The Halving: What Bitcoin’s Block Reward Milestone Means

Today the 420,000th block of bitcoin’s blockchain was mined, bringing about the first reduction in the mining reward since 2012. Computer processing power around the world combines to secure bitcoin’s network and verify transactions; the reward they get for mining a single block is now 12.5 bitcoin, falling from 25.0. It will fall again to 6.25 sometime in 2020. Crypto-enthusiasts around the world are celebrating bitcoin’s maturity with halving parties. Instead of around 3,600 newly minted bitcoin becoming available on a day-to day basis, this number is cut in half to 1,800. A lot of the recent appreciation in bitcoin against fiat currencies has been attributed to the halving event, as it is essentially a reduction in the supply of the crypto-currency.  We will now look at what bitcoin’s block reward halving really means.

This event has only ever occurred once before when, on November 28, 2012, the miners’ reward dropped from 50 to 25 bitcoin per block. bitcoin is decentralized meaning that no central authority controls its supply. The inventor (or inventors) designed the process of ‘mining’ bitcoin to be similar to the extraction of gold; a decreasing rate of supply and a finite amount in circulation over a given period of time. The halving is akin to digging deeper for gold and obtaining less and less as the reserves are depleted. Furthermore, since bitcoin is decentralized, unlike national currencies and central banks, the distributed network issues bitcoin and follows the rule-based policy ingrained in its design, illustrated below.

Source: Nakamoto Institute

The rule that bitcoin follows is known as “asymptotic money supply targeting.” As the number of bitcoin in circulation grows asymptotically to a fixed limit of 21 million, the growth rate of the money supply gradually decreases with each block reward halving. Roughly every four years, the block reward halves until 21 million bitcoin are created, hence ‘asymptotically targeting’ a money supply equal to 21 million. It can thereby act as an anchor for everything else to be valued against, similar to how gold was used historically for trade and as money.

The rigidity of the system suggests that since the rate of money growth has now decreased from 9.09 percent to 4.17 percent annually, we should see general price levels fall according to the quantity theory of money. The theory states that changes in the rate of the money supply generate proportional changes in the general price levels in an economy. Therefore, the reduction in the rate of money supply for bitcoin should lead to proportionate reductions in the prices of goods and services. Thinking in terms of simple demand and supply, it may be obvious that the price of bitcoin will steadily rise after the halving. But what is also important to consider is how the halving will affect the velocity of bitcoin or more simply, the frequency at which a given unit of bitcoin is used to purchase goods and services in a given time period.  

There is very good reason to believe that the velocity of bitcoin is fairly constant as most people hold bitcoin, backed up by research from 2012 showing that 78 percent of bitcoin was not circulating but, instead, stashed away. In fact, the halving might reduce the velocity even further which would reinforce the effect of the money supply decrease on the price. The now emergent fact that 75 percent of all bitcoin has been mined may make people save more aggressively, refuse to spend any of their bitcoin holdings and drive the velocity down. This should act to reduce the general prices in terms of bitcoin over the long-term. So the halving provides another incentive to save if you own bitcoin. Compare that with the disincentive to save cash with the currently ultra-low interest rates. While people stash their savings in bitcoin, they could turn to other virtual currencies to spend their money.

The importance of the asymptotic money supply targeting it that it is non-discretionary; policy-makers cannot interfere. This is why a lot of people think the price will continue to rise as the halving openly displays the credibility of the ecosystem. More people will hoard bitcoin with the halving a reminder of its finite supply. Increased saving in bitcoin will in turn lower consumer prices, known as deflation. It was designed as a self-stabilizing cycle in which higher interest rates reinforce more saving and deflation increases consumption due to the ‘wealth effect’. The reduction in supply may also lead to dynamic effects on demand, increasing demand over time as the non-discretionary, self-regulating nature of bitcoin is viewed in an increasingly favorable light.

On the other hand, the reduction in the reward may force miners to be forced to shut down mining. The previous reward halvings in bitcoin and other cryptocurrencies saw miners drop out and their hash rates drop significantly. The hash rate for bitcoin after the first halving recovered soon afterwards and the price jumped to around $30 by February 2013, outweighing the drop in the block reward. Marco Streng, co-founder of Genesis Mining, gave a figure of $200 to produce one bitcoin, which has now doubled to roughly $400 following the halving. Because costs are not yet overcoming profits, large miners will choose not to shut-down production even although profits have dropped. Firms, in the short-run, are prepared to sustain losses, so a miner exodus may not be as large as the first halving and even then may take up to a year to fully manifest.

We will most likely see a similar, if not smoother, outcome this time, where bitcoin’s price will rise to outweigh the drop in the block reward. Only the least efficient miners will be forced out of the ecosystem thereby bring gains in terms of securing the network. Moreover, this time around there is a threshold to compare with. Valery Vavilov, CEO of BitFury, says his company is prepared for the block reward halving, “ We’re prepared, we already went through one halving event in 2012. You can forecast this… so if you have time to prepare and if you’re prepared you can live quite easily. “ As the statement above suggests, the industry has benefitted from learning-by-doing.

Compare the ability to forecasts changes in the money supply for bitcoin and the yoyo-ing of monetary policy by central banks such as the Federal Reserve over the past decade. Markets are unsure what to expect next from central banks whereas the bitcoin network has provided an open, non-discretionary monetary rule that will remain unchanged. Roughly every four years the reward will halve and the total supply will never be higher than 21 million. Whereas the supply of the U.S. Dollar has bloated over decades and people don’t know what central banks are going to do next. This should allow a greater consensus on the value and the price of one bitcoin as compared to what the value of one dollar is worth, contributing to stability bitcoin’s price over the long term. The increasing uncertainty and loss of confidence in the forward guidance given by central banks could be compounded by the halving and precipitate a huge increase in demand for bitcoin.

But aren’t expectations of the halving already built in to the price; since this event is fully anticipated by market participants, it should have no substantial effect on the price. But this assumes individuals have perfect information about the effects of the halving; are our expectations always a perfect reflection of reality? Probably not. “Buy the rumour, sell the news” has been given as a reason to anticipate a decline in the price of bitcoin after the halvening; conversely, the price surging up (until recently) could be attributed to people “buying the rumour” and anticipating that the halvening event will push BTC-USD higher. Now that the event has passed, people will look to lock-in profits and sell BTC-USD, making downward momentum dominant and decreasing its value.

Also, irrationality could start to dominate markets; while the knowledge of this event was present in people’s mind, they may not act on it until afterwards, give in to regret and buy into bitcoin. It could work the opposite way as well; if the hash rate declines, people could panic or start to sell to lock-in profits and cash out. The long-term effects may have been under-estimated or over-estimated by the market requiring a correction in the price. While the direction may be uncertain for some time, there is certainty that increased volatility will be ahead of us in bitcoin markets.

Nevertheless, recent price action indicates that the ‘equilibrium’ zone for BTC-USD on the BitStamp exchange over the next month or so lies between $605 and $650. This is displayed in the chart below by the green Ichimoku cloud. A breakout to either side of this zone would see irrationality come into play. Below the cloud would see a major sell-off whereas a break above $650 would see increased upward momentum take hold. Today’s price action has seen a low of $626.00 established but BTC-USD has recovered since then, trading at $646.24 at the time of writing. The yellow ray indicates a fractal buy level at $605.50, corresponding with the lower span of the Ichimoku cloud which signals strong support found around this level. Long positions could be entered into around $605.00/$600.00 if downward momentum remains weak. Alternatively, short positions just below $605.50 could capitalize on a breakout to the downside.