been charging high premiums for matching trades on the crypto exchanges suggests that bitcoin may have gotten too far ahead of its production cost given the apparently slow growth in its user community. If that is case, then perhaps miner revenue per transaction need to come down further before the crypto currency is able to sustain further price gains. 

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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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