Modeling the Trajectory of Bitcoin using System Dynamics

Cryptocurrencies today have a cumulative market cap in the trillions of dollars, consume more energy annually than many countries, and show explosive volatility in their prices. Despite the extensive literature studying their rise, few attempts have been made to use a structural or mechanistic modeling approach to describe the dynamics of the ecosystem. In this study, a model has been built using System Dynamics to formulate and describe the mechanisms and decisions affecting the production side, which consists of the mining of blocks into the blockchain, and the market side, which involves actors using cryptocurrency units to serve different ends. Bitcoin (BTC), the first cryptocurrency, is now over a decade old, and is still the most popular. It has a market cap larger than all the others. It serves well as a template or point of comparison to build models that seek to understand the dynamics of this system, and is hence used as the basis of this study. The supply or production side of the system focuses on the mechanisms and interactions that determine the mining of blocks awarding BTC. The demand or market side of the system looks to explain the decision-making mechanism for the different users in the system – classified as ‘chartists’, ‘fundamentalists’, and ‘transacters’ in addition to the miners. The model developed looks to capture the feedbacks generated by the process of mining in the network, the inherent design of the BTC protocol, supply-demand balancing to cause changes in BTC price, exogenous data factors such as the price of mining hardware, transaction volume and fee, and cost of energy, and connect it to the decisions made by the different actors in the system based on an analysis of their costs and benefits. The model is then calibrated to historic data. Results from this calibration process are discussed. Further refinements and scenarios to be analyzed are suggested.S.M