Why the Bitcoin Dominance Index is a Misleading Metric

August 17, 2018 / by Jackson Rickun

With Bitcoin’s dominance jumping past 50 percent this week, much of the discourse on Twitter and Reddit has been rushing to praise Bitcoin’s supreme reign. It’s surprising to see how fickle speculators and investors are to jump ship or get back on the bandwagon when it comes to talking about Bitcoin and its potential as an effective cryptocurrency. Fundamentals certainly haven’t changed in a week nor has adoption budged by any relevant metric.

Analysts and investors will frequently use the Bitcoin Dominance Index (BDI) as indication of Bitcoin’s strength relative to all other cryptoassets. When dominance falls, some would argue that money is leaving Bitcoin for alternative cryptoassets. Conversely, when dominance rises, some believe that it’s indicative of money leaving altcoins and flowing back into Bitcoin. However, using the BDI to make these inferences is unfounded.

Currently, there are 1,843 different cryptoassets as listed on CoinMarketCap. That number is increasing every day. Every time a cryptoasset is added to CoinMarketCap, its market capitalization is naturally added to the total market capitalization of all cryptoassets. Adding new cryptoassets to the market does not signify money is flowing away from Bitcoin. Still, it affects Bitcoin’s dominance negatively.

What further skews the credibility of the BDI is the existence of premines. For a heavily premined coin like XRP, whose current market capitalization is 10 percent of Bitcoin’s, only about 40 percent of XRP are in circulating supply. Ripple itself owns and holds upwards of 60 percent of all XRP, so only the circulating supply is counted in market capitalization. This means that the current valuation of Ripple ($0.28 at the time of this writing) is based on only a portion of the supply in existence. What happens when all XRP are released into circulation? What is the release schedule? Can we trust it? Where Bitcoin’s supply growth is predictable, Ripple’s is at the discretion of Ripple itself.

When we take into consideration that the majority of cryptoassets listed in the BDI are ICOs while also taking into consideration that the vast majority of ICOs fail, we begin to understand that the value these cryptoassets add to the total market capitalization is trivial. ICOs and other cryptoassets too easily have the ability to decrease the BDI without having much to prove.

All prices held the same, if 100 ICOs were to debut tomorrow, Bitcoin’s dominance would decrease no matter the amount of future staying power those ICOs have. When dominance falls, it’s no indication money is moving away from Bitcoin. That said, using BDI to determine the current state of Bitcoin is arbitrary.

In the same vein, most of these coins have no substantial liquidity. If you take a look at many of the lower-billed coins on CoinMarketCap – some of them are worth several millions in market capitalization – many have trading volumes of only thousands or sometimes hundreds of dollars. If I were to create a cryptocurrency with a supply of 1 billion, and I sold one to a friend for $1.00 on an low-volume exchange, this would add a total of $1 billion to the total market capitalization, enough to move the BDI about 1 percent. There are plenty of coins like this, hundreds in fact. As such, it’s clear that the way valuation is packaged into the BDI is improper and perhaps an unwise way to determine much at all.

When you consider that there are several coins with premines and coins with dearth of liquidity, we see that the Bitcoin’s Dominance Index is being measured against too many variables for it to make any sort of meaningful conclusions.

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