B — Bitcoin

Why Is Bitcoin Back At Record High?

03 January, 2021




 

Bitcoin is back at record high topping $34,000 and is up more than 350% compared to a year ago. This article discusses the main reasons which can partly explain this phenomenom and also points to potential downside risks.

 

 

1- Improving network efficiency

When Bitcoin reached its previous record high in late 2017, one of the key problems was the delay for transactions to be executed. Mempool size — the aggregate size in bytes of transactions waiting to be confirmed – remained high, resulting in longer average confirmation time and higher priority fees. Fortunately, as the chart below shows, the issue has been addressed through software improvements and most importantly increasing power dedicated to the network.

 
Bitcoin mempool

*Note: Nice charts from Jochen Hoenicke are also available here.

 

In the details, the hash rate — a common term of measurement of how much computing power everyone around the world is contributing toward mining Bitcoin — has grown significantly reflecting massive investment. The fact is that miners are providing servers with dedicated processing chips to solve a difficult mathematical problem based on a cryptographic hash algorithm in exchange for the opportunity to be rewarded with new coins (created with each new block) and transaction fees (from all the transactions included in the block).

 

As a result, Crypto Voices noted “as Bitcoin and other cryptocurrencies have become very valuable in the marketplace, many, many more miners and mining “pools” around the world have joined the party, in search of earning those Bitcoins inside the block reward.”

hash rate bitcoin

 

2- Increasing number of users

Despite the price of Bitcoin fell below $4000 in early 2019, the number of active addresses has rebounded from June 2018 according to Glassnode data. It confirms that the cryptocurrency has became more popular especially among retailers. A lot of platforms have emerged and it’s now very easy to use and trade Bitcoin. As an example, PayPal recently launched their new service that enables customers to buy, sell, and hold cryptocurrency. It already had a significant impact according to Pantera Capital. Furthermore, as Jeffrey Tucker underlined, “The currency is held and accepted by many thousands of institutions, both online and offline. Its payment system is very popular in poor countries without vast banking infrastructures but also in developed countries.” In this context, Glassnode highlighted that the total number of Bitcoin transactions reached 600 million in late December 2020.

 

 

3- Convergence with mainstream finance

The Bitcoin wasn’t only adopted by payment companies but also by the finance industry. In December 2017, the CME “announced that it has self-certified the initial listing of its Bitcoin futures contract to launch Monday, December 18, 2017.” In November 2019, according to a statement, the CME Group “announced options on its Bitcoin futures contracts will be available for trading starting Jan. 13, 2020, pending regulatory review.” By the end of December 2020, Frank Chaparro highlighted that “Aggregated open interest across bitcoin futures markets hit $8.89 billion”, the highest ever.

 


 

The explosion of trading was accompanied by the emergence of research inside the finance community. More and more investment banks are now considering cryptocurrencies as an asset class and included Bitcoin in their coverage.

 

 

4- Growing participation of institutional investors and skeptics’ capitulation

One of the key developments this year has been the rising participation of institutional Bitcoin investors. A Bloomberg piece noted that “Among the big-name investors who have turned bullish are Paul Tudor Jones, Stan Druckenmiller and Bill Miller. Even Ray Dalio admitted the other day that he “might be missing something” about Bitcoin.” In addition, the article also underlined that “Financial journalists, too, are capitulating”.

 

 

More recently, the avalanche of institutional investors continued. They are looking at Bitcoin in a context where most of assets are offering lower potential returns. As a matter of fact, the total negative-yielding debt in USD reached a record high last year.

 

negative-yielding debt

 

The move has been the result of massive interventions from central banks in advanced economies (and to a lesser extent in emerging economies) which cut interest rates (sometimes in negative territory) and increased significantly the level of their balance sheet. Latest data confirmed that G7 Central banks’ combined balance sheet kept climbing in December, increasing by almost $9T since February 2020.

 

G7 CBs combined balance sheet

 

Therefore, several investors are now turning to Bitcoin as the supply is per definition finite (even though it’s possible that bitcoin’s protocol will be changed to allow for a larger supply) while several people fear that money supply from central banks will become uncontrollable at some point. In a report released on December 29th, 2020, Glassnode underlined “that around 78% of the circulating Bitcoin supply is considered illiquid” and “More than 1 million BTC has become illiquid in the course of 2020.” According to the firm, “This points to a bullish investor sentiment as large amounts of $BTC are being hoarded – which reduces sell pressure“.

 

 

5- Bitcoin could be used as a source of portofolio diversification

Bitcoin is showing low correlation with traditional assets and could therefore be used as a source of diversification. In a long report called “BITCOIN INVESTMENT THESIS – BITCOIN’S ROLE AS AN ALTERNATIVE INVESTMENT”, Fidelity reported that “Bitcoin’s correlation to other assets from January 2015 to September 2020 is an average of 0.11, indicating there is almost no relationship between the returns of bitcoin and other assets.” It added that “low correlation is an encouraging first sign in evaluating alternative investments with portfolio diversification utility.”

 

 

Several risks to monitor

Despite Bitcoin is back helped by improving fundamentals, its market structure is still far from perfect. One of the key weakness is that it can be manipulated by a small amount of people. In details, according to a Bloomberg article citing Flipside Crypto research, “A few large holders commonly referred to as whales continue to own most Bitcoin. About 2% of the anonymous ownership accounts that can be tracked on the cryptocurrency’s blockchain control 95% of the digital asset.” Therefore, a lot of institutional investors will be reluctant to enter the market facing potential large sales of whales.

 

 

Finally, central banks are also considering their own digital currencies which could be a real competitor. Such a move would probably also imply more attempts to regulate Bitcoin and other cryptocurrencies.

 

 

In October 2020, the Bank for International Settlements and seven central banks including the Federal Reserve, European Central Bank and the Bank of England published a report laying out some key requirements for central bank digital currencies, or CBDCs. China is at the forefront and is expected to launch the world’s first CBDC. Recently, Chinese officials confirmed that Chinese e-commerce company JD.com Inc will become the country’s first virtual platform to accept China’s homegrown digital currency.