The bitcoin Squeeze
Many people who have held bitcoin for a long time have been through several boom and bust cycles. Recently, many folks have noticed a pattern to these cycles linked to the bitcoin halving event that happens every 210,000 blocks or approximately every four years. The next one is anticipated to occur in April/May 2020. Historically, these halving events have not been properly priced into the market, thus causing a large bull run; followed by a bear market. This bullishness is supported through fundamental factors that cause a downward shift in the supply of bitcoin while historically, there is a possibility of an increasing demand for it. If this is true, this ultimately could lead to a price surge and eventually correct back to a new equilibrium price.
A pseudoanonmous person named Plan B based in Amsterdam has provided a very interesting financial model for pricing bitcoin. You can read more about it in his medium article. He has created three models where the new equilibrium price could be within the range of $50,000 to $100,000. I personally believe his model is fairly accurate. However, I also think the high price in the next bullish rally might exceed his prediction. When the market enters a bearish territory, it may trade below $50,000 but I predict it might be higher than the previous high of $20,000.
Bitcoin has behaved similarly to a commodity. Even the nomenclature for bitcoin uses terms such as “mining”. However, there is no physical mining of tokens but there is a Proof of Work mechanism to mine new “coinbase” transactions, as they are called, which generate new bitcoin (not to be confused with the exchange Coinbase). Many sites have already explained Proof of Work, coinbase transactions, and UTXO (Unspent Transaction Output) so I won’t go into details here.
The effects of the bitcoin halving event are possibly analogous to the oil embargo that occurred in October 1973 and ended in March 1974. It’s not a perfect analogy but it is comparable. Before the embargo was instituted, the Nixon administration withdrew from the Bretton Woods agreement and abandoned the gold standard. This affected oil prices since oil was and is still priced in US dollars. In addition, OPEC wanted to make a statement towards nations that were supporting Israel during the Yom Kippur war. The US market was a heavy importer of OPEC oil. When the oil embargo was placed, the nominal average price of crude oil jumped from $3.50 per barrel to as high as $15 per barrel during the embargo. Even when the embargo was lifted, the price of oil continued to increase to a high of $39.50 per barrel and eventually went down in price. However, even after the price drop, oil prices have continued to stay above the price before the oil embargo. Graphic 1 demonstrates the price move before and after the oil embargo. This demonstrated an event where the demand stayed constant or possibly increased while the supply curve shifted and decreased. This led to a permanent increase in oil prices. This singular event is very similar to the bitcoin halving event where it had led to a permanent increase in the bitcoin price.
In November 2012 (see Chart 1), the cryptoasset market experienced the first bitcoin halving event without much fanfare. During this month, bitcoin traded at approximately $11. The protocol was still relatively obscure. During the first year after the halving event, the price slowly trickled up and then increased starting in November 2013, reaching a peak price in December 2013 of approximately $1,200. The market eventually corrected. There were two negative news events that occurred at the start of January 2014. Mt. Gox was hacked and filed for bankruptcy in February 2014 and China banned Chinese banks from handling bitcoin trades in December 2013. Despite the negative news, bitcoin maintained a higher price in November 2014 compared to the beginning of the halving event.
The second bitcoin halving event occurred in July 2016 (see Chart 2). In that month, bitcoin hovered around $600–700. Starting around December 2016, bitcoin starts to tick higher to almost reach $1,000. Many people in the industry were hoping the Winklevii bitcoin ETF (Exchange Traded Fund) would pass in early 2017. It did not ultimately pass but the price did start to trend higher. As the media started to cover the industry more, it led to an increased demand for bitcoin. The Wall Street Journal and Barron’s first mentioned bitcoin on their front page on June 2, 2017 and July 3, 2017, respectively. As with the previous event, the price corrected itself which led to a bear market. Despite this, the price at the end of July 2018 around $7,000 was still higher than $600–700 when the halving event started. In addition, bitcoin hit a low of $3,300 in December 2018. This price is still higher than the previous high of $1,200.
The oil embargo in the 1970s provides a good example of supply shocks to a commodity. In bitcoin’s scenario, the halving event is a permanent supply shock to the market. In my analysis, I speculate there is an increasing demand in bitcoin while the supply is drastically reduced by 50%.
Economics: Supply Curve
The Proof of Work mining mechanism generates the supply of new bitcoin until it reaches the cap of 21 million. Bitcoin miners are important players in the market because they help update the ledger to track all UTXO. As compensation, they receive a coinbase transaction which is currently 12.5 BTC in addition to transaction fees (also priced in BTC). At this point, transaction fees are fairly nominal so it will be disregarded in this discussion. Miners are rewarded approximately every 10 minutes. Currently, the majority of the payment derives from the coinbase transaction. An assumption is made that institutional bitcoin mining operations only care about net profit in fiat terms. The owners might be agnostic to the bitcoin protocol since many miners can now hedge their bitcoin with futures contracts. If this assumption is correct, bitcoin miners don’t want exposure to exchange risk. It is in their best interest to liquidate their BTC into fiat. Many of them do this through contracts or OTC (over the counter) desks with large purchasers. Based on Table 1, for 2019, there will be an approximate total of 657,000 BTC created through coinbase transactions and the transaction fees are not included in this total.
Assuming bitcoin miners are selling their coinbase transactions, the market has been absorbing it in 2019 without putting much downward pressure on the price. The common question to ponder is who and why are these people buying bitcoin. There are several theories and data on this. They include the following:
- A movement of #stackingsats (defined in detail further in the article) where individuals are accumulating bitcoin to hold for the long term, referred to as bitcoin hodlers.
- Dark Markets are unfortunately still using bitcoin to engage in illicit transactions.
- Localbitcoins.com provides valuable data on which nations have citizens converting their fiat to bitcoin.
- There are billionaires who are trying to amass a position as a hedge against a global financial crisis or an inflation of fiat currencies. There is one in particular who wants to purchase a double-digit percentage of the entire supply.
- Bitcoin whales want to continue supporting the network through purchases to protect their current holdings.
- Nations are purchasing it to diversify their sovereign wealth. Rumors have circulated for the past 3 years that China has been purchasing bitcoin to hedge their large US Treasury position.
There are probably other bitcoin buyers I am not covering. They might be significant in the marketplace but it would be difficult to properly quantify or estimate their purchasing power.
Unless otherwise stated, all bitcoin amounts are assumed to be priced at $10,000 USD per BTC.
There has been a movement trending on Twitter call #stackingsats. The smallest unit of bitcoin is referred to as a satoshi, or sats. Hence, the term stacking satoshis, or stacking sats. One satoshi is one hundred millionth of a single bitcoin. It is the same as 0.00000001 BTC. Stacking satoshis is a movement encouraging believers of bitcoin to dollar cost average bitcoin in amounts usually less than $100. Users post screenshots of their buys on Twitter. Not everyone is posting their purchases due to security reasons. Thus, it is difficult to estimate how much bitcoin is purchased from this movement. I am estimating this to be a nominal amount to the overall market but it could possibly be significant.
Dark markets use bitcoin as a method of payment to conduct their transactions. Although, once users educate themselves on UTXO, they will realize that cash is a much better medium to conduct illicit transactions because bitcoin leaves an auditable record. Law enforcement can track bitcoin transactions on the blockchain and use it as evidence in the courts. According to Chainalysis (Graphic 2), approximately $620 million (about 82,000 BTC) of bitcoin was used on the dark markets in 2018. This is not a bullish use case for bitcoin since this violates regulations and federal laws. However, it is still contributing to trading volume and demand. Many people incorrectly assumed that bitcoin is fungible. The recent shutdown of a child porn website in October 2019 demonstrates that bitcoin is highly traceable and can be used as evidence in a court of law. Bitcoin is still an easier token to obtain and transact compared to other privacy coins such as zcash or monero. Those would be the preferred method for the dark markets due to their fungibility.
Localbitcoins.com is a peer-to-peer trading exchange. Historically, bitcoin has traded at a premium to the spot price here. Since there is a premium to the spot, I don’t believe there are traders here trying to make money since the premium is usually around 5%. This site is primarily used for fiat to bitcoin conversion. After extracting and aggregating this data, the average weekly trading volume globally is approximately $61 million of bitcoin in 2018. The average weekly trading volume denominated in BTC is approximately 8,200 bitcoin which translates to roughly 424,414 BTC traded in 2018. Citizens from developed and developing countries are trading on this platform. Countries such as Venezuela have seen an increase in the trading volume as the local currency, the Venezuela bolivars, has experienced hyperinflation. In 2018, Venezuelans traded a total of approximately 35,000 BTC. One can speculate that Venezuelan citizens have started using bitcoin as a storage of value. As of November 2019, the total trading volume on localbitcoins is already about 10% higher compared to 2018 in the same time frame. The localbitcoins.com volume is enough to suggest that we are witnessing an increasing demand over time as more people become educated in this space.
There are wealthy individuals who are seeking to protect their wealth. They understand the value proposition of bitcoin so they might have started to slowly accumulate BTC in the open market. According to this Forbes article, there is an individual trying to accumulate 25% of the current circulating supply. That amounts to over 4 million bitcoin. There are about 2,200 billionaires. If only 1% of those billionaires are interested in purchasing 1% of a billion dollars into bitcoin, this still totals over $200 million dollars of bitcoin or 20,000 bitcoin. Staying on the conservative side, I estimate wealthy individuals are purchasing about 15,000 BTC for 2021.
At the same time, sovereign wealth funds are possibly purchasing bitcoin. This is all speculation based on unsubstantiated rumors. Bulgaria has publicly stated that they own bitcoin through government confiscation from organized crime. They currently own over 200,000 BTC which is equivalent to over $2 billion. This made headlines because the value of their bitcoin exceeds the value of their gold holdings. Other countries such as South Korea also own bitcoin through seizure from illegal activity. I believe this will eventually lead to governments hedging their portfolio through the purchase of bitcoin. Eventually, rich individuals and sovereign wealth funds may publicly announce their holdings. The news could become a positive catalyst because it validates bitcoin’s value proposition. I estimate that this could be a low amount of 30,000 BTC for 2021.
According to this Bloomberg article, Venezuela already has bitcoin in their government accounts to avoid US sanctions. This is not positive news for bitcoin adoption. However, it shows how one government sees the value in bitcoin. I believe some governments might be slowly accumulating bitcoin in their coffers. Once they are content with their portfolio allocation, they might make a big announcement that may ignite a race amongst countries to seize a piece of the limited supply of bitcoin. If a major super power announces a position in bitcoin in 2021, I believe this could extend the rally.
As important as price and demand for bitcoin can be, over the long term, the most important factor is most likely the acceptance of the protocol in conjunction with the development of the infrastructure. As software for the wallets, nodes, and miners become more user friendly, many people might start to view it to be better than the gold standard. As more users support the network, it puts it in a better position where this protocol might be here to stay and will not head towards the same history as the Dutch tulip bubble. This ultimately produces large network effects within the ecosystem. This is also where Facebook and Instagram derive its large valuation. Since everyone uses those social media networks, it becomes much harder to disrupt.
Many well-known speakers and professors continue to argue against bitcoin. However, the data demonstrates there is an increasing interest in bitcoin. Education plays a large role in this as many universities such as Baruch College (my alma mater), New York University, Stanford, and many others have started to offer courses around blockchain and cryptoassets. In addition, there are online courses offered by the University of Nicosia and Udemy. There is even a certification to become a Certified Bitcoin Professional. The increase in education probably contributes to an increasing demand to purchase bitcoin. I believe there is an educational barrier to understand the technology and its value proposition. People who start devoting 30 minutes on a daily basis to understanding bitcoin will eventually fall down the proverbial rabbit hole.
There are some additional catalysts that could propel the bull run even further. As this industry gains legitimacy where different infrastructure companies are built and tremendous investment is contributed, this increases the possibility that a bitcoin exchange traded fund (ETF) might be approved by the Securities and Exchange Commission (SEC). I speculate that early 2021 might see the first approval. Leveraging Spencer Bogart’s write up in January of 2017 where he discussed the potential impact of a Bitcoin ETF, he speculated that a conservative estimate of $300 million could enter the bitcoin market. This translates to approximately 30,000 bitcoin purchased in a short period of time.
As the infrastructure is built around crypto, we might witness larger institutions beginning to invest significant amounts into the space. The narrative in 2017 that the “institutions are coming” might come to fruition in 2021. This might not be a large influx of capital immediately but we might start witnessing small amounts of institutional capital flowing into the space. Bitcoin might be the first choice versus other cryptoassets if pension funds and endowments seek alpha for their portfolios. This catalyst could push the market even higher.
Square’s Cash App has made it really easy for users to purchase bitcoin on their phones. There is also a premium purchasing bitcoin on Cash App. Square makes money from the spread since they don’t charge a commission. The recent earnings released by Square show that users are starting to purchase more bitcoin over time through their app. At this point, I am not including their data in my estimates but I will eventually provide more research around Cash App’s numbers.
In addition to the above factors, many crypto exchanges are offering leverage beyond our imaginations. In the traditional equity market, the most you will receive as an investor is 2X on your existing asset base. If you invest in smaller capitalization companies, brokerages won’t typically offer any leverage. In the current environment, many crypto exchanges are offering leverage beyond 2X. Here’s a summary of the type of leverage you can currently receive.
When retail investors utilize this available leverage, this will add substantial fuel to the fire. In other words, if I only have $1,000, my buying power is actually $125,000 on Binance. Thus, I believe we might witness a greater rally than 2017 as investors use this leverage to purchase more cryptos. I predict this might result in an overextension of the higher equilibrium price ($100,000) Plan B has estimated. When the bubble deflates, I think this will result in a drastic downward movement that will be very painful for anyone who purchased near the top.
Economics — Demand Curves
The bitcoin supply schedule decreases approximately every four years. This causes a sudden shift in the supply curve. During the next halving event, to be conservative, the demand may stay constant but the supply suddenly drops in half. As people continue their purchases, they will notice it becomes harder to purchase the amounts they desire at the price demanded. Slowly, this starts to push the price higher. As this happens, eventually people might start to experience FOMO (fear of missing out) and start purchasing bitcoin.
Based on this information, I believe the bitcoin halving event happening around April/May 2020 is not properly priced into the market. After the event, purchasers will probably realize there is a shortage of bitcoin available to purchase. Historically, the halving event correlates to a bull run a year after the halving event. Due to the increased education in the space, I believe this might happen sooner compared to previous halvenings. My best guess is sometime in December 2020 or earlier. If there is a shift up in the demand curve (increased demand), we might possibly see a bigger bull run than we witnessed in 2017. It is difficult to know when the event will occur, so these dates are all speculative.
In Table 3, I summarize the possible demand of 703,000 BTC for 2021 assuming demand doesn’t increase. The current annual supply created of 657,000 will suddenly decrease to 328,500 per year, starting around May 2020. This sudden shift in the supply curve will most likely be the catalyst for the next bitcoin bull run.
Disclaimer and Assumptions
The demand curve stated earlier could have some overlap with the localbitcoins data and the dark markets demand. Also, some of the estimates could be completely inaccurate. I am trying to present data in the most conservative manner since I haven’t accounted for data from other exchanges and possibly other buyers interested in bitcoin.
Chainalysis data on the dark markets might not be complete. There is a possibility they don’t have all the dark market bitcoin addresses to capture the complete data. Their estimates on the dark market volume might be more on the lower end.
The bitcoin protocol has programmed some rules that many people believe are hard rules. Since this protocol is decentralized, rules can only change through consensus. This includes changing the supply cap of 21 million bitcoin. Although, many bitcoin maximalists will deem this to be sacrilegious. However, this is a possibility. The odds of it happening might be low but it is worth mentioning. There might also be a bug in the code that allows infinite printing of new bitcoin. In the past, there was a bug that allowed it but thankfully, it was patched before someone took advantage of it.
Bitcoin does and will face competition for its particular use case. Currently, bitcoin is not easy to use due to its complicated user interface (UI) so it ultimately creates a bad user experience (UX) for the average user. There can be a new protocol that solves bitcoin’s problems quickly. That could ultimately lead to users switching over to the new protocol. In social media, Myspace was the first mover but Facebook created a better product so it convinced users to switch to their platform. This can happen with bitcoin.
More Disclosures: I own bitcoin. This material does not constitute an offer to sell or the solicitation of an offer to buy any securities. Any data here is obtained from what are considered reliable sources; however, its delivery does not warrant that the information contained is correct.
This report is for informational purposes only and should not be construed as investment advice. It is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product. The research for this report is based on current public information that I consider reliable, but I do not represent that the research or the report is accurate or complete, and it should not be relied on as such. My views and opinions expressed in this report are current as of the date of this report and are subject to change. Past performance is not indicative of future results.
Any projections, forecasts and estimates contained in this document are necessarily speculative in nature and are based upon certain assumptions. In addition, matters they describe are subject to known (and unknown) risks, uncertainties and other unpredictable factors, many of which are beyond my control. No representations or warranties are made as to the accuracy of such forward-looking statements. It can be expected that some or all of such forward-looking assumptions will not materialize or will vary significantly from actual results. Accordingly, any projections are only estimates and actual results will differ and may vary substantially from the projections or estimates shown.
Past performance of these strategies is not necessarily indicative of future results. There is the possibility of loss and all investment involves risk including the loss of principal.