Understanding the Bitcoin Halving
Fabian Schär — Professor for DLT (Blockchain) and Fintech, University of Basel
Introduction
Bitcoin’s growth rate is about to half. Once every 210,000 blocks — that is approximately every 4 years — the rate at which new Bitcoin units are issued is cut in half. From block 0 to block 209,999, each block brought 50 new Bitcoin units into circulation. Between blocks 210,000 and 419,999, the reward was 25 Bitcoin units. Currently, the amount is 12.5 Bitcoin units. In less than a month, most likely on May 12th, the block reward will decrease once again to 6.25. In this article we take a closer look at the Bitcoin halving and tackle some common misconceptions surrounding this event.
Price Effect
The Bitcoin system’s monetary base currently has a ~3.6% annual growth rate. This number will decrease sharply to approx. 1.8% mid-May, bringing down supply-side pressure from newly issued Bitcoin units. For this reason many people argue that a potentially stable or even increasing demand, will be met with a decreasing supply. They jump to the conclusion that this must lead to increasing prices. Unfortunately, it is not that simple. Economic theory suggest that anything that is public knowledge, should already be priced-in. The Bitcoin halving follows a strict schedule. While there is some randomness on the exact date and time, the mechanism and the approximate timeline are deterministic with no surprises whatsoever. If people can reliably anticipate an event that may lead to a price increase on day t, they have an incentive to buy the asset on day t-1. When everyone wants to buy the asset on t-1, a rational economic agent would want to buy the asset on t-2, and so on. Consequently, there is no reason to believe that the halving will have any sudden price effects. Or in other words: any expected price effects from the upcoming change in the growth rate of the monetary base should already be reflected in the current price — at least in theory. In practice things have been a little more complicated than that. While it would not be wise to presume causality, it is an empirical fact that each of the previous halving events has been followed by a Bitcoin price rally. This might be due to a number of reasons including: higher interest due to increased media coverage, the emergence of a self-fulfilling prophecy or the relief that the halving has not lead to any unanticipated issues. Finally, sudden price action may raise questions regarding the efficiency of the market.
Security Considerations
The security mechanism of the Bitcoin Blockchain is based on the expenditure of computational resources. It is a clever game theoretical mechanism that makes it very hard to attack a transaction with a double spending attempt. The more computational resources are allocated to the Blockchain’s consensus mechanism, the more expensive and less likely such an attack (see Schär (2020) for a more formal analysis here: Researchgate).
To understand why this is relevant in the context of the Bitcoin halving, we first have to understand that people who are providing these computational resources (miners), are compensated with newly created Bitcoin units. If the reward goes down, as is the case with the halving, the computational resources will drop as well, making the Blockchain less secure. However, once again, it is not that simple.
First, there is good reason to believe that the Bitcoin Blockchain currently is producing excess security — meaning that the implicit subsidy of the block reward may have lead to an overallocation of computational resources. Subsidized excess computations are a burden on the environment and a direct cost to current Bitcoin holders, who have to bear the inflationary pressure. As such, it is far from clear whether a decrease of the provided security is a bad outcome. Secondly, the reward is paid out in Bitcoin units and is therefore a function of the Bitcoin price. Consequently, there are several scenarios how this could play out. If the Bitcoin price does increase again, this might offset the nominal drop of the reward, cushion the effects or even result in an increase of the computational resources. After all, people who are providing the computational resources care about the dollar value of their reward. If, however, the Bitcoin price decreases, then the reward would get hit twice, that is, through a decrease in the number of Bitcoin units as well as through a decrease of the dollar value per Bitcoin unit. This would inevitably force some miners to shut down their operations and lead to a further centralization in the mining business. It could therefore partially undermine Bitcoin’s value proposition.
Practical Advice
The Bitcoin halving certainly marks an important day for the future of Bitcoin. It will be interesting to watch how this event plays out in practice. If Bitcoin once again survives the event unharmed, it will have passed yet another very important milestone. That being said, if you are planing to accept Bitcoin transactions shortly before or after the halving event, it is very important that you wait for a few extra confirmations. The halving is a time of relative uncertainty. Miners may compete for the last blocks with a larger reward. This could lead to so-called reorgs and potentially facilitate double-spending attempts. Waiting for the extra confirmations is a simple remedy, but one you have to be aware of.
Prof. Dr. Fabian Schär is the Credit Suisse Asset Management (Schweiz) AG Professor for Distributed Ledger Technology (Blockchain) / FinTech and the Managing Director of the Center for Innovative Finance at the University of Basel. His research focus is on smart contracts, asset tokenization and potential applications of Blockchain. He has a PhD in cryptoassets and blockchain technology and co-authored several publications, including the bestselling book «Bitcoin, Blockchain and Cryptoassets». He is the organizer of the «Blockchain Symposium», the «Blockchain Challenge» and the co-initiator of the «Blockchain Diploma project».
Moreover, he is a member of several boards, an advisor to prestigious Blockchain projects, an invited speaker at numerous renowned conferences, including the G20 Global Financial Stability conference, and has professional experience in the financial industry.
