The Bitcoin Dominance Index is the proportion of the entire cryptocurrency market's valuation that is attributed to Bitcoin. The metric is typically used to show the importance of bitcoin against other cryptocurrencies.
The Bitcoin Dominance Index, displayed below, measures the demand of bitcoin relative to the demand for altcoins. The index is calculated as the market capitalisation of bitcoin divided by the market capitalisation of the entire cryptocurrency market. When the Index falls, altcoins are gaining a larger market share of the overall cryptocurrency market. When the Index rises, altcoins are losing market share.
As a result, the Bitcoin Dominance Index can be thought of as a proxy for cryptocurrency investor’s risk appetite, where a low Index score is associated with risk taking and a high Index score means investors are playing it safe and flocking to bitcoin.
One limitation of the Bitcoin Dominance Index is that not all coins are created and distributed in the same way. Take XRP for example, where all the coins were pre-mined but only a fraction of these coins are circulating (a large portion of XRP are under the control of Ripple Inc.) providing a misleading market capitalisation figure.
Imagine someone creates a new coin and sells 20 units for $10 each. If 1 billion coins are created in total, it follows that the market capitalisation is then $10 billion and the Bitcoin Dominance Index will fall slightly. However, in reality the effect of this new coin on the cryptocurrency market is much lower than the dent made in the Bitcoin Dominance Index.
Another limitation of the Index is that trading volume. or liquidity is not accounted for. For the example above where someone creates a new coin with a supply of 1 billion, if the market capitalisation was adjusted to account for liquidity, the index would give a clearer picture of the relative strengths of different cryptocurrencies. When adjusting for liquidity, bitcoin’s dominance is suggested to be much higher (around 90%).