How Will the Third Halving Affect Bitcoin?
An overview of the theories related to block subsidy reductions and previous halving events to provide clues on the possible scenarios for BTC-USD after May 2020.
In around five months, Bitcoin will go through with the third block subsidy halving event — expected to occur on May 12, 2020 (you can find a countdown here).
In this article, we’ll look at the theories put forward for why the halving will (or will not) influence the price of bitcoin and assess previous block subsidy reductions to uncover some clues as to how the price of bitcoin may behave this time round.
What is the Block Subsidy Halving?
The block subsidy is cut in half every 210,000 blocks (around four years) as part of Bitcoin’s programmed monetary policy, which guarantees its fixed supply. Miners receive a subsidy for a block they produce, on top of transaction fees and taken together this is known as the block reward.
From May 12, 2020 onwards, miners will receive 6.25 BTC instead of 12.5 BTC for each block they mine until the next halving in 2024.
Bitcoin’s monetary policy also ensures that inflation gradually falls over time, which will decrease from 3.68% to 1.80% per annum during the third halving event.
Inflation in most major economies is pretty low but the statistics are not necessarily representative of the average consumer (with many important items excluded from inflation calculations). For instance, inflation in the US is estimated to be around 6% if the relatively more robust methodology from 1990 were to be used.
Therefore, it will be the first time since the cryptocurrency’s inception that inflation rate of bitcoin is lower than it is in the developed economies of Europe and North America. Bitcoin’s inflation rate will also fall below gold’s after the May 2020 halving.
An inflation differential between a fiat currency like the euro and bitcoin opens up a potential carry trade with a long-term horizon. This is exactly why some people are excited about the Bitcoin halving: it reinforces bitcoin’s rules-based approach versus the discretionary approach of central banks, i.e., the setting of interest rates relies on decisions made behind closed doors by unelected monetary policy committees.
But not everyone is so optimistic about the milestone. Let’s have a look at the differing views on the impact and significance of Bitcoin’s upcoming halving.
Differing Views on Bitcoin’s Halving
As the halving has come into focus in 2019/2020, there has been a lot of debate in recent months with differing views on the event’s impact on the price of bitcoin.
There are those that believe each halving spurs a new wave of demand, as the reduction in supply bids prices higher as players expect higher prices in future because of the fixed supply. However, there are only two data points to go from, and extrapolation could turn out to be inaccurate or misleading.
Some investors are not so sure the third halving will be bullish for bitcoin, reasoning that because the block subsidy reductions are known well in advance, the event is already priced in. Let’s look at this argument in more detail below.
Narrative 1: The Halving is Already Priced In
Advocates of the Efficient Markets Hypothesis (EMH) argue that all the major players have known about the halving well in advance and is therefore accounted for by the current price of bitcoin.
Nic Carter of Castle Island Ventures wrote a great introduction to EMH if you’re unfamiliar with the theory. In the article, Carter discussed the exceptions to the EMH and stated the only one that applies to bitcoin, namely the lack of a shared valuation model for cryptocurrency. All other exceptions are not applicable to bitcoin.
While many argue that not everyone knows about bitcoin (and even less know about the halving), EMH only requires enough rational participants to be aware of the halving for markets to be efficient. This is reflected in the available data, as the price showed little reaction to each halving. Since no new information was revealed, the price does not react immediately in either direction.
But the EMH relies on rational expectations — which cannot be held true for all market participants. Many laboratory experiments in game theory have shown that participants act in a non-rational manner and that the conclusions of rational analysis sometimes fail to conform to reality.
Also, EMH does not explain why bitcoin tends to rise following the halving months or even a year or so later, which could be explained instead by traders anticipating a reduction in the selling pressure of miners.
Narrative 2: Reduction in Supply Pushes Price Higher
The bullish narrative for the bitcoin halving is that the reduction in newly mined bitcoins cuts the selling pressure originating from miners in half and increases demand for bitcoin as the scarcity of the crypto-asset becomes more apparent.
A slowdown in the flow of miners’ bitcoin sales can have a large impact on price over time. Since each miner’s cost is denominated in fiat currency but their earnings are in BTC, they must sell BTC to cover their costs. At each halving, the amount of bitcoin extracted by miners is cut in half — translating into a lower supply of bitcoins on the open market.
One research study found that the changes in the remuneration to miners and the average price of bitcoin are positively correlated (although that doesn’t necessarily imply causation). The results show that the halving starts to affect the price of bitcoin after around five months.
A related piece of research is the stock to flow model, outlined by Plan B here. We can think of stock as the existing supply of bitcoin while flow is the amount of new bitcoin produced. At present, Bitcoin has a high stock-to-flow ratio which is comparable to gold or silver, since it will take a long time for current production to match the existing stock. According to this model, scarcity drives value and the halvings reinforce this into the minds of traders and investors.
In the third halving, the stock-to-flow ratio for bitcoin will double from its current level of 25 to 50, edging closer to gold — which has a stock-to-flow ratio of 62. The stock-to-flow model predicts a price of $55,000 for bitcoin after the May halving, shown in the chart below.
One criticism levelled at the stock-to-flow model is that the use of linear regression is unfounded, as time series variables such as the price of bitcoin and the stock-to-flow ratio may be spuriously correlated — meaning that there seems to be an apparent relationship between the two when actually they just share a similar trend component.
This criticism was rebutted by Marcel Burger, who analysed Plan B’s data to show that the price of bitcoin and the stock-to-flow ratio are cointegrated, which means there is a long-run relationship between the two. The actual estimation of the long-run relationship remains open for research.
Another criticism of the stock-to-flow model is that there are no good explanations for why supply drives prices. Since the supply of bitcoin is pretty much perfectly inelastic, only changes in demand can influence the price — at least according to microeconomic theory.
While the straight line supply and demand curve diagrams are a nice abstraction, the reality is that demand curves can be any shape — except one that doubles back on itself, as proved by Gorman in the 1950’s. The static nature of supply and demand analysis probably means that it’s probably not the best model to understand Bitcoin’s halving.
Previous Halving Events
Price comparison before and after halving events.
First Halving: November 28, 2012
The first ever block subsidy halving occurred on November 28, 2012.
A month prior to the halving, the price was trading around $10 and continued its slow rise into the halving — with BTC priced at $12 at the time of the reduction of the block subsidy. The price stayed relatively stable until January 2013, where a rally took bitcoin from $13 to highs of $260 by April 2013.
The chart above shows the evolution of the bitcoin price in response to the halving. It took 367 days for bitcoin to reach $1,163, the all-time high until that point.
The cost of production statistics are not available for this time period, but we analyse the second block subsidy halving with respect to the costs of production below.
Second Halving: July 9, 2016
The second block subsidy halving took place on July 9, 2016.
The price prior to the halving was trading at $440. About a month before the halving event, the price rose in anticipation of the halving to a high of around $780. By the time of the actual event, the price fell to the $600s and fell further to a low of $465 one month later. Then the price entered a bullish phase, rising to $1,000 by the end of 2016.
After the second halving, it took BTC-USD 526 days to reach a new all-time high.
If we extrapolate this to the third halving and assume each market cycle is proportionally longer than the last, a new all-time high for BTC-USD would be expected 754 days after the third halving — which would be June 12, 2021.
Since each halving directly impacts the production cost of a single bitcoin, we can also look at how BTC-USD reacted in relation to the production cost after the second halving.
The chart below shows that before the second halving the price was bid higher. Then the production cost doubled overnight on July 9 as the reward reduction occurred. The price then traded below the estimated total production cost of 1 BTC, almost reaching the electricity cost at $427.26.
Bitcoin traded below the total production cost (the upper band at $712.27) for just over one month until the price broke above this range — bitcoin then increased from around $500 to above $2,000 by June 2017. During this run, however, bitcoin kept returning to test the total production cost (trading near $376.71, $736.13, and $899.37).
As shown by the chart below, as the hash rate increases the production cost also increases as older machines become obsolete and more miners compete for the fixed block subsidy. Innovation also leads to more competition in mining, raising the production cost of a single BTC as more powerful machines — and a great number of them — are required to mine profitably.
For the third halving, we can use the current costs of production to make some predictions.
The current electricity cost is $4,396.52 and the total production cost is estimated to be $7,372.52. If the third halving proceeds as the second did, we could expect a rally in the run up to the halving, only to retrace fully and pierce below the electricity cost of production.
Assuming that the costs of production do not change much until May 2020 and that miners pay $0.05 per kW/h for electricity, then from the time of the third halving event the current production costs will double.
As a result, we’d get an electricity cost of $8,800 and a total production cost of around $14,800 for 1 BTC, which suggests BTC-USD could go as low as $8,800 during May/June 2020.
If miners hold out and refuse to sell their holdings below the total production cost of $14,800, then a sustained move above this level could spark a fresh rally in 2020. However, this scenario assumes that new miners will continue to enter the market and the hash rate will continue to rise, which is not guaranteed. There’s also no accounting for increased mining efficiency from newly released machines. Some miners may also have lower costs since they manufacture their own machines and mine with
Conclusion
There are strong arguments for and against the halving being a major event that will see the price of bitcoin appreciate.
On one side, the reduction in miner selling pressure and the reinforcement of bitcoin’s scarcity should provide upward momentum for bitcoin. On the other side, given that each halving is known well in advance and all significant entities will prepare themselves accordingly, then the event is already priced in. The limited reaction after each halving seems to support the EMH perspective, while the longer-term effects are more supportive of the bullish perspective.
If the third halving is anything like the second, we should see the price appreciate prior to the event, and then drop as the cost of production doubles.
A back of the envelope calculation — assuming the cost doesn’t change too much between now and May — the lowest point bitcoin may reach is $8,800 (which is the electricity cost of 1 BTC). Of course, this floor is lower if the actual rates paid for each kW/h is lower than the $0.05 figure frequently quoted in research on the topic.
Despite the strong convictions about the effect of the block subsidy reduction for bitcoin, there are still many unknowns. For example, we do not know that much about the behaviour of miners: Are they optimistic/pessimistic on the price of bitcoin going forward? Do they tend to HODL during halvings and avoid selling at a loss to drive out inefficient competitors? How much of miners revenue flows to exchanges before and after each halving?
As the sector continues to mature and Bitcoin experiences its third halving, it will no doubt be another interesting case study. Along with bitcoin, altcoins such as bitcoin cash, bitcoin sv, monacoin, and zcash (and more) will also experience block subsidy reductions in 2020, which may shed more light on which of the theories — if any — are vindicated by the data.
Do you think Bitcoin’s third halving will be bullish, bearish or neutral for BTC-USD? Let us know your thoughts in the comments below.
