Bitcoin Halving and Deflationary Pressures

Inflationary Fiat vs Deflationary Bitcoin

Unlike fiat currencies which operate on a model of inflation, Bitcoin is deflationary in nature. Inflation refers to a general increase in the prices of goods and services within the economy. For example, a bottle of whiskey would have cost you £2.69 back in 1970 but would set you back by more than £12 today. Inflation in the context of currencies then refers to the decrease in their buying power. With reference to the example above, the value of the Sterling Pound has fallen since 1970. Compared to 1970, if you were to purchase a bottle of whiskey today you’d require almost 5 times the amount of Sterling Pounds. All major fiat currencies today such as the US Dollar, Sterling Pound and Euro are inflationary. A deflationary environment is simply the reverse of the situation described above. Building on the example of the price of whiskey, this would be equivalent to a bottle of whiskey costing £12 back in 1970 and £2.69 today.

The primary reason for this difference between fiat currencies and Bitcoin is that the supply of fiat currencies are infinite while that of Bitcoin is finite. With respect to fiat currencies, central banks can print new money (fiat currency) at any time and there is technically no limit to how much money they can create. Over time as the central bank constantly issues new money as part of monetary policy, the value of the respective fiat currency falls as it becomes less scarce. In order to facilitate these inflationary pressures, central banks intentionally increase the amount of new money issued every year. The underlying principle is that agents in the economy will be more incentivised to spend (as opposed to holding) if the value of the fiat currency diminishes and in doing so, facilitating a robust economy with free-flowing cash.

In the case of Bitcoin however, money supply is fixed as there is hard cap on production of new currency and the rate of mining is predictable; The algorithm behind Bitcoin dictates that its supply is limited to 21 million units and that the last Bitcoin will be mined in the year 2140. Crucially, the in-built algorithm powering Bitcoin works such that the number of Bitcoin mined declines year on year. Coupled with the fact that after the year 2140, any Bitcoin that is lost (e.g. if an owner of Bitcoin loses his private key) is permanently removed from the money supply, the value of Bitcoin will rise as it becomes increasingly scarce.

Bitcoin Halving

Bitcoin halving is a pivotal component of the mechanism deployed to sustain the deflationary model that Bitcoin operates on. Every 210,000 blocks mined (roughly every 4 years) on the Bitcoin blockchain, the Bitcoin protocol halves the reward for mining new blocks. In other words, with each halving, miners receive 50% less Bitcoin in reward for verifying transactions. To illustrate, when Bitcoin was first launched in 2009, the reward for mining a block of transactions was 50 new BTC. After the first and second halving in 2012 and 2016, this block reward was recursively halved to 25 BTC and 12.5 BTC respectively. As lead developer of the Ethereum project Vitalik Buterin explained the essence of Bitcoin halving: “The main reason why this is done is to keep inflation under control”, Bitcoin halving ensures that the production of Bitcoin decreases over time so as to resist inflationary pressures.

Historical Impact of Bitcoin Halving on BTC Price

Historically, Bitcoin halving has tended to have a positive long-term effect on the price of BTC. In the year following the first Bitcoin halving in November 2012, the price of BTC surged 100 fold from around $11 to a high of $1100 in 2013. The second Bitcoin halving saw the price of BTC erupt from $600 to $20000. The economic concept of supply and demand provides a succinct explanation for this trend. As the production of Bitcoin slows, demand outstrips supply leading to a rise in the price. The theory of demand and supply however rests on crucial assumptions about the economic forces at play, particularly that the demand for BTC remains robust.

Alternatively, we can attempt to dissect the correlation between Bitcoin halving and the price of BTC by considering the role of miners. First it is important to note that the Bitcoin protocol keeps mining rates constant by adjusting the difficulty level of mining every 2016 blocks are added to the Bitcoin blockchain. This means that as a collective whole, miners are unable to verify more blocks than is stipulated by the Bitcoin protocol within a given period. On average, the Bitcoin protocol allows for 4380 blocks to be mined each month. At the time of writing the price of BTC is about $9000 and the block reward is 12.5 BTC. Each month miners are thus earning:

4380 * 12.5 * $9000 = $492,750,000

Following the halving, if miners were to cash in at the prevailing BTC price of $5000, monthly revenue will likewise be halved to:

4380 * 12.5/2 * $9000 = $246,375,000

The miners’ profits will be severely reduced and many smaller players may even be forced out of the market. Given that the mining rate of 4380 blocks per month is fixed, the only option miners have to circumvent this situation is to sell their newly mined BTC for an amount no less than $18000 (twice the prevailing price) in order to maintain their profit levels:

4380 * 12.5/2 * $18000 = $492,750,000

The main idea is that miners who persist with mining will only be willing to sell their newly minted mined Bitcoins at a profitable price. Since the block reward is halved and the mining rate is fixed, this will inevitably lead to an increase in Bitcoin’s asking price.

PlanB’s S2F Model

As Bitcoin’s 3rd halving scheduled for May 2020 draws closer, conversations around a potential BTC price correction have intensified. In March of 2019, an early Dutch bitcoin adopter pseudonymously known as PlanB published a report on Medium titled “Modeling Bitcoin’s Value with Scarcity” in which he/she leveraged upon the emerging Stock to Flow (S2F) pricing model to price Bitcoin. The report’s bullish predictions of the price of BTC has gained significant traction within the Bitcoin community and has since been established as one of the leading bull arguments vis-à-vis the impact of the third halving on the price of BTC.

In the report, PlanB uses S2F ratio to quantify scarcity. This simple ratio is given by:

SF = stock / flow

where stock is the volume of existing reserves and flow is the yearly production. PlanB then found statistically significant relationships between

and BTC market value as well as between

and BTC price on logarithmic scales. Based on the S2F pricing model presented in the report, PlanB forecasts BTC price to reach $55,000 after the third Bitcoin halving in May 2020. In essence, PlanB uses S2F to estimate the market value and price of BTC and in doing so, presents a highly bullish prediction for the price of BTC following the impending May 2020 halving.

3 Critiques of PlanB’s S2F Model:

Demand Conditions

While PlanB’s bullish case for Bitcoin is understandably celebrated by the Bitcoin community, the S2F pricing model driving PlanB’s predictions also has its fair share of critics. Critics argue that the S2F pricing model is fundamentally flawed as price is determined by a combination of supply and demand factors. The S2F pricing model which only takes into account supply conditions whilst omitting the latter is thus an erroneous measure of BTC market value and price. In layman terms, even as the Bitcoin halving acts as a negative supply shock, we cannot reliably predict a surge in BTC price without ascertaining that demand conditions persists or improve; Bitcoin scarcity in itself is not a sufficient condition of value.

OLS Assumptions

Flaws in the statistical methodology supporting PlanB’s S2F model have also been flagged out by critics. PlanB uses a simple Ordinary Least Squares (OLS) regression to map SF to BTC market value and price. OLS regression rests on 4 key assumptions known as the Gauss-Markov assumptions. However, statistical tests conducted on the Bitcoin dataset used in PlanB’s report have shown that not all the assumptions hold at conventional confidence levels. This gives rise to the possibility of OLS regression identifying spurious relationships, casting doubt on the veracity of PlanB’s S2F model predictions. In particular, one critique of the statistical methodology behind PlanB’s S2F, after treating the original PlanB model for its respective violations of the Gauss Markov assumptions, finds that only orthogonal shocks to Bitcoin’s SF would result in a permanent correction of BTC price. Since the SF of BTC can be calculated ahead of time, the critique posits that PlanB’s prediction of a permanent price correction following the May 2020 halving is misguided.

Efficient Markets Hypothesis

The Efficient Markets Hypothesis (EMH) holds that at any given point in time, any known information about a given asset should already be priced in. The date of Bitcoin’s halving is stipulated by the Bitcoin protocol and is publicly available information. Pointing to BTC’s recovery since its low of $3,300 following the 2017 Bitcoin crash, some critics postulate that in accordance with the EMH, markets have already priced in the May 2020 halving ahead of time and hence we can expect there to be little price movement following the actual date of the halving. In Bitcoin’s first 2 halvings in November 2012 and July 2016, it took more than a year before the Bitcoin market took off. In fact, in the immediate period following the 2016 Bitcoin halving, BTC’s price initally fell from $707 to $570. While the EMH argument appears especially salient considering the initial sluggishness of BTC prices observed in previous halvings, the longer term price corrections which subsequently ensued suggest that the markets may not have been as efficient as the EMH posits. Indeed, markets are never perfectly efficient and particularly in what is a relatively nascent market which remains deeply exposed to various risks including government regulation and fraud, the validity of the EMH as applied to the Bitcoin market is seriously challenged.

Conclusion

The process of halving does not alter the fundamental value of Bitcoin in the traditional investment sense; It is more appropriately characterised as a supply-side development which sees Bitcoin becoming increasingly scarce. The price of an asset is ultimately a function of both supply and demand factors and hence any credible attempt to prognosticate the impact of the halving on BTC price must factor in demand conditions. Accurately forecasting the demand conditions of the Bitcoin market is a herculean task as there are simply too many unknowns surrounding the future developments of the revolutionary DLT technology (especially in areas such as regulation and scalability). Having said that, history has shown that the occurrence of Bitcoin’s halving in itself tends to generate bullish hype about BTC’s price (and thus demand), inflating BTC’s price up in recursive fashion. Should this trend persists, we can expect to see Bitcoin prices react favourably to the upcoming halving in May in the longer term, if not the more immediate term.