Bitcoin Halving — functionality and implications for investors
In the past weeks, numerous media and analysts have outbid each other with extreme price targets in the course of the Bitcoin halving (Bonnet, 2020). However, explanatory notes on the underlying functional principles of the halving have often been neglected. Its influence on the Bitcoin price has often been oversimplified or illuminated in a biased way. In the following article, the background and functionality of the current Bitcoin halving are explained, possible effects on the Bitcoin ecosystem are discussed and implications for investors are explained.
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In order to understand the Bitcoin halving and its effects, it is necessary to develop a basic understanding of the monetary creation process of Bitcoin (mining). This process is often is falsely stated in the media or reduced to the mere creation of new Bitcoins. Since there is no central bank in a distributed money system such as Bitcoin, a mechanism is needed that allows the collection and validation of past transactions in a transparent ledger. This consensus mechanism further needs to ensure that individual network participants cannot manipulate this ledger.
The role of the Bitcoin Miner
In essence, mining involves the validation of transactions in the Bitcoin system. Approximately every 10 minutes a new block is created, which contains around 2000–3000 Bitcoin transactions (Blockchain.com, 2020b). In order to validate a transaction block, miners calculate complex cryptographic puzzles (hash functions) which require a lot of computing power to solve. If a solution is found, the network of globally distributed computers (nodes) checks whether the proposed solution is correct. The first miner who calculates the solution determines the transactions that are included in the next block. For solving the block he is rewarded with the so-called block reward in the form of Bitcoin. The more computing power (hashrate) a miner has, the greater the chance that he will solve the upcoming block and receive the block reward. By proving that a lot of computing power was used for the transaction validation (proof-of-work) and rewarding the correct validation of transactions, incentives are created to ensure that data manipulation not profitable. Thus, the mining process not only ensures the money supply through the creation of new Bitcoins as block reward, but also provides the basis for the decentralized currency through an immutable chain of transaction blocks — the Bitcoin blockchain.
Money supply, block rewards and the halving
The incentive system for miners consists of two components. On the one hand, miners receive transaction fees from Bitcoin users for transactions. On the other hand, the validation of transactions (block reward) provides a further incentive for miners. The Bitcoin protocol defines hereby that every 210,000 blocks the block reward for the miners is halved. Since a block is created every ten minutes, this means that the block reward is halved roughly every four years. For the first 210,000 blocks, the block reward was 50 Bitcoins. This means that in the first four years after the creation of Bitcoin in the year 2009, 10.5 million Bitcoins were issued as block reward. With the first halving in 2012 the incentive for the miners was reduced to 25 Bitcoins per block and in 2016 to 12.5 Bitcoins per block. This process is predefined in the Bitcoin protocol and can be found in the code of the Bitcoin clients. The halving process thus programmatically controls the inflation rate of Bitcoin and ensures that the money supply of the cryptocurrency is limited to 21 million Bitcoins. Today, with the creation of 630,001 Bitcoin blocks, the third halving is triggered and the block reward is reduced to 6.25 Bitcoins per block. (BTC Direct, 2020)
Possible effects of halving
As the chart below shows, Bitcoin strongly increased against the US dollar after the last two halvings in November 2012 and July 2016 (TradingView, 2020). However, whether this price increase was triggered due to lower Bitcoin inflation as a result of the halvings remains open to interpretation.
In order to anticipate possible effects of today’s halving, different aspects have to be considered. As with any liquid asset, the price of Bitcoin is determined by supply and demand. On the supply side, it can be noted that the third halving will reduce Bitcoin’s inflation rate from 3.6% to 1.8%. This is relevant because the block reward is almost completely resold by the miners due to ongoing operational costs (e.g. personnel, hardware, electricity) and is included in the supply side of Bitcoin. For example, as of February 2020 Bitcoin.com estimates the mining costs per Bitcoin at 6,851 US dollars (Redman, 2020). This corresponds to a margin of 30% which means that Bitcoin miners have to sell about 70% of the block rewards against fiat money to cover their operational costs. In practice, this effect is difficult to estimate. For example, Young (2020) shows that Bitcoin miners are currently holding back their Bitcoins because they expect a price rise due to the halving.
The Bitcoin protocol stipulates that the inflation rate will continue to halve every four years until there is no more block reward in about 120 years (BTC Direct, 2020). For this reason, the shortage of supply is expected to have a significant impact on the Bitcoin price in the long term. In the short term, on the other hand, the Bitcoin price is mainly driven by positive and negative news, currency risks due to low liquidity or uncertainty about the intrinsic value of the crypto currency (see Herrnberger, 2020). Especially the intrinsic value is often doubted in the course of halving. It is assumed that many miners will be forced to discontinue their operations due to the reduced block reward. There is a fear that the Bitcoin network will become vulnerable due to increasing centralization of computing power by large mining corporations.
However, based on the total computing power in the Bitcoin network after the last halving in July 2016 (see figure), no immediate decrease in computing power (measured by hashrate) has been observed. On the contrary: In the following year, the hashrate of the Bitcoin blockchain almost quadrupled. Today, four years later, the network has a hashrate that is almost 100 times as high as in July 2016 according to Bitinfocharts (2020).
Regarding the distribution of computing power among different parties, the time series comparison by Blockchain.com (2020; see figure) shows that the hashrate of Bitcoin has been relatively well distributed among different mining pools in the recent years. Hence, it can be assumed that there is currently no danger from a centralization of mining power in the Bitcoin network.
What are the implications for investors?
In general it can be summarized that a shortage of the Bitcoin supply with increased demand can increase the value of Bitcoin in the long term. In the short term, no clear conclusions can be drawn with regards to the halving. External factors such as the corona pandemic, quantitative easing by central banks, or bold price forecasts might have a greater influence on the Bitcoin price than the purely technical act of reducing Bitcoin’s inflation rate by halving the block reward.
Investors who wish to invest a portion of their portfolio in Bitcoin should do so in line with their own risk profile. By spreading the investments over a longer time period, an averaged purchase price can be obtained to mitigate the high price volatility of cryptocurrencies.
Sources
Bitinfocharts. (2020). Bitcoin Hashrate grafiken. Retrieved May 9, 2020, from https://bitinfocharts.com/de/comparison/bitcoin-hashrate.html
Blockchain.com. (2020a). Hashrate Distribution Over Time. Retrieved from https://www.blockchain.com/charts/pools-timeseries
Blockchain.com. (2020b, May 9). Average Transactions per Block. Retrieved May 9, 2020, from https://www.blockchain.com/en/charts/n-transactions-per-block?timespan=2years
Bonnet, P. (2020, May 7). Countdown zum Bitcoin-Halving: Analysten überbieten sich mit extremen Kurzielen. Retrieved May 9, 2020, from https://www.finanzen.net/nachricht/devisen/reisserische-prognosen-countdown-zum-bitcoin-halving-analysten-ueberbieten-sich-mit-extremen-kurzielen-8828940
BTC Direct. (2020). Wie viele Bitcoins gibt es? Retrieved from https://btcdirect.eu/de-at/wie-viele-bitcoins-gibt-es
Herrnberger, S. (2020, March 2). Was beeinflusst den Bitcoin Kurs. Retrieved from https://blockchainwelt.de/was-beeinflusst-den-bitcoin-kurs/
Redman, J. (2020, February 15). Tradeblock Estimates Post-Halving Mining Cost of $12,500 per BTC. Retrieved from https://news.bitcoin.com/tradeblock-estimates-post-halving/
TradingView. (2020). Bitstamp: BTCUSD . Retrieved from https://de.tradingview.com/chart/
Young, J. (2020, May 7). BTC Miners Expect Bitcoin Price to Surpass $12K After Reward Halving. Retrieved from https://cointelegraph.com/news/btc-miners-expect-bitcoin-price-to-surpass-12k-after-reward-halving
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