ELI5 — Simplified Economics of the Bitcoin Halving
In just a little over 4 days, Bitcoin is going to go through its official third halving. This is the process whereby the issuance of new Bitcoin through the process of mining is cut in half, in order to fulfil the creator’s (Satoshi Nakamoto) declared vision that there can only be 21 million BTC to ever exist.
Functionally, the halving is a simple blockchain implementation to allow Bitcoin’s supply to increase gradually while reducing this increase slowly to achieve the end-goal of a limited supply. In order to understand why a limited supply is relevant, we have to look at the equilibrium between demand, supply, and price:
When demand for a good or service increases while supply remains the same, price increases.
This means that if Bitcoin’s usage and demand increases, the open market price for Bitcoin is expected to increase if the supply remains the same.
However, during the early days of Bitcoin, in order to incentivise users to utilize the currency, keeping the supply low allows a more steady price increase, as some of the un-mined supply is “locked” and unable to be part of the circulating supply. Additionally, miners are incentivized to perform proof of work to secure the network and get Bitcoin to spend (or just collect!). With a larger issuance of Bitcoin for mining activities early on, the early adopters are rewarded for their belief in the system. As more miners join and perform proof of work, the network has a stronger chance to grow and be more stable due to the network effects of having tons of users.
However, the endgame as dictated by the Bitcoin whitepaper is for a hard-coded limited supply. By ensuring that only 21 million BTC will ever exist, the currency would be protected from the effects of excessive inflation — where over-issuance of currency results in its devaluation. This has traditionally been a problem for centralized currencies, where “printing money” causes the existing issued currency to devalue and reduce a person’s net worth just for holding onto the currency.
In terms of usage, Bitcoin can be split into amounts as small as 8 decimal places, known as a Satoshi, which means that increased valuation for it would still be well supported — a person can transact in tiny percentages of a Bitcoin as easily as they would for a single full Bitcoin.
Expected price behavior due to the Halving
In addition to increased media coverage, historically, Bitcoin’s halvings are always followed by an uptrend in price. This is due to one of a few factors:
- Miners are expecting to receive less Bitcoin for the same amount of work. In order to compensate for the smaller amount of Bitcoin received, they stop selling Bitcoin to the market at the original lower prices in order to ensure their return on investment in terms of electricity committed is still viable — this reduces the market supply and causes the price of Bitcoin to increase.
- Media coverage around Bitcoin during this period creates huge awareness and interest in the currency. Speculators often like to purchase and hold onto Bitcoin during these periods, creating increased demand and thus an increase in price.
Volatility and guesswork
Even with the economics pointing towards an uptrend in price, speculators have been on the fence about how the halving will affect Bitcoin. Although the past 2 halving events have historically shown that halving events are usually followed up with huge increases in the price of Bitcoin, the total amount of Bitcoin available now is much higher than before — and the amount of Bitcoin being added to the system will be much less. Even as the halving event reduces the supply increments by half, the expected increase in demand may not happen, and once media hype over the halving event is over, there is a good chance that speculators exit Bitcoin once more.
Whether Bitcoin will continue to rise in price is anyone’s guess. However, the halving event is definitely significant for Bitcoin’s future, as each halving marks the start of a new equilibrium between miner rewards/earnings, Bitcoin usage, and its price.
