The Bitcoin Dominance Index is a metric that traders can use to quickly get a sense of Bitcoin's 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.
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.
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.
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. By functioning like digital gold, Bitcoin has drawn many investors during these difficult times.
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."
Criticisms Surrounding The Index
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.
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.
In 2014, NVIDIA engineer John Ratcliff estimated that approximately 30% of all Bitcoin had been lying dormant for more than one year. 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 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. This further complicates efforts to use the index effectively.
Investors can benefit from keeping these considerations in mind when using the Bitcoin Dominance Index.
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.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…