All you need to know about Bitcoin
¿What is it? ¿How does it work? ¿Does it have value? ¿How do bitcoins issue? ¿What kind of investment is it? ¿What are the bitcoin cycles? ¿What is halving? ¿What are the most important on-chain metrics? ¿What are the regulations? ¿What is market capitulation?
Index
Introduction
Concept
¿How does it work?
Miners and emission
The halving
Academic discussion: ¿What kind of asset is Bitcoin?
Bitcoin and markets: Monetary policy
Bitcoin vs S&P500
Bitcoin cycles: Technical analysis
On-Chain analysis: Top 3 metrics
Regulation
Fonts
Introduction
“Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for nonreversible services. With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party.”
This is the introduction of the technical document that Satoshi Nakamoto (his identity is still a mystery until now) published just before the explosion of the financial crisis in 2008 (See) , the most severe since “The Great depression” in 1930, which had a big impact in all internacional markets around the world. The document in question, titled “Bitcoin: A Peer-to-Peer Electronic Cash System ” explains the fundamentals. design, goals and functionality of Bitcoin. Bitcoin’s network was officially born on 3 January of 2009, when Nakamoto mined the initial block of the chain, better known as “genesis block”. He is considered one of the richest men in the world, as it is estimated that his fortune amounts to U$S 20.000.000.000, considering the asset price at the moment of writing this article (U$S20.000).
Concept
It is a virtual currency which comes to break with the traditional model based on a trust party (intermediaries) and regulated by central banks, making it completely decentralized, so that its use is costless, fastest and anonymous.
Bitcoin builds on a structure called “blockchain” where every transaction of the asset is registered. Colloquially could be understood as a global account book in which through an encrypted code called “hash”, where issuer as well as recipient, public addresses, quantity and exact time are stored. It is very important to clarify, although addresses are public, that this cannot be necessarily attached to an identity, but also stay anonymous. Privacy is the main characteristic of the blockchain.
¿How does it work?
Blockchain is backed by an incentive system called “pow” (proof of work), where “miners” apply informatic power (GPU’s) to generate those encrypted codes we mentioned before, and that way, approve transactions and add blocks to the chain. For each block added to the chain, the blockchain generates a reward in bitcoins which is distributed between miners who participated in that block consolidation. This constant addition of bitcoins is analog to a group of gold miners spending resources to add gold into circulation. In this case, the resources are time spent and electricity consumed by the GPU.
Miners and emission
As we mentioned before, the same way fiat money is issued by central banks, bitcoin does it through algorithm resolutions with every validation of miners in the blockchain Applying game theory and aligning incentives, the system tells miners “if you provide security to the network, you will be rewarded”. Thus, miners will have incentives to keep working on being rewarded, even when they have the computational capacity to infringe upon bitcoin functioning.
The halving
Halving is produced every four years. Is simply the reduction of miners' reward to half. That is to say, before the first halving (November 2012) the compensation for every validated block was 50 bitcoins. From then onwards, it was reduced to 25 bitcoins. When the second halving came in July 2016, it dropped to 12.5; and when the last halving arrived in May 2020 (still current) the production of bitcoins per block has been being of 6.25. It is for this reason that total emission of bitcoins has a limit. This year the quantity circulating exceeded the 19 millions of bitcoins already (90%). And it is estimated that it will reach 21 millions in circulation by 2140.
Academic discussion: ¿What kind of asset is Bitcoin?
One of the most discussed topics between defenders and detractors is whether bitcoin does really work as a value refugee in a context of inflation or as a risk hedging in an investment portfolio. But in order to answer that question, we have to answer another one first: ¿what kind of asset is bitcoin? ¿Is it a digital currency or a commodity?
The academic journal “Tylor & Francis” published on 24 March this year an article called “Bitcoin, as a digital commodity” (See). Applying the labor theory of value from classic political economics (Adam Smith), they reach two conclusions. They first state that bitcoin does not classify as “digital gold”, since it does not add human labor in its production. In other words, economic activity resulting from issuing more bitcoins do not generate new value-added, as there is no human work in the production chain, but new coins generated by the computers only consume an insignificant amount of energy (in relative terms). For this reason, the paper concludes that, what in fact happens, is a redistribution of already existing value-added (from the pools towards miners who find the way to solve the blocks)
Bitcoin and markets: Monetary policy
Bitcoin was born in an era of very low interest rates and monetary expansion, better known as QE (quantitative easing). From the subprime crisis, which took place in 2008, central banks from around the world began an economic stimulation policy with no precedent which accentuated after covid-19 crash in 2020. Financial markets have responded positively to those politics, resulting in a constant and generalized growth of prices.
However, in December 2021, the president of the Federal Reserve, Jerome Powell, announced that inflation, which had started to increase at the beginning of the same year, was no longer a transitory issue, but a permanent one. From then onwards, the FED took a different strategy, which has inflation as the target, applying rate hiking and a reduction of the balance sheet as the main policy monetary tools.
Financial markets responded to that strategy rapidly, triggering an important correction, that is, until now, of 25% for conventional market (S&P500), more than 70% for bitcoin and more than 90% por the majority of “altcoins”.
This correlation between conventional and crypto market strengthens what we mentioned before about the type of asset bitcoin is. The high sensitivity from it to the rise of rates is another indicator that markets perceive bitcoin as a technological asset or as a digital commodity.
Bitcoin vs S&P500
In another research ”Bitcoin, an alternative investment” (See) it studies return and volatility (measured as standard deviation) of bitcoin and S&P500 from 2009-2020 period. Taking the weekly prices on both indexes, authors conclude that, in those years, bitcoin has a volatility 9 times bigger than S&P. For its part, Sensato Labs consulting, analyzed the same variables but for april 2020 to 2022 period (post covid crash) using historical data from Investing, finding that bitcoin volatility was only four times bigger than S&P’s. This, a priori, could be directly related to a major institutional money on bitcoin, due to the world uncertainty caused by the pandemic.
Analyzing bitcoin’s chart against principal financial indexes of the world (S&P500 and Nasdaq) we have the following: (See)
The behavior of bitcoin in the last two years (above all from the last maximum until now) seems to be more correlated to these two indexes, supporting the numbers calculated in the previous paragraph.
On the following chart we analyze bitcoin with commodities (gold and wti) and against dollar index (DXY) (See)
Commodities, historically, have had an opposite behavior to dollar index movements. When this last appreciates against other currencies, commodities drop. The first reason is related to those assets being valued in dollars. The second one is that commodities are used to hedge value precisely. It is to say, when the strongest currency of the world weakens, investors try to hedge their portfolios by adding commodities.
If we take a glance, we can see bitcoin moving in a similar way to those commodities, but with a clear difference: volatility. It seems to have negative correlation to DXY as well, but showing price changes proper of a high risk asset, as a technological company, for instance.
Small conclusion:
We have enough evidence to think that from covid-19 onwards, is a bad idea to analyse bitcoin price as an isolated market. Nowadays bitcoin shows a behavior much similar to the main financial indexes, and much less volatile than its first year of existence. It is sensitive to interest rates as a technological share and, as a digital commodity, it dims when the dollar strengthens.
Bitcoin cycles: Technical analysis
One of the assumptions technical analysis is based on is that history repeats. The second one is within price assets are all the information and variables discounted (efficient market hypothesis). There are different types of technical analyst: chartist, scalpers, elliotists, etc. Depending on what tools and time frames they use. The target they have in common is to try to predict the next asset price, whether it be in the next two minutes or in the next two years.
If we take the analysis we did in the previous section, where we defined bitcoin in two different stages (before and after covid crash), we are going to mention two types of analysis. One that we believe worked until 2020 (chartist), on the one hand, and another that is more adapted to nowadays circumstances (elliotist).
What used to work before covid crash:
Copied from some twitter user, the next chart was one of the most utilized before the bear market of 2022 to determine in what part of the cycle we were.
After every halving, the price had repeated a pattern with two parabolic movements and an accumulation phase in the middle, to continue towards the top of the cycle. If we take the 2011 highest price as a base (it does not appear in the graphic, it was near 32 dollars) and we draw a fibonacci extension, we can see that the following maximum of each cycle took place very close from 2,27 (second cycle) and 3,27 (third cycle).
At last, we can see that the third cycle reached its maximum 520 days after the halving, a 42% larger than the quantity of days that the first cycle took. Again, if history was going to repeat in the current cycle, we should have seen the maximum at around 730 days and close to the 4,27 Fibonacci's extension. For the first time in bitcoin history, none of this happened.
What does work today:
This chart is taken from an elliotist trader who has a profile in tradingview (See). When bitcoin reached 69k dollars, he combined the elliott wave counting with a divergence between the two highest peaks (64k and 69k) and forecasted the price was going to fall about 83% (taking as reference the previous bear markets) the rest of the 2022, what so far is respecting very well.
This allows us to keep in line with what we were discussing. It is not possible to do a crypto market analysis in an isolated form. In the last years the institutional entry of money to the crypto market has made bitcoin behave as a risk asset. Sensitivity to interest rates, correlation with conventional markets and volatility. Adding, as well, it has a similarity with commodities and moves conversely to dollar strength.
On-Chain analysis: Top 3 metrics
On-chain metrics allow us to visualize crypto market movements. From big wallet transfers, liquidity inflows and outflows from exchanges and even miners behavior.
Analysts use these tools to know in which moment of the market we are and in order to make better investment decisions.
Two of the three more important questions which market agents often make are the following:
• What are whales doing?
• What are miners doing
In order to answer these questions, we will analyze the three of the most used tools in the market
Inflows and outflows of bitcoin from exchanges
This indicator can insinuate next significant movements in bitcoin price in the short term. Assuming that an important and constant inflow to exchanges may be translated into “big hands” sell-off. By contrast, a big and constant amount of outflow of exchanges may represent an accumulation stage from those wallets.
Chart taken from cryptoquant (See)
Number of wallets > 1 BTC
This probably would be a mid/large term indicator, since it represents the quantity of wallets bigger than 1 bitcoin that are being created in the market. while it should not have an immediate effect on prices in the short term. The fact that market capitalization grows, may have an impact on long term prices.
Hash Ribbons indicator - Miners capitulation
Hash ribbons are one of the most used in on-chain analysis. When hash rate (mining power) increases steadily in time and it is not followed by a rise in the prices, it means that miners profits are decreasing, forcing miners to capitulate, which means a massive bitcoin sell-off in order to cover electricity cost. When this happens, it generates a downward pressure on prices, usually diving into bear markets.
Regulation
Until now, there are just a few countries who have adopted regulations on bitcoin and cryptocurrencies. However, we can classify 3 different positions from them so far.
First of all, we have the case of El Salvador, who has decided to formalize bitcoin as a legal currency, and followed by the Central African Republic (CAR). On the opposite side, there are the countries who have prohibited cryptocurrencies as China, Bolivia, Argelia, among others.
Finally, we have the majority of countries, who seek to regulate the sector and to adopt technology. There are projects being already treated in some of them, giving a clue to where they are going in the next few years.
Fonts
- “Bitcoin: A Peer-to-Peer Electronic Cash System”. S. Nakamoto - bitcoin.pdf
- “Bitcoin as a digital commodity”. Tomás N. Rotta - https://bit.ly/3R3gJA7
- “Bitcoin, an alternative investment asset”. Peón, D. & Martínez-Filgueira, X.M Z - https://bit.ly/3BCu6R
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