Basics: Supply and demand

The basics of price, part 2

This is part two of a three-part series on price. Part one can be found here, and part three can be found here.

Last week, we learned that the price of an asset is determined by a buyer and a seller agreeing upon the price. We discussed how this agreement happens, how buys and sells affect price, what liquidity is, how arbitrageurs spread liquidity across exchanges, and how poor liquidity can inhibit accurate price discovery. This week, we’ll discuss how buyers and sellers determine what price to agree upon.

Demand is how desperately people want an asset. Supply is how much of the asset is available. Supply and demand determine price by the equation “price = demand / supply”.

Measuring supply and demand

With cryptocurrencies, the supply is usually fairly easy to determine, as it is determined in the source code of the programs which implement the cryptocurrency. As of the time of this writing, here are the supplies of some popular cryptocurrencies (taken from CoinGecko):

Bitcoin (BTC): 18,917,150

Ethereum (ETH): 118,983,489

Cardano (ADA): 32,066,390,668

Demand is a bit more complicated—cryptocurrencies can’t just put a demand number in code. Remember that demand is how desperately people want the asset. The value of demand exists in people’s heads, so we can’t measure it directly.

However, remember the equation “price = demand / supply”. If we have determined the price through price discovery on exchanges, and we know the supply from the source code of the cryptocurrency, we can use algebra calculate a value that represents the demand for the cryptocurrency. This value is known as the market capitalization:

market capitalization (demand) = supply x price

Here are the market capitalizations of the same three coins:

Bitcoin (BTC): $896,496,318,405

Ethereum (ETH): $445,054,300,622

Cardano (ADA): $42,949,439,342

Switching the numbers around like this to calculate the market capitalization might give the impression that supply and price determine demand, but that is not the case. Demand (partly) causes and determines price, not the other way around.

Also, remember that last week we showed how liquidity problems can cause price discovery to obtain an inaccurate price. An inaccurately-discovered price will result in an inaccurate market capitalization.

Demand will be covered more in depth in the third part of this series on price. The rest of this article will primarily focus on supply.

Circulation and effective supply

One of the things that took me a little while to understand about supply and demand was how the price as determined by an order book can discover the value of every coin that exists, when only a small fraction of the coins that exist are traded on an exchange. If a coin is sitting in someone’s wallet, how can its price be captured by the buys and sells on an exchange?

People who simply hold coins in their wallets participate in price discovery, not by what they do, but by what they don’t do: place sell orders for their coins. By refusing to place their coins for sale on an exchange, they’re effectively placing a sell order for those coins at a price of infinity.

This brings us to the concept of circulation. Coins which are in circulation are coins that may come up for sale. There total number of coins in circulation is known as the circulating supply, the effective supply, or the effective circulating supply.

There are a lot of reasons why a coin might exist but not be in circulation. Many Bitcoins are lost forever, locked in wallets that have broken or been thrown away, encrypted with lost keys or forgotten passwords. Most proof-of-stake cryptocurrencies require that validators lock their coins for a staking period, during which these coins cannot be transferred between addresses. Often, coins are sold during presales, with vesting schedules which prevent the buyer from selling for a predetermined period of time.

Whether or not a coin is in circulation isn’t a black-and-white issue. Coins which have been deposited on a centralized exchange with good liquidity are easy to trade, and many cryptocurrency holders believe that it is best to hold coins in your own wallet. As a result, we can look at coins which have been deposited into a centralized exchange as being more “in circulation” than coins which are held long term in a cold storage wallet. This is why many people believe that Bitcoin on exchanges is a leading indicator¹ of price: an increase of Bitcoin on exchanges indicates that incoming sales will drive price down, while a decrease of Bitcoin on exchanges indicates that reduced effective supply will drive price up.

Another example is that it is very unlikely that the coins from Satoshi Nakamoto’s wallet which mined the genesis block will be sold, since these coins have never been sent anywhere since the beginning of Bitcoin. As far as we know, these coins could be sold at any time, but given the long inactivity, we can venture the guess that these are not part of the effective supply of Bitcoin.

A final example is Curve Finance. Their trading platform rewards users for locking up their CRV tokens, making it inaccessible for up to 4 years. This has reduced the effective supply of CRV. This likely contributed to CRV’s growth of almost 1000% during 2021.

Dilution

While there are a lot of factors which might prevent coins from being part of the effective supply of a cryptocurrency, there are also factors which might cause new coins to enter the effective supply. This is called dilution. Failure to account for dilution is one of the easiest ways to lose money in cryptocurrencies.

It’s worth reiterating at this point that supply and demand determine price, not the other way around. There are many cases where new supply of a coin comes into circulation, but this new supply is not immediately reflected in the price. This is simply because the coins don’t immediately get put up for sale as soon as they are created. This delay means that dilution is a leading indicator of price, which makes it valuable as a predictor.

Sites like CoinGecko or CoinMarketCap give separate numbers for circulating supply and total supply. In this case, “total supply” is typically the maximum number of coins that can exist. Some coins provide such a value as a hardcoded number in their source code.

For example, at the time of this writing, FileCoin (FIL) has a circulating supply of 144,110,175, and a total supply of 1,970,906,319. This means that the current supply is only 7% of the total supply. This means that as the total supply comes into circulation, FileCoin will need to see a 1400% increase in demand just to maintain its current price. While FileCoin is highly regarded as a project, the dilution risk makes it hard to justify investing in FileCoin.

Another very common example of dilution causing price to drop is in reward tokens. Many DeFi projects want to incentivize some behavior, such as providing liquidity, so they mint and distribute a reward token. But without any limitation on the minting of this reward token, the reward token is diluted until it becomes worthless. Two examples of such reward tokens are Adamant (ADDY) and PolyCat (FISH). Despite attempts to add value to their tokens, neither project has managed to create demand that outpaced the infinite dilution of their reward tokens, and as a result, the prices of these tokens have decayed exponentially.

Dilution risk doesn’t mean that price will inherently go down. Remember that there are two components to price—supply and demand. If growth in demand for a coin outpaces dilution, it’s possible for a coin to grow in price. Bitcoin and Ethereum are the quintessential examples of this. Both are diluting constantly as new coins are minted to reward miners for validating new blocks—in fact, Ethereum doesn’t have a maximum supply. However, demand for both of these coins has risen so dramatically that they have both grown exponentially since their inceptions.

Burning

Coins can also be removed from circulation. Permanently removing coins from circulation is called burning. There are a few ways to do this. Some coins explicitly allow removing coins from existence in their source code, while others other burns are performed by sending the coins to an address that nobody has access to (popular addresses for this purpose are 0x0000000000000000000000000000000000000000 and 0x000000000000000000000000000000000000dead)².

Combined with buying back the coin, burning can be a way of distributing profits from project activities to coin holders. Binance has made a strategy of this, with frequent buyback-and-burns of the BNB coin which underlies their Binance Smart Chain (BSC). They have also applied this strategy to some ecosystem coins such as Venus (XVS) and even stock in related companies such as Swipe (SXP). While stock is not “burned” as such, removing shares from circulation predates cryptocurrency and is widely used, even by major companies such as Apple.

Buyback-and-burn strategies are an elegant way to distribute profits to all coin holders. By reducing the effective supply, one increases the value held by coin holders without having to find each and every coinholder, which can be problematic if, for example, your coin exists on multiple chains and/or exchanges.

Another way that coins get burned, is through normal operations of the coin’s platform. EIP-1559 introduced such a mechanic to Ethereum, where some portion of the transaction fees in each block are burned.

Sometimes coins are burned which aren’t in the effective circulating supply. Sometimes projects initially plan to distribute some percentage of the total supply to early investors, or invest it in development, but later decide they don’t need to. It’s important to understand that burning coins which were never in effective circulation has no effect on price. Burning these coins reduces dilution risk, but it does not increase the price of the coin. Sometimes projects will burn coins which were never in circulation to promote their coin, to take advantage of people’s mistaken belief that burning coins increases price (I’m looking at you, KuCoin).

Exercises

Use the following exercises to test your understanding. Answers are below the questions.

1. The circulating supply of ChainLink (LINK) is just under 500,000,000. The price is approximately $20. What is the market capitalization?

2. At the time of this writing, the supply of Bitcoin is just under 19 million. The maximum supply of Bitcoin is 21 million. The current price of Bitcoin is approximately $48,000. If demand for Bitcoin stayed exactly the same as it is today, what would the price of Bitcoin be once all 21 million coins are mined?³

3. A fictional coin FireCoin (FIRE) has a circulating supply of 11 million, and a price of $10. The FireCoin team decides to use $10 million in profits from the FireCoin project to buyback-and-burn FIRE. If demand from other areas of the market remains constant, what would we expect the price of FIRE to be after the buyback-and-burn?

4. A fictional coin RebaseCoin (REB) has a supply of 1 million, and a market capitalization of $5 million. What is the price of REB?

5. The RebaseCoin project promises a 800% gain on REB. The way they plan to do this is by minting 7 million REB, and distributing it proportionally to everyone who holds REB. They also plan to mint 2 million REB and give it to themselves as a fee. What is the new supply of REB at the end of the year?

6. The demand for REB remains the same over the year, so the market capitalization at the end of the year is still $5 million. What is the new price of REB, given the new supply (from question 4)?

7. You start the year by buying 100 REB because you believe the RebCoin’s promise of an 800% return. Given the initial price of REB (from question 3), how much does this cost you?

8. Given the RebCoin team’s promise to distribute 7 million REB proportionally to all REB holders, how much REB do you hold at the end of the year?

9. Given the price of REB at the end of the year (from question 5), and the amount of REB you now hold (from question 7), what is the value of your REB at the end of the year?

10. Given your initial cost (from question 6) and your final value (from question 8), how much money did you actually make from the RebCoin’s promised 800% return?

Answers to Exercises

1. 500,000,000 x $20 = $10,000,000,000

2. The demand is the market capitalization. The current market capitalization is 19 million x $48,000 = $912 billion. If this demand (market capitalization) remains the same while the supply dilutes to 21 million, the new price will be $912 billion / 21 million = $43428.57 (approximately).

3. First we must calculate the market cap: 11 million x $10 = $110 million market cap. We divide the $10 million buyback by the price $10 ($10 million / $10 = 1 million), and then we remove that from the circulating supply (11 million - 1 million = 10 million). This allows us to divide the market cap by the new supply to get the new price ($110 million / 10 million = $11).

4. The price of REB is $5 million / 1 million = $5

5. The new supply is 1 million + 7 million + 2 million = 10 million.

6. The new price is $5 million / 10 million = $0.50.

7. The initial price is $5, so the initial cost of 100 REB is 100 x $5 = $500.

8. The team distributes 7 million REB to the holders of 1 million REB, so you receive 7 REB for every 1 REB you hold. So you end up with 100 REB + 700 REB = 800 REB.

9. You now hold 800 REB, but each REB is now worth $0.50, so your REB is now worth 800 x $0.5 = $400.

10. You initially paid $500 and you now hold $400 worth of REB, so even though you received a 800% gain denominated in REB, you have lost $100 in value.

1. A leading indicator is a value that tends to change before some other value. Leading indicators are particularly valuable because they allow you to make predictions. For example, dilution is a leading indicator of price, because increased dilution usually comes before a decrease in price. A trailing indicator is a value that tends to change after some other value.

2. Shiba Inu (SHIB) and a few other dog-themed coins “burned” coins by sending them to Vitalik Buterin, the creator of Ethereum, under the assumption that he would never spend the coins. This assumption turned out to be false.

3. It’s slightly more complicated than this, I know. Bitcoin block mining rewards halve ever few years, so the maximum supply will never be reached. Ever. Don’t give me crap for this—it’s an exercise, not an example. If you don’t like it make your own blog.