3 reasons why the Bitcoin dominance metric is a flawed indicator

Bitcoin (BTC) dominance has always been one of the first pieces of information displayed on cryptocurrency ranking websites like Coin360 and CoinMarketCap. Although it seems a consolidated and straightforward metric, there’s an argument that the market share indicator makes less sense as time goes by.

One point to note is the staggering growth of the stablecoin industry. As Tether (USDT) and USD Coin (USDC) have seen their market capitalization explode over the past year, should they also be aggregated on the same ‘dominance’ rankings?

Regardless of the answer, crypto investors need to understand that merely looking at BTC dominance to decide whether or not to change altcoin allocations within a portfolio has become less effective.

The free float problem

Simplicity is probably the primary reason for the popularity of the reason behind the market capitalization metric. Even investors new to the game can understand that multiplying the last trade price by the number of outstanding coins allows one to view the total market capitalization. The same rationale works for stocks, mutual funds, ETFs, and most tradable assets.

The problem occurs when the amount regularly being traded is very little compared to the outstanding capital. Some of the most relevant stock indexes worldwide are based on the free float concept. 

This adjustment is made to avoid the distortion caused by inflated market capitalization, and it works by disregarding shares that aren’t allowed to move freely. The shares or coins which cannot move freely are typically the result of lock-up periods or a shareholders agreement.

In traditional markets, free float is used by the S&P 500, Nasdaq-100, CAC 40, DAX, HSI, and the FTSE-100. Therefore, each companies’ market capitalization is adjusted by the percentage of shares freely available for trading.

Crypto still lacks transparency

Although the information on public stock availability might be readily available due to the U.S. Securities Exchange Commission (SEC) filings, there is no similar rule for cryptocurrencies. One might easily verify how many Bitcoin has been sent to its Genesis addresses. Those coins are unspendable, but this is not the case of every cryptocurrency. 

As Cointelegraph reported, Bitcoin holdings under Grayscale investment funds are also under lock-up. GBTC and similar funds currently have no set redemption programs, meaning there is no way for an investor to take hold of the underlying BTC asset.

Apart from those most straightforward cases, one can only infer how many BTC has been lost over the years. Studies have shown that up to four million Bitcoin are gone forever, including the one million attributed to Satoshi’s mining.

The free-float problem is even larger on forked cryptocurrencies. Bitcoin Cash (BCH), for example, has one-third of its supply that has never been touched.

Aggressive supply calendars and double counting are problematic

One can argue that there hasn’t been much change in untouched and lost cryptocurrencies when referring to Bitcoin and its forks. Therefore it shouldn’t impact more recent BTC dominance data. Although this is true, it does not take into account the equivalent inflation of those coins.

According to Messari data, in 2020 alone, there will be 20% more Ripple (XRP) in circulation. Such an increase is followed by Compound (COMP) 40%, Stellar (XLM) 17.4%, ZCash (ZEC) 15.6%, Polkadot (DOT) 13.8%, and Cosmos (ATOM) 10% growths.

It is important to note that a cryptocurrency supply increase will not necessarily increase market capitalization. This effect will depend on the unitary price change for each cryptocurrency. Nevertheless, this inflationary pressure looms larger on altcoins and exerts negative pressure on Bitcoin’s dominance rate

For every DAI issued, there is a basket of other cryptocurrencies backing it. The same can be said of the ERC-20 token Wrapped BTC (WBTC), backed on a 1-to-1 basis with Bitcoin. These are a few examples of double counting that may inflate cryptocurrencies market capitalization.

Past performance does not guarantee future results

Reflecting on the 2017 bull run, the Bitcoin  1,318% rally might seem unthinkable, but the truth is, it didn’t even make the top 10 by performance that year, led by XRP (36,018%), NEM (XEM) (29,842%), Ardor (ARDR) (16,809%), and XLM (14,441%).

This initial 1,318% move may have created the myth that BTC dominance must go down during cryptocurrency rallies, and the term altcoin season was coined to reflect the perceived rally that takes place when Bitcoin’s dominance rate drops.

Bitcoin USD price (blue) and dominance (red)

Bitcoin USD price (blue) and dominance (red). Source: TradingView

Take notice of how BTC dominance plunged from 95% to 37% in early-2018. Back then, new ICOs were placed every month, and some exceeded valuations of $5 billion. 

Thereby, these newcomers inflated the altcoin market capitalization by a large sum, regardless of Bitcoin’s price increase.

Fast-forward two years to the recovery mid-2019 and its subsequent accumulation period, and the exact opposite trend is set. 

BTC dominance grew while Bitcoin price was increasing, and flattened or adjusted when the leading cryptocurrency failed to surpass the $12,000 level.

BTC/USD (blue) and BTC dominance (red)

BTC/USD (blue) and BTC dominance (red). Source: TradingView

BTC dominance shifts accordingly to current listings

BTC dominance has ceded from 70% to 60% throughout 2020, while Bitcoin rallied from $7,100 to the current $10,200 level. As mentioned earlier, countless factors are affecting the indicator.

Some investors and analysts point to the whole emerging decentralized finance (DeFi) token movement as a leading factor behind the current shift in Bitcoin dominance. Stablecoin issuance has also grown immensely, reaching the $17 billion mark in 2020.

Regardless of the rationale behind the recent BTC dominance drop, it is incorrect to infer a direct relationship between the indicator and bull or bear market trends. What should be noted is that the current 60% dominance rate cannot be compared side-by-side with previous years.

The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph. Every investment and trading move involves risk. You should conduct your own research when making a decision.

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