Bitcoin Mining and the Halving
The Bitcoin mining ecosystem has an incentive structure almost as perfect as the modern financial system incentives are imperfect.
Free Markets
Last week we addressed the undeniable chaos of late stage capitalism due to the ongoing degradation of sound money. Like it or not, we find ourselves in a situation where the state is bailing out companies with taxpayer money and the largest beneficiaries of these bailouts are the executives, bondholders, and shareholders of such companies. Our over-leveraged debt-based economy, encouraged by decades of short-termism, hangs like the sword of Damocles over the very cohesion of society.
In an all too perfect example, the airline Easyjet last week received a £600 million loan from the Bank of England. On 20th March, Easyjet’s co-founder was paid £60 million as a dividend.
In free market capitalist economies, weak and failing companies should be allowed to fail so their IP, customers, and products can be picked up by new investors with fresh capital who will produce better products and services with more fiscal prudence. The moral hazard that comes with bailouts perpetuates the cycle of share buybacks, high dividends, and executive compensation for companies deemed ‘essential’ by the state.
No one knows exactly how this stage in history ends but as more respected names voice concerns over the economy [just last week — Dalio cash is trash — Palihapitiya Zombie companies] — and with central banks pushing ahead with Central Bank Digital Currencies, it’s clear change is afoot. Simon Dixon (@SimonDixonTwitt) offers a solid thesis on how this plays out and is well worth a listen.
“I believe that increasingly there will be questions by bondholders who are receiving negative real and nominal interest rates, while there is a lot of printing of money, about whether the debt assets they are holding are good storeholds of wealth. I believe that cash, which is non-interest-bearing money, will not be the safest asset to hold.” Ray Dalio
“On Main Street today, people are getting wiped out. Right now, rich CEOs are not, boards that have horrible governance are not. People are,” Chamath Palihapitiya
Bitcoin Mining and the Halving
With Bitcoin’s halving event less than a month away, it is worth looking at how this market operates, not only from a trading and investment perspective but also as a reminder of how capitalist free markets can and should operate. As a reminder, Bitcoin’s inflation schedule is pre-programmed to reduce by 50% every 210,000 blocks or approximately every 4 years. Around May 12th, 2020 will see Bitcoin’s 3rd reduction as the reward for mining each block will be reduced from 12.5 BTC to 6.25 BTC, which will result in Bitcoin becoming scarcer than gold.
Refreshingly antithetical to the modern financial system, the Bitcoin mining ecosystem has an incentive structure almost as perfect as the modern financial system incentives are imperfect. Perhaps the greatest stroke of genius from Satoshi was the Difficult Adjustment Algorithm (DAA) built into Bitcoin. This automatically adjusting incentive mechanism acts in a way that pressures the miners to become more efficient over time and ultimately better guardians of the Bitcoin protocol, which encourages adoption and price appreciation.
The Difficulty Adjustment Algorithm is a way of creating the required pressure on the mining ecosystem so that incentives are aligned and those companies, investors, and miners who have the best strategies are rewarded accordingly.
Each time there is a dramatic price drop in Bitcoin, many commentators spin back up the concept of the ‘mining death spiral’ which in simplified terms is the idea that the market price of Bitcoin is lower than the cost of production, therefore rendering mining unprofitable and forcing all miners to sell Bitcoin down to zero and fold. Miners are essential in providing the security and value to Bitcoin, and any perceived risk to their business model impacts market sentiment, and therefore investment appetite for Bitcoin.
Satoshi realized that the process of mining — or put another way, maintaining the inflation schedule and monetary policy of Bitcoin — was essential to the global adoption of the protocol. Satoshi was clear that the failures, via human influence and manipulation as we see so clearly today in the current ‘’free market’’ economy would not be repeated in the Bitcoin network. The difficulty adjusting algorithm provides the incentive mechanism, much akin to the price discovery found in free markets. It provides pressure to the system.
The Bitcoin protocol is programmed to produce a block every ~10 mins. Every 2016th block (approximately every 2 weeks), the SHA-256 algorithm will automatically recalculate the difficulty that miners are subjected to when mining. At the 2015th block, each node will look back down the blockchain and calculate the ratio between how long it should take to mine each block (10min) Vs the actual time it took to mine each block.
The reason for the possible deviation from the target 10mins is that miners are free to join and leave the network as they like during each 2-week period/over time. The more miners that join, the more hashrate is added, and the faster each block is mined, and conversely, the opposite is true. If the difficulty adjustment algorithm calculates that blocks are being mined 10% too fast, then the difficulty target will be adjusted down to reflect this.
To fully understand how this crucial mechanism impacts mining, and therefore price, it is important to understand that no 2 miners are the same. Each miner has different hardware mix, different electricity costs, varied debt obligations as well as power purchase contracts. There will be jurisdictional risk and varied labor costs combined with seasonality considerations if miners are using renewables. This creates a complex matrix of miners with different cost of production and all with different sensitivities to market conditions.
So…if the Bitcoin price falls as we have seen recently due to the global COVID-19 pandemic, then the least efficient miners will suffer first due to their relatively higher cost of production. Those that can’t survive the pressures on their margin will be forced to turn off their mining equipment or sell their inventory to continue mining at a loss if they are contractually forced to. If prices remain low then selling will increase as the percentage of miners affected will also increase, thus speeding up the decline in price. Eventually, the weakest miners will fold as they should do in a free market.
As miners leave the network and hashrate moves lower, the speed at which blocks are mined decreases, the difficulty adjustment algorithm will recalculate the ratio after 2 weeks, and increase the target thus making mining easier for those remaining miners. The strongest, most efficient miners that survived the lower prices due to lower cost of production, are now rewarded with the BTC that was previously mined by the weaker miners. It will be distributed fairly, with the most efficient ‘’stronger’’ miners receiving the most.
As profitability increases, new capital moves into the mining business and now competes with the ‘’strongest’’ miners, and the evolution process continues. New investment that creates the stronger miners, via the best strategies, will typically have the strongest conviction in Bitcoin as an investment. Therefore, each cycle creates stronger and more resilient miners, who become the most bullish investors in Bitcoin.
This dynamic and continuous relationship between hashrate, efficiency, quality of miners, and cost of production relative to BTC market price is what determines the sell pressure in the market. Better quality mining businesses, created via Satoshi’s free market, contribute to raising the price floor of Bitcoin.
The block reward halving is fundamentally bullish for Bitcoin supply dynamics. In light of the current macro outlook, the demand in the market for BTC also looks highly favorable. We do not expect dramatic price increase straight away post halving as the process of strengthening the mining ecosystem takes time (months), but we do expect to eventually see another leg up in price which may very well leave many investors behind scratching their heads in disbelief. Bitcoin is self-correcting and decentralized, it doesn’t need a central bank or pseudo-economist politicians to tinker with it, and that is precisely why it has a not insignificant chance of becoming much more than a $150 billion market cap.
In a world of constantly changing central bank policies and unknown trillions about to be printed, the free market characteristics of Bitcoin’s sound money monetary policy is something to be hugely grateful for and invested into.
This Week in Crypto
It is not a surprise that Bitcoin seems to be consolidating along the log long term trend line, the attraction to this trajectory has been in play for over a decade. We feel that there is still considerable risk that the current relief rally in equities will lose momentum, and markets will retest the lows. 2nd and 3rd wave COVID-19 infections could easily provide the impetus for a flight to cash and drag bitcoin down with it.
With much of the social media channels turning bearish over these past 7 days, sentiment does indeed feel heavy, and a clear rejection of $7,200 on Monday is adding to view that BTC prices may head down and test the $6,200 level. Don’t underestimate the pull of the trend line and buying below this line still represents great entry prices for those accumulating long term.
Tracking sideways and up along the trend line akin to Q1 2019 and prior to the 2017 all-time high would make for a nice set up later this year and the completion of this triangle formation. See below.
In summary, we remain bullish long-term and post the block reward halving but short-term, we may see some continued weakness, especially if equities sell-off and the pandemic remain unpredictable. We believe there remains sell pressure from Bitcoin miners at these lower levels, and this may continue as the halving takes effect, so be prepared for more ‘’death spiral’’ talk if we see prices fall due to miner sell pressure increasing.
Interestingly, gold hit a 7 year high yesterday. This is encouraging for Bitcoin as clearly investors are anxious about fiat devaluation and are seeking stores of value as an inflation hedge. Despite the big draw down during the COVID-19 panic, gold has rebounded aggressively, and this sentiment is good for Bitcoin but in time. Bitcoin’s volatility contradicts its store of value narrative, but as the Bitcoin price rises, we expect to see lower volatility and the store of value narrative come into play. Gold investors are likely to allocate to Bitcoin accordingly, and many will look to front run this expectation.
What is clear here is the global market certainly needs and wants sound money in their portfolio, currently, the most popular and valuable solution is gold with a market cap around $9 trillion and widely expected to rise.
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