Bitcoin Halving: Economic & Behavioral Impact
15 Aug, 2019 16:08
Author: Vishal Karir
History doesn’t repeat itself but it often rhymes. — Mark Twain
The World Cup is every four years. The Olympics are every four years. The reward for mining Bitcoin blocks also halves every four years. The block reward started at 50 bitcoin, dropped to 25 in late 2012, and to 12.5 bitcoin in 2016. The third halving of the Bitcoin block reward will occur on or around May 20th, 2020 and the reward will further halve to 6.25 Bitcoin.
By design or chance, the last two Bitcoin price cycles have centered around block reward halvings. I review the two halvings, and analyze the impact on supply, demand and price of Bitcoin. The goal of this empirical review is to develop an explanation for the formidable price cycles associated with previous halvings. I hope the review provides insights, and helps investors prepare for the third cycle.
Price Source: Yahoo Finance
First Halving & The Retail Cycle
I dub this the retail cycle because Bitcoin was very much on the fringes then and found early adoption among technologists, and retail investors. At the beginning of this cycle, the entire Bitcoin economy was too small for institutions to take notice.
Before the price cycle for the first halving began, the previous cycle ended with Bitcoin price falling over 90% — from $31 to $2 — between June and November of 2011.
The price began rising in November 2011, through the halving in November 2012, and continued to rise until it hit an all-time high of over $1200 in November 2013. The symmetry of the rally — 12 months before and 12 months after the halving — is noticeable.
Price Source: Yahoo Finance
Majority of the price appreciation came after the halving — Bitcoin rose to $13 up to the halving, and went parabolic to $1200 after. The overall price appreciation during this rally was 350–400X, depending on the price source and liquidity you look at. Only 4X came before the halving, majority after.
A 14 month long deep recession followed the rally where the price fell by over 80% to around $200. Bitcoin price accumulated in the $200–300 range for the next 10 months.
Second Halving & The Venture Cycle
Let’s call this one the venture cycle because several venture capital firms and hedge funds observed the massive first cycle, bought into Bitcoin’s idea of decentralized money, and entered the market in the second cycle. Several crypto hedge funds opened shop; many of them did not survive the crash that followed at the end of the venture cycle but around 150 still survive.
Bitcoin price rose significantly in November 2015 to kick off the second halving price cycle, 8 months ahead of the halving in July 2016. The rally continued on after the halving and also lasted approximately 24 months like the previous one, until a new all time high of over $19,000 was reached in December 2017.
Price Source: Yahoo Finance
Majority of the appreciation again came after the halving — Bitcoin rose to $650 up to the halving, and went parabolic to $19,000 after. The overall price appreciation during this rally was 80–90X. Only 3X came before the halving, and the majority after.
The rally was followed by a 12 month long recession and the price fell by over 80% again to around $3000. Bitcoin price accumulated in the $3000–4000 range for the next 4 months.
Third Halving & The Institutional Cycle
Bitcoin price pushed above $5000 in April 2019, and continues pushing higher in what appears to be the start of the next cycle.
Price Source: Yahoo Finance
Large institutions that didn’t participate in previous cycles appear to be entering this cycle — the institutional cycle. Fidelity is rolling out crypto trading soon. Jamie Dimon, JP Morgan CEO, infamously called Bitcoin a fraud during the previous cycle; JP Morgan is now running their own JPM coin. Facebook banned crypto ads during the previous cycle; now its planning to launch Libra in partnership with several large institutions.
JPM coin and Libra obviously don’t support Bitcoin directly, but their initiatives bring attention to crypto, and to Bitcoin. Institutional investors and regulators are looking at these various projects and asking themselves — should I support (or invest in) a decentralized algorithmic currency like Bitcoin, or hand over the control for printing money to large corporations?
The Shape of Halving Cycles
Let’s summarize the key findings from halving cycles so far.
There’s a few interesting numbers and patterns in the table above, but one pattern intrigued me the most:
Why did majority of the rally come after the halving, not before?
Bitcoin halving is a known event and markets are intelligent to anticipate the price impact
from reduced supply. Why is it then that prices didn’t adjust better before the halving? Hold that thought — more on it later.
Marginal Supply = Miner Revenue
The price of an asset at any point in time balances the supply with the demand. The preliminary explanation of how halving results in higher Bitcoin price is a supply-side story centered on Bitcoin miner activities. Bitcoin miners play the vital role of confirming transactions on the Bitcoin network. They are rewarded new Bitcoin for every block they mine. The miners are the marginal suppliers that sell freshly mined Bitcoin adding it to the circulating supply. All else equal, if the miners have fewer Bitcoin to sell (after halving), they will demand a higher price for it. Similarly, if there are fewer Bitcoin available, the buyers will pay a higher price.
There’s one other supply component that doesn’t get discussed as much. Bitcoin miners have two sources of revenue — new Bitcoin mined, and fees from transactions confirmed. As a matter of fact, when all 21 million Bitcoin has been mined, transaction fees will remain the only source of revenue. Although transaction fees result from transactions in existing Bitcoin, they’re no different from the miner’s perspective as a source of revenue. Miners are just as likely to sell these to cover their operating expenses (electricity, computers, staff, etc).
Marginal Supply = Miner Revenue = Bitcoin Mined + Transaction Fees
Let’s review how the two components have evolved historically.
Daily Bitcoin Mined
Prior to the first halving, 7500–8000 Bitcoin was mined daily and added to the supply. This dropped to 3700–4000 after the first halving. Presently, 1900–2000 Bitcoin is added to the supply every single day, which will drop to around 1000 Bitcoin per day after the next halving.
Look at the same in US dollar terms and a very different picture emerges. The price of Bitcoin was $13 on the day of the first halving and the daily marginal supply reduced by around 4000 BTC (from 8000 to 4000). That amounted to a reduction in marginal supply worth $52,000.
$13 * (8000–4000) = $52,000
Bitcoin price was around $650 on the day of the second halving, and the marginal supply fell by 2000 BTC or $1.3 million.
$650 * (4000–2000) = $1,300,000
Let’s assume Bitcoin price doesn’t change much until the next halving and stays around $10,000 (poor assumption I know, but humor me). At that price, the upcoming reduction in daily supply of 1000 BTC will amount to $10,000,000.
$10,000 * (2000–1000) = $10,000,000
Over the course of a month, that’s $300,000,000 in reduced supply, and over the course of a year that’s $3,650,000,000.
Halving Reduces Liquid Supply Significantly
This drop in marginal supply clearly reduces the liquid supply. How much and how do we measure it? Using Bitcoin inflation rate, which compares the new supply with total Bitcoin supply, is not meaningful because a large portion of the supply is not liquid — its held (HODLed) in investors’ wallets for several months or years.
The marginal supply reduction has to be compared to total liquid supply.
One way to quantify is to compare the reduced liquidity due to halving with daily exchange trading volume. Unfortunately, trading volume reported by crypto exchanges is not reliable. A study Bitwise submitted to the SEC reported a whopping 95% of the trading volume to be suspect. Given that, the generously rounded numbers I use in this section should not be relied on — I use them merely to illustrate the logic, and the potential magnitude.
Per coinmarketcap, around 2 million Bitcoin trades on crypto exchanges daily. At the current block reward rate, 2000 Bitcoin are added to the liquid supply every day — this amounts to 60,000 new Bitcoin every month, and 730,000 every year. That means the market has the capacity to absorb 2,730,000 in annual liquid supply. When the block reward halves and only 1000 Bitcoin are mined daily, that would reduce the annual supply to 2,365,000. That’s roughly a 13% reduction in annual liquid supply.
On the other hand if we believe 95% of the reported trading volume is suspect, then the actual volume would be closer to 100,000. The next halving reduces the annual supply from 830,000 (100,000 + 730,000) to 465,000. That’s a 44% reduction in annual liquid supply.
Transaction Fees Add to Marginal Supply
Let’s now discuss the second component of miner revenue. Since 2015, the Bitcoin network has been processing over 100,000 transactions per day. An all time high of around 500,000 transactions was hit in December 2017. The transaction count fell sharply after the high, then continued to rise again over 2018 and 2019.
Barring a 12 month period in 2017–18 when transaction fees skyrocketed, the chart below shows that daily transaction fees have generally stayed below 200 BTC. In 2019, daily transaction fees have averaged at about 70 BTC so far. Transaction fees also show a strong correlation to Bitcoin price rallies — transaction fees (even when measured in BTC terms) have risen and fallen with Bitcoin price.
Stacking Bitcoin mined & transaction fees — gives us the full picture of miner revenue, and the daily marginal supply they potentially introduce. New Bitcoin mined has been the dominant source of miner revenue historically. Even today, transaction fees averaging 70 Bitcoin per day are small in comparison to 2000 new Bitcoin mined daily. However, as the uptrend in transactions and the halving of block rewards continues, it’s only a few years before transaction fees become the majority source of revenue.
Price Is Where Supply Meets Demand
We covered the supply-side extensively. Let’s review demand now.
Bitcoin is the first, and most popular implementation of a directly monetized network. Unlike other social networks that rely on indirect sources of revenue — advertising as an example — the Bitcoin network rewards miners directly for their efforts.
The number of Bitcoin blockchain wallet users has risen to 40 million at an astounding rate; 8 million users were added only in 2019. The network has grown rapidly since inception.
Metcalfe’s law states that the value of a network is proportional to the square of its nodes.
Given the limited supply, it is obvious then that Bitcoin price should rise with the growth of the network.
I discussed in a previous post, how the value of a scarce asset is in its limited supply, and unique narrative that helps it stand out from the competition. Bitcoin was the first popular implementation of digital scarcity, and single handedly ushered in the crypto revolution. There have been dozens of other blockchains since Bitcoin, and thousands of crypto assets, but Bitcoin continues to hold its top spot.
An asset with a stable price clearly has utility as a medium of exchange, but the rising price of a scarce asset increases its appeal as a store of value and accelerates the demand for it.
Rising price accelerates Bitcoin demand
The chart below shows search interest in Bitcoin per Google Trends. The largest number of searches for Bitcoin were in December 2017 when the price hit an all time high. The peak in search interest in December 2013 also coincides with the previous all time high. Recently, search interest has started rising again along with Bitcoin price.
Source: Google Trends
There’s more evidence of demand-price correlation in blockchain activity. Transaction activity on the Bitcoin blockchain increases and decreases with price. Note we’re looking at the number of transactions, and not the dollar value of transactions.
Let’s use the evidence reviewed so far to develop an explanation for the price cycles.
The Digital Gold narrative has gathered traction, and the demand for Bitcoin continues to rise. This is evident from the rising number of wallets, transactions, searches, media coverage, etc.
The past two Bitcoin halvings resulted in price cycles that followed these phases:
Before halving — A halving event leads to a meaningful reduction in liquid supply (hard to measure because of unreliable trading volume data). Bitcoin price starts rising in anticipation of the upcoming halving event.
After halving — The rising price attracts fresh demand from investors and speculators with increasingly deeper pockets, as Bitcoin finds acceptance among VCs, hedge funds and institutional investors. The new demand exceeds expectations and price continues to rise after the halving event. Increase in demand resulting from a rising price was grossly underestimated in past cycles.
Bubble — The rising price instills FOMO and attracts more speculation. A bubble forms and prices hit all-time highs. Speculative prices far exceed sustainable demand at this stage, and the bubble eventually crashes.
Crash — Crashing prices result in a reduction in demand, just the way rising prices led to an increase in demand. Many leave the party.
New base — Bitcoin eventually finds a price and demand equilibrium at the current rate of marginal supply, and forms a new base significantly higher than the previous cycle base.
Back to step 1 from a higher base.
It’s important to clarify here that above logic hinges on the demand generated by Bitcoin’s unique narrative of Digital Gold, and its position as the first crypto asset. As a point of contrast, Litecoin halving may be interesting but Litecoin lacks a powerful narrative and demand. As such, Litecoin cycles have not followed the phases listed above.
Markets are intelligent — they learn and adapt — so no two cycles are ever the same. Let’s see how much of Bitcoin’s third halving follows past patterns. History doesn’t repeat itself but it often rhymes.
Vishal Karir, CFA is Co-Founder and Chief Investment Officer at Huddl — world’s first social financial marketplace. Huddl founders — former BlackRock and Mastercard executives — saw first hand how the current financial environment favors the wealthy. They have committed to expanding opportunities and lowering costs for everyday investors by bringing the best of Wall Street to Main Street.