What Is The Significance Of The Bitcoin Dominance Index?

The Bitcoin Dominance Index is a metric that traders can use to quickly get a sense of Bitcoin's (BTC) value relative to that of the broader digital currency market. This index, offered by CoinMarketCap, measures Bitcoin's market capitalisation (market cap) compared to the overall market for these digital assets.^[1]

Perhaps an easier way to understand Bitcoin dominance is to think of BTC's value as a ratio of the total crypto market cap. According to a historical Bitcoin dominance chart from Statista, this value has been on the decline since 2013. In 2013 Bitcoin enjoyed a dominance ratio upwards of 95%; as of June 2022, this value fell below 40%.^[8]

The reasons for the decline in Bitcoin dominance are multifold. The introduction of other crypto assets such as Ethereum (Ether, ETH), Ripple (XRP), and Dogecoin (DOGE) certainly expanded the valuation of the entire asset class. Further, a steep decline in Bitcoin's price from November 2021 to June 2022 also prompted Bitcoin to surrender more than 60% of its marketshare in under one year.

Origin Of Bitcoin Dominance Index

According to a Medium post written by Jimmy Song (a self-described Bitcoin educator, developer and entrepreneur), the Bitcoin Dominance Index was originally created to illustrate how much importance Bitcoin, the first digital currency to scale, had in the overall crypto economy.^[2]

Initially, BTC dominance was a vital metric as Bitcoin accounted for nearly 100% of the cryptocurrency market capitalisation. However, as the crypto bull market of 2020 and 2021 subsided, the metric as a whole became diluted between BTC and assorted altcoins.

Uses For Bitcoin Dominance Index

Traders can use the Bitcoin Dominance Index to gain insight into the market and more specifically, the sentiment of traders. The price of any asset is a function of supply and demand, so the index effectively measures demand for Bitcoin relative to demand for altcoins. Essentially, as the BTC Dominance Index increases, the demand for BTC is robust in comparison to altcoins and stablecoins. Conversely, if Bitcoin's share of the total cryptocurrency market cap dwindles, it may be said that BTC demand is decreasing.

Risk Aversion

Traders could also use the index to infer the market's risk aversion. At some points, Bitcoin has functioned as a safe-haven asset, serving as a strong store of value during macroeconomic turmoil.^[3] By functioning like digital gold, Bitcoin has drawn many investors during these difficult times. In fact, Bitcoin's value is typically measured in terms of the world's reserve currency and periodic safe-haven, the United States dollar (USD).

If the value of altcoins starts plunging and Bitcoin does a far better job of holding its value, one could interpret this as meaning that investors are buying up Bitcoin in a "flight to safety."^[4] Given this scenario, one can quantify Bitcoin's strength versus the broader crypto environment with the BTC market dominance metric.

Tradable

The BTC dominance index is also a tradable instrument. Binance futures offers traders access to BTCDOM futures, which allows for people to open long or short positions on the index's value.^[9] Charts for BTCDOM are available on Trading View, a mass purveyor of data local to the capital markets.

Bitcoin Dominance Index Criticisms

As with any economic or financial metric, the Bitcoin dominance index is subject to critique. Detractors cite increased crypto supply, dormant BTC, and limitations of market cap itself as key reasons why the index is unreliable.

Increased Supply

One major criticism of the Bitcoin Dominance Index is that market participants could easily reduce this particular measure by creating their own coins and also holding airdrops, which is when members of the cryptocurrency and blockchain community receive free units of digital currency.^[5]

A recent example of an airdrop occurred during the Terra blockchain restart following spring of 2022's meltdown. Classified as one of the world's leading stablecoins and Defi projects, Terra USD (UST/USD symbol on Coinbase) was pegged to the USD. On the blockchain, Terra was represented by the Luna coin.

Through the process of minting and burning Luna coins, a non-volatile relationship with the dollar was sought.^[10] However, after the UST/USD plunged to near zero, an airdrop of Luna was conducted on the new Terra network in an attempt to restore market integrity.^[11] The added coins were awarded to Terra participants as compensation for losses in the market crash.

Market Cap Shortcomings

It is also worth noting that some analysts have criticised the usefulness of market cap by pointing out its limitations. Market cap has traditionally been defined as the number of units of a particular security multiplied by that security's price.

If ABC company has 1 million outstanding shares that trade for US$50 apiece, then the market cap of that company is US$50 million. By harnessing this measure, investors can get a quick sense of how much a company is worth.

Investors can also use it to get a better idea of a digital currency's market value. However, market cap has its limitations when used in this way. For example, much of Bitcoin lies dormant, as it has been abandoned or sits in wallets that cannot be accessed.^[6]

In 2014, NVIDIA engineer John Ratcliff estimated that approximately 30% of all Bitcoin had been lying dormant for more than one year.^[6] While these coins would be counted using the traditional definition of market cap, they are not in a position to be accessed.

Additionally, many altcoins or alts have "died" over the years, meaning that the team behind them never delivered a product or the digital tokens were either scams or a joke.^[7] This further complicates efforts to use the index effectively. Investors can benefit from keeping these considerations in mind when using the Bitcoin Dominance Index.

Although the index furnishes market participants with an idea of BTC's value against the entire market, the metric's accuracy can be questioned. The cryptocurrency space is highly dynamic, featuring an abundance of volatility, ICO listings, and the introduction of new coins. In this regard, the Binance BTCDOM syllabus disclaimer is instructive: "the numbers in this article are subject to change without further notice."^[12]

Summary

The Bitcoin Dominance Index is a metric that investors can use to get a quick sense of Bitcoin's value relative to the broader digital currency market.

The index was originally created to illustrate the key role that Bitcoin plays in the overall crypto economy. And while it can quickly provide investors with valuable information, the index has its limitations and investors can benefit from knowing about these potential considerations.