The economics of BitCoin price formation


    I. Introduction

    During the last decade, a wide range of digital currencies, such as BitCoin, LiteCoin, PeerCoin, AuroraCoin, DogeCoin and Ripple, have emerged. The most prominent among them is BitCoin, both in terms of its impressive price development and price volatility. BitCoin price has increased from zero value at the time of its inception in 2009 to around $1100 at the end of 2013 (see Fig. 1). At the end of 2014, its price has dropped to around $250, but is increasing again since then. Such market volatility with huge price movements (±8000%) is not usual for traditional currencies, suggesting that there must be other determinants of price formation, which are specific to digital currencies. The present article attempts to identify and assess the factors behind the BitCoin price formation.

    Figure 1. BitCoin price development, 2009–2015. Source: Blockchain.

    Its rising popularity has attracted a growing interest in BitCoin in general (e.g. Grinberg 2011; Barber et al. 2012; Kroll, Davey, and Felten 2013; Moore and Christin 2013; Bouoiyour, Selmi, and Tiwari (2014); and BitCoin price formation in particular (e.g. Buchholz et al. 2012; Kristoufek 2013; van Wijk 2013; Bouoiyour and Selmi 2015). Several factors affecting BitCoin price have been identified in the previous literature: (i) market forces of BitCoin supply and demand (Buchholz et al. 2012; Bouoiyour and Selmi 2015); (ii) BitCoin attractiveness for investors (Kristoufek 2013; Bouoiyour and Selmi 2015); and (iii) global macro-financial development (van Wijk 2013). Our article is the first in the literature that studies BitCoin price formation by considering both the traditional determinants of currency price, such as market forces of supply and demand, and digital currency-specific factors, e.g., BitCoin attractiveness for investors.

    Buchholz et al. (2012) find that an important determinant of BitCoin price (as price of any currency) is the interaction between BitCoin supply and demand. The supply of BitCoin determines the amount of units in circulation and thus its scarcity on the market. The demand of BitCoin is mainly determined by transaction demand as a medium of exchange for goods and services. Buchholz et al. find that, to a large extent, BitCoin price movements can be explained by interactions between its supply and demand.

    According to Kristoufek (2013), the price formation of BitCoin cannot be explained by standard economic theories, such as future cash-flows model, purchasing power parity, or uncovered interest rate parity, because several features of currency supply and demand, which usually form the basis of currency price, are absent on BitCoin markets. In particular, BitCoin is not issued by a specific central bank or government. Thus, it is detached from the real economy implying that there are no macroeconomic fundamentals that would determine its price formation. Similarly, findings of Bouoiyour and Selmi (2015) provide support that BitCoin is largely detached from macroeconomic fundamentals and rather behaves as a ‘speculative bubble’. According to the Bouoiyour and Selmi estimates, the contribution of speculation (proxied by investors’ attractiveness to BitCoin) to BitCoin price formation dominates other drivers such as market forces of supply and demand.

    van Wijk (2013) stresses the role of global macro-financial development, captured, e.g., by stock exchange indices, exchange rates and oil price measures, in determining BitCoin price. van Wijk finds evidence that, for example, the Dow Jones index, the euro–dollar exchange rate and oil price have a significant impact on the value of BitCoin in the long run.

    An important shortcoming of previous studies is that they look separately at specific BitCoin price determinants, without considering interactions between them. A second shortcoming of previous studies is that they do not account for potential structural breaks in BitCoin price series which can lead to the biased results when performing econometric estimations. The present article attempts to close this research gap by accounting for all three types of BitCoin price determinants identified in the previous literature: market forces of supply and demand, attractiveness indicators and global macroeconomic and financial development to explain the formation of BitCoin price, and by accounting for interactions between them. Further, the present article tests for structural breaks in BitCoin price series and, based on the identified break, provides a more nuanced dynamics of BitCoin price formation over time.

    In order to identify and assess the determinants of BitCoin price formation, first we derive an econometrically estimable model from the Barro (1979) model for gold standard. Second, based on previous studies on BitCoin price formation, we extend the canonical model to capture factors which are specific to digital currencies and formulate testable hypotheses. Finally, in order to test the BitCoin price formation hypotheses, we apply time-series analytical mechanisms to daily data for the period 2009–2015.

    Our empirical results confirm that market forces of BitCoin supply and demand have an important impact on BitCoin price and their importance tends to increase over time. Second, we cannot reject the hypothesis that investors speculative behaviour affect BitCoin price in the short- and long run. The short-run price fluctuations are driven by online information search about BitCoin in the first years after its introduction, when it was little known. In the later years, when it became more established on financial markets, the impact of online searches seems to be minimal. Third, our estimates do not support previous findings that macro-financial indicators are driving BitCoin price. Furthermore, the results of our analysis underline the importance of analysing different drivers of BitCoin price simultaneously, as the results are likely to be biased when looking at one factor at a time.

    The rest of the article is structured as follows. Section II provides background information about BitCoin, which is a relatively new digital currency with several features being different from traditional currencies. Section III introduces the underlying conceptual framework and formulates testable hypotheses of BitCoin price formation. Section IV outlines the econometric approach and discusses how we address the key estimation issues. Section V details the data sources used in the empirical analysis, the construction of the estimable model’s variables and…