Original author: TechFlow
The price changes of Bitcoin are the weather vane of the entire crypto market.
When the price of a currency rises, other crypto assets tend to rise with it, and vice versa.
Therefore, predicting the changes in Bitcoin prices and analyzing which factors will affect the price of the currency have become a regular topic in crypto information; whether the results are slapped in the face or come true, everyone may not take this wild analysis seriously.
When this type of analysis gradually becomes a tool that can only provide bullish emotional value, scientific and serious discussions on "what factors will affect the price of Bitcoin" have become a scarce and difficult thing.
However, the big guys always take action.
In the past two days, a long paper titled "What Drives Crypto Asset Prices" was published. The whole paper discusses the factors affecting Bitcoin prices with a scientific econometric model, and several authors are also quite influential:
Austin Adams ： Researcher at Uniswap and Variant Fund;
Markus Ibert: Former Federal Reserve economist, professor of finance;
Gordon Liao: Chief Economist of Circle, former Federal Reserve economist
The analysis and opinions of the leaders of top institutions are certainly worth reading. However, considering the length of 39 pages and the various complex mathematical calculations contained therein, Techflow has refined and interpreted the paper, trying to convey the core ideas of the paper in a more popular way, and provide a reference for everyone to grasp the price trend of the market.
TLDR, key conclusions
Traditional factors affect the crypto market: The price of Bitcoin is not only affected by factors internal to the crypto market, but is also significantly affected by traditional financial markets such as monetary policy and risk sentiment.
The dual effect of monetary policy: In 2020, the Fed’s loose monetary policy drove Bitcoin up, while the tightening policy in 2022 caused a sharp drop in prices, and the impact of tight monetary policy accounted for 2/3 of all factors affecting the price drop. Without this policy change, Bitcoin’s returns would likely be higher.
Impact of risk premium: Since 2023, the returns of crypto assets have been mainly driven by risk premium compression (investors' reduced risk perception of BTC, resulting in their willingness to accept lower additional returns), and the market's risk assessment of crypto assets is changing.
Complexity of daily fluctuations: Factors such as crypto adoption and risk premium play a dominant role in explaining the variation in Bitcoin’s daily returns, with the impact of traditional monetary policy being more pronounced over long-term timeframes and less significant on a daily basis.
Impact of specific events: Case studies such as the COVID-19 market turmoil, the FTX crash, and the launch of the BlackRock spot ETF confirm the impact of specific events on the short-term price of Bitcoin.
Bitcoin price influencing factors methodology
When asking how volatile a new asset class is, you actually need to look at two parts — how much is due to spillovers from traditional financial markets, and how much is due to idiosyncratic risks inherent in the asset itself.
To explore this question, the paper will analyze the daily return series of three assets:
Bitcoin: A representative of cryptocurrency.
Two-Year Treasury Zero Coupon Bond: Represents a traditional safe asset.
Standard & Poor’s 500 Index (SP 500): represents the overall performance of the U.S. stock market.
In fact, the prices of these three assets change over time, and the next step of this research is very clear - comparing the co-movement of the daily returns of the three assets. In layman's terms, the returns of multiple assets show a similar upward or downward trend in the same time period.
In the real world, we can all intuitively feel that BTC prices are obviously correlated with traditional financial markets. The paper abstracts this commonality in a more rigorous and scientific way, forming three specific factors that can affect the prices of Bitcoin and traditional assets:
Monetary policy shocks: The impact of policy changes from central banks (the Federal Reserve) on the price of Bitcoin. For example, if they lower interest rates, borrowing money becomes cheaper and people are more willing to invest, which may drive up the price of assets such as Bitcoin.
Traditional risk premium shocks: impacts associated with changes in investor attitudes toward risk. For example, if most people in the market are worried about risk, it could cause the price of Bitcoin and other assets to fall.
Crypto-specific demand shocks: The impact on prices of changes in demand that are specific to the crypto market. These are factors that affect only the cryptocurrency market, such as the emergence of new technologies, changes in laws and regulations, or changes in cryptocurrency adoption and shifts in sentiment.
Based on this idea, we can further quantitatively analyze the impact of each impact factor, as well as how and how they affect the price of Bitcoin.
Here, we will skip the details of the high-sounding mathematical regression analysis model used in the paper and go directly to the more understandable analysis and results.
Bitcoin plummeted in 2022, 50% of the reason is attributed to tight monetary policy (interest rate hike)
The paper analyzes the factors affecting the daily price of Bitcoin from January 2019 to February 2024.
Bitcoin's returns can be decomposed into three structural shocks: monetary policy shock, traditional risk premium shock, and crypto demand shock. (Note: You can simply understand the shock as the impact of XX factors on Bitcoin prices)
The impact of these shocks on Bitcoin prices varies over time.
Market turmoil in March 2020:
Amid the market turmoil caused by COVID-19, traditional risk premium shocks were the main reason for the decline in Bitcoin prices.
The price of Bitcoin dropped from $8,600 to $6,500, a drop of 24.2% (simple return) and 27.7% (log return).
Figure: The figure shows the daily return rate of Bitcoin (black line) after mathematical logarithm processing. The height of the other colored lines shows the contribution of different factors to the return rate.
Recovery in 2020:
Subsequent increases in Bitcoin prices have been supported by falling traditional risk premiums and loose monetary policy, but a portion of the increase cannot be explained by traditional factors and reflects a significant crypto demand shock.
Price declines in 2022:
In 2022, the decline in Bitcoin prices was mainly caused by a negative monetary policy shock and a negative crypto demand shock, while the decline in traditional risk premiums continued to support prices.
From January 2022 to January 2023, the log return of Bitcoin’s price fell by approximately 1.02, equivalent to a 64% decline in simple return.
Severe impacts of contractionary monetary policy shocks:
The model shows that monetary policy shocks contribute about 50 percentage points to the decline in Bitcoin prices. Without the impact of tight monetary policy (such as interest rate hikes), the decline in Bitcoin prices may be only 14%.
Volatility Analysis:
Most of the variation in daily Bitcoin returns cannot be explained by traditional risk premia and monetary policy shocks, with crypto demand shocks accounting for over 80% of daily volatility.
The impact of monetary policy is mainly reflected in fluctuations over longer periods of time, indicating that Bitcoin is a highly volatile asset whose volatility cannot be explained solely by traditional asset drivers.
This passage highlights the impact of different factors on the volatility of Bitcoin returns, particularly the importance of monetary policy in the long term, while also pointing out the significant volatility of factors within the crypto community.
Therefore, the next part of the paper will explore in more detail the specific sources of crypto demand and how this variable affects the price of Bitcoin.
The price increase in 2021 is due to the increase in crypto adoption, and subsequent investors gradually no longer require high returns from BTC
When analyzing the encryption demand itself, the author breaks down this influencing factor into:
Adoption of the crypto market itself (e.g. new technology/narrative, market sentiment) and the risk premium in the crypto market (the additional return investors demand for taking on additional risk).
The above two points also jointly affect the changes in Bitcoin's returns and the changes in the size of the stablecoin market.
Growth from 2020 to 2021:
The model suggests that the increase in Bitcoin price from 2020 to mid-2021 is primarily attributable to the impact of increased crypto adoption. Both Bitcoin and stablecoins have experienced significant price growth during this period, reflecting increased market acceptance of cryptocurrencies.
Changes in 2022:
Since the end of 2022, stablecoin growth has slowed and even declined at some points. This has led to a breakdown of Bitcoin’s price showing a negative crypto adoption shock, meaning that interest and demand for Bitcoin has declined, and with it, demand for stablecoins.
The continued compression of cryptocurrency risk premiums has been a consistent driver of cryptocurrency returns since 2021.
In Figure a the light blue line represents cryptocurrency risk:
In mid-2021, the line fell sharply, indicating a sudden increase in risk premium (investors became more worried).
Starting at the end of 2021, this line starts to rise slowly but steadily. This upward trend is what is called risk premium compression.
A rising line means that risk is decreasing and investors no longer require such a high additional return.
Stablecoin growth in 2020-2022:
During this period, the growth of stablecoins was mainly driven by the development of the cryptocurrency market. From the chart, we can see that the pink line (representing Crypto Adoption) was at a relatively high position before the beginning of 2022, indicating that the adoption of cryptocurrency was the main factor driving the growth of stablecoins.
Starting from 2022, the chart shows that the blue line (representing Conventional Risk) began to rise and surpassed other factors. This shows that the risk factors of traditional financial markets began to become the main driving force for the inflow of stablecoins.
Traditional risk factors may include risks in traditional financial markets such as stock market volatility, economic uncertainty, inflationary pressure, etc. When these risks increase, investors may seek stablecoins as a safe-haven asset.
The factors affecting Bitcoin prices have been verified in various events
COVID-19:
Market Turmoil Background: Between January and May 2020, Bitcoin earnings declined significantly in March 2020 due to the impact of COVID-19, while the stablecoin market size increased significantly. This is when the market is described as a "risk off" phase, with asset prices falling more than can be explained by changes in fundamentals.
The safe haven role of stablecoins: The growth of stablecoins during this period shows that they act as a safe haven in the crypto asset market, attracting capital inflows from investors. This verifies the hypothesis put forward by the researchers that stablecoins can provide a relatively safe investment option amid market uncertainty.
Risk premium shock: Investors’ risk requirements for traditional assets (such as stocks, bonds, etc.) increase, causing the prices of these assets to fall. Similarly, investors’ risk requirements for crypto assets (such as Bitcoin) also increase, causing their prices to fall.
FTX Crash:
Market Turmoil Background: When FTX collapsed in November 2022, the price of Bitcoin dropped significantly. The market size of stablecoins saw a brief spike during the FTX crash, suggesting that stablecoins are still viewed as safe havens amid market turmoil.
Difference in market reactions: Under the direct impact of the FTX collapse, the crypto market experienced large fluctuations, while the price changes in traditional markets were relatively small. This shows that the crypto market is more sensitive to the FTX incident.
During the FTX crash, crypto market shocks will dominate, especially positive risk premium shocks (investors’ demand for crypto asset risk increases) and negative adoption shocks (investors’ confidence in crypto assets decreases). In comparison, traditional market shocks will have less impact.
BlackRock ETF Launch:
Background of market warming: After BlackRock announced its application for a Bitcoin spot ETF, Bitcoin income increased significantly. The event marked a major shift in investor sentiment and market dynamics.
Influencing factor analysis: The model identified two main influencing factors:
Positive crypto adoption shock: This reflects market acceptance and increased investor interest in Bitcoin, particularly due to the legitimacy brought by the involvement of large institutions such as BlackRock.
Negative crypto risk premium shock: This indicates that investors’ risk perception of Bitcoin has decreased and the required additional return has decreased, which means that the perceived risk of investing in Bitcoin has eased.
Reasons for the rise in Bitcoin prices: The rise in Bitcoin prices from September to December 2023 can be mainly attributed to the decline in these risk premiums.
As can be seen from the above 3 examples, these findings highlight the profound impact that major market events (such as the involvement of large institutions) have on crypto markets, especially in terms of adoption dynamics and risk assessment.
This shows that changes in market sentiment and the makeup of participants can significantly affect the value of crypto assets and investor behavior.
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