Bitcoin Halving and the Validity of the Stock-to-Flow Model
By Blocksize Capital on The Capital
Last week, the third bitcoin halving took place, cutting the mining reward from 12.5 to 6.25 Bitcoins per processed block. After the previous halvings in 2012 and 2016, the price of Bitcoin rose substantially; although with a delay of about 3 months. In anticipation of the halving, it was passionately discussed if this pattern will be repeated. It is obvious that the Bitcoin has matured and the concept of halving moved further into people’s minds. From the price prediction models that have emerged around Bitcoin, the so-called stock-to-flow model is arguably the best known. This results from the increasingly popular belief that Bitcoin is comparable to gold as it is finite and relatively expensive to produce. The model assumes a strong price elasticity in relation to changes on the supply side. This is contradicted, at least in theory, by the absolute transparency of bitcoin’s financial policy; an informed market participant would know about the maximum supply and the concept of halving. In an efficient market, the price would have to be determined solely by fluctuations in demand and the expectations of market participants.
Authors: Christian Labetzsch, Thomas Faber
Bitcoin’s Origin
Under the pseudonym Satoshi Nakamoto, a white paper was published in 2008 that was intended to bring about a lasting change in the existing financial and payment systems. The electronic payment system presented in the paper, Bitcoin, is now the most prominent cryptocurrency in circulation. Bitcoin is controlled by a decentralized network with a transparent set of rules, which represents an alternative to fiat money controlled by the central bank. It allows payments to be sent electronically and directly from one party to another without the need for an intermediary (e.g. a bank). Despite all its potential, Bitcoin initially had a difficult time. It was mainly associated with black markets and thus drug trafficking, ransom payments, money laundering, or tax evasion. It was often referred to as fraud or Ponzi scheme. And yet it still exists. It turns out: Bitcoin is brilliantly designed and its blockchain has been running without problems for 11 years. Moreover, it is technically impossible to switch it off again. It will remain with us for many years to come. However, there is still extensive discussion about what the real value of Bitcoin is based on. In order to shed more light on this, it makes sense to first take a step back and ask: Where does the value of today’s currencies come from?
The value of money and gold
In many societies, goods or precious metals have historically been used as means of payment because they were considered to be relatively stable in value. However, because it was very difficult for individuals to carry lots of cocoa beans or gold, societies eventually turned to minted currency as an alternative. Minted currencies were reliable stores of value because they consisted of metals with a long durability and low risk of devaluation. Today, minted currencies often take the form of paper money, which does not have the same intrinsic value as, for example, coins made of precious metals. Some types of currency are representative, i.e. each coin or banknote can be directly exchanged for a certain quantity of a commodity. However, as countries have left the so-called gold standard, the world currencies are now classified as fiat currencies. Fiat currencies are issued by a government and are not backed by commodities or trading goods, so they have no intrinsic value. Rather, the value of fiat money is determined by the stability of the issuing government and the country’s economy. This is true for most modern paper currencies, including the US dollar and the Euro. But it is precisely the dependence of value on political stability and economic performance that leads to a loss of confidence in fiat currencies in dark times.
In crises, investors trust in scarce goods
Historical crises have shown that investors often invest their assets in scarce goods such as gold. The scarcity of gold is the basis for a market capitalization of currently over 7 trillion US dollars, which is generated by demand from global financial institutions, private individuals, and central banks. When prices collapse, the price of gold rises — so the common assumption. In fact, this correlation has been observed frequently in the past, for example in August 2015, when stock markets crashed globally and the price of gold rose to almost USD 1800. If you look at long periods of time, you notice a very low correlation between the gold price and stock indices such as the S&P 500 of about minus 0.1 to plus 0.2. Now imagine there was such a scarce commodity, but with another special characteristic: it can be transported electronically via the internet.
Bitcoin is a scarce commodity
The production of new Bitcoins requires a lot of computing work in a process known as “mining”. So in order to fully understand the scarcity of Bitcoin and the production of new Bitcoins, one must look at the system behind it: With the release of Bitcoin, a fixed maximum circulation of 21 million Bitcoins was defined a priori. Today, there are already about 18 million Bitcoins in existence, and new Bitcoins are issued at a rate of about 3.6% annually. Almost every ten minutes, when the miners process a new block, new Bitcoins are mined. In May 2020, the output of new Bitcoins at the so-called “halving” decreased to 6.25 new Bitcoins per processed block. Halvings happen approximately every four years. The mining process distinguishes Bitcoin from gold in important ways. Despite best estimates, no one can name the gold stock with any conclusive certainty; there is no way to independently verify the entire gold supply. With Bitcoin, however, the entire existing Bitcoin inventory can be verified with a simple computer. Nevertheless, gold has a considerable advantage in terms of trust due to its long history. The belief in the scarcity of gold and its value has been innate to us. In the case of Bitcoin, comparatively few people recognize an electronically generated, dematerialized scarcity to date. Yet Bitcoin is the first successful demonstration that properties once reserved for physical assets such as gold can be reflected in digital assets.
What influence will the recent halving have on the value of Bitcoin?
It is difficult to predict how the halving will ultimately affect the price. In an efficient market one could assume that all future halvings are already priced in. In fact, we are still operating in a fragmented, sometimes illiquid, and rather complex market in the middle of a pandemic. This complicates an assessment enormously. However, due to the significant drop in price caused by the coronavirus pandemic, it is possible that the halving may not actually be fully reflected in the price. If we also look at the history, Bitcoin gained considerably in value after the halvings in 2012 and 2016, with a delay of about 100 days. Therefore it is not implausible to think that the price could now rise in the summer months. But this is not a serious indicator. The Bitcoin is now much more marketable and the crypto community has also become more experienced and has better anticipated the halving. There are, however, different valuation models that make predictions about the Price of Bitcoin. Arguably the most discussed and popular one is the Stock-to-Flow model. Let’s take a look.
The Stock-to-Flow model: A fair way to evaluate Bitcoin?
The stock-to-flow model is typically applied in the context of natural resources such as gold. The World Gold Council estimates that about 190,000 tons of gold have been mined since time immemorial. We can refer to this amount as the stock. The annual production of about 2,500–3,200 tons of new gold represents the production volume (“flow”). From these two figures we can now determine the ratio between stock and flow. In essence, it shows how much supply comes onto the market each year for a particular resource in relation to the total supply. The higher the ratio between stock and flow, the less new supply comes to the market in relation to total supply. Therefore, an asset with a higher stock/flow ratio should theoretically retain its value well in the long run. For Bitcoin, too, it makes sense to apply the stock-to-flow model. Bitcoin is scarce, finite, and relatively expensive to produce. The model assumes that there is a statistically significant relationship between stock-to-flow and market value. Consequently, the price of Bitcoin would have to increase significantly over time, because the ratio of stock to production volume increases with each halving. Figure 1 shows the stock-to-flow model estimates of the Bitcoin price over time:
Whether the model will be able to reliably predict the price development of Bitcoin is possible but also questionable. The market is still extremely volatile and the amount of historical data is sparse. Moreover, the price does not rise because of the stock-to-flow model per se, but only if demand is greater than supply. That demand has to come from somewhere. But as of today, few people have really understood what Bitcoin is in detail — so few people invest in Bitcoin. In addition, the amount of available Bitcoins and the output rate are predefined in the protocol and transparent for everyone. This disproves the assumption that changes on the supply side have such a large influence on the price. In theory, Bitcoin should even be inelastic with respect to the supply side. So it can be assumed that the driving influence on the price is largely on the demand side. Fluctuations in demand and the expectations of market participants are ultimately what determines the price.
Conclusion
In May 2020, the supply rate of new Bitcoins decreased to 6.25 new Bitcoins per processed block with the so-called “halving”. This has, again, fueled speculations about the impact on the price of Bitcoin. Looking at the previous halvings, the Bitcoin considerably increased with a delay of about 100 days. This may or may not happen again. What we know is that Bitcoin now is much more marketable and the crypto community has better anticipated the halving. From the different Bitcoin valuation models that have emerged, the stock-to-flow model is arguably the most popular one. Its application to predict the price of Bitcoin gained popularity as people more and more view Bitcoin as a scarce commodity since it is finite and relatively expensive to produce. However, the poor amount of historic data combined with a highly volatile, fragmented, and partly uneducated market makes it difficult to forecast the future price trend. Moreover, the uncertainties resulting from the corona crisis still gear the markets, further complicating a profound assessment. The model assumes a strong price elasticity with respect to changes on the supply side. This is contradicted, at least in theory, by the absolute transparency of bitcoin’s financial policy; an informed market participant knows about the maximum supply and the concept of halvings. In an efficient market, the price would have to be determined purely by fluctuations in demand and the expectations of market participants.
Remarks
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Christian Labetzsch is co-founder and CEO of Blocksize Capital as well as micobo. His main areas of expertise include the structuring of investment vehicles in the form of digital assets as well as the active support of securities issues on the Blockchain. As a technology consultant, Christian Labetzsch has worked on the development and implementation of blockchain solutions, Robo Advisory, and digital banking solutions in the financial sector. You can contact him via email and LinkedIn.
Thomas Faber is a research fellow at the Frankfurt School Blockchain Center and a project manager at the International Token Standardization Association (ITSA). His areas of interest include distributed ledger technology (DLT), security tokens (STOs), crypto-assets as well as blockchain ethics and blockchain-related sustainability issues. Mr. Faber holds a B.Sc. degree in Management, Philosophy & Economics as well as an M.Sc. degree in Management with a focus on digital business models from the Frankfurt School of Finance & Management. You can contact him via email and LinkedIn.
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