Bitcoin – The Halving, what does it all mean?

Let us first agree I plan to refer to it as Halving… other blogs have been written to cover this topic, so I won’t go there.

The number of bitcoins (BTC) entering circulation every 10 minutes (known as block rewards) will drop by half, to 6.25 from 12.5. It’s a milestone that’s easy to predict because it happens every four years and has happened twice before in 2012 and 2016. “Unlike most national currencies we’re familiar with like dollars or euros, bitcoin was designed with a fixed supply and predictable inflation schedule.

Another unique characteristic of Bitcoin is how Nakamoto programmed the block reward to decrease over time. This is another way in which it differs from the norm for modern financial systems, where central banks control the money supply. In stark contrast to Bitcoin’s halving block reward, the supply of the dollar has roughly tripled since 2000.

Nakamoto left clues that Bitcoin for political reasons. The first Bitcoin block features the headline of a newspaper article: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”

There will only ever be 21 million bitcoins. This predetermined number makes them scarce, and it’s this scarcity alongside their utility that largely influences their market value, crypto wallet company Blockchain.com wrote in a blog post ahead of the 2016 halving. If only they would have been able to look ahead to 2020 when money printers are going crazy with COVID-19 related stimulus.

The Bitcoin halving has taken place on the 11th May 2020.

This blog plans to cover:

  • What is the halving?
  • How will the halving affect the price?
  • What does the valving mean for miners?
  • What is the longer-term view of Bitcoin?

For the uninitiated nocoiners what is the halving?

Bitcoin miners earn new tokens by completing complex cryptographic math problems. After a halving event, they receive fewer bitcoins in reward for helping create new blocks. Currently, when miners produce a new block, they receive 12.5 BTC. After the halving, they’ll receive 6.25 BTC.

Why do miners get these rewards?

To explain this concept in more depth, let’s look at the base technology for Bitcoin, the blockchain. A blockchain is a digital ledger that stores information about its transactions in blocks that are each around 1 MB in size. For instance, when person A sends Bitcoin to person B, this transaction will be stored on a block, along with around 500 other transactions that happened at around the same time.

A block reward is the amount of cryptocurrency that miners receive when they successfully validate/mine a new block by solving highly complex mathematical problems with their mining hardware. It is a reward for their hard work.

Bitcoin wouldn’t work at all without these block rewards. There are two parts to making Bitcoin work. Bitcoin’s ledger state should answer the question of ‘who owns what, when?’ The first part, who owns what? is solved by cryptography. Only the owner of a private key (which is like a secret access code) can spend the bitcoin.

The game theory that secures Bitcoin requires that:

  • miners have an incentive to mine honest blocks
  • miners have a cost to attempting dishonesty

Without the block rewards, the network would be in chaos. If miners have enough computing power, they can attack the network in two ways: By double-spending coins or by stopping transactions from going through. However, the whole model behind Bitcoin is that they are strongly incentivised not to try either because then they would risk losing their block rewards. Put another way, miners will lose money if they don’t follow the rules.

In 2009, mining rewards started at 50 BTC. The first halving in 2012 brought rewards down to 25 BTC on Nov. 28, 2012, when bitcoin’s price was near $13. The second took place on the 9th July, 2016, when bitcoin was ~$660.

The calibration occurs every 210,000 blocks. The last halving is predicted to take place well after 2100.

The decentralized nature of Bitcoin means that there isn’t a central authority pulling a lever to initiate the halving. The process was put into motion when Satoshi Nakamoto, bitcoin’s pseudonymous creator, released the protocol in 2009.

Why is this programmatic process of currency ‘minting’ important?

In stark contrast to fiat currencies, whose supply governments can increase by printing money, bitcoin was designed to be deflationary. Halvings are designed to control the rate of inflation so bitcoins do not lose purchasing power over time.

Bitcoin’s total supply is capped at a fixed 21 million and it would take a huge community who would lose out as a result to change this fact. Right now, there are around 18 million BTC in circulation, which is roughly 85% of the total cap.

How does the Halving affect the price of bitcoin?

Cryptocurrency analysts, enthusiasts, traders, and the wider Crypto Twitterverse debate (often noisily) whether the halving is already ‘priced in’ to the prevailing Bitcoin price.

The best source of data I have seen is from PlanB on twitter who has done detailed analysis on the ‘stock to flow’ model of Bitcoin.  His whitepaper is well worth a read although it is tough going for the non-quants.  Suffice to say, anything that is in less supply should see an increase in price over the medium to long term.

“Halving will be make-or-break for S2F model. I hope this halving will teach us more about underlying fundamentals & network effects.” States PlanB

Stock-to-flow measures the issuance of new Bitcoins each block against Bitcoin’s existing supply, a method which has proven highly accurate in charting price performance.  According to the model’s latest incarnation, BTC/USD should hit $30,000 by the end of 2020.

My take – Anyone who provides charts with too much certainty is not to be trusted.  Please be aware this is still a new market at 12-years old.  Proceed with caution. Invest what you can afford.

What is the longer-term view of Bitcoin?

The periodic decline in Bitcoin’s minting rate could have a deeper significance than any near-term price movements for the functioning of the currency. The block reward is an important element of the Bitcoin system and it ensures the security of this decentralised system. As miner rewards dwindle to zero in the decades ahead, the impact could be to potentially destabilize the economic incentives underlying bitcoin’s security.

The more computing power miners direct towards Bitcoin, the harder it is to attack because an attacker would need to have a significant portion of this processing power, known as the hashrate, to execute such an attack. The more money they can earn by way of block rewards, the more mining power goes to Bitcoin, and thus the more secure the network is.

What happens when block rewards disappear?

That is one reason the periodic decrease in rewards might become an issue in the future. Miners need an incentive to do what they do. Miners need to get paid. Miners are not running expensive, electricity consuming computer farms for the fun or sports of it. The designed-in consequence of a dropping block reward is that eventually, it will reduce to nothing. Transaction fees, which users pay each time they send a transaction, are the only other way miners earn money. The fees are expected to become a more important source of remuneration for miners as block rewards reduce due to subsequent halvings.

“In a few decades when the reward gets too small, the transaction fee will become the main compensation for nodes. I’m sure that in 20 years there will either be very large transaction volume or no volume,” Nakamoto wrote. Part of the problem is that more than a decade after Bitcoin’s inception the market is still figuring out the true cost of protecting the network.

Miner Capitulation

As the block reward becomes less significant, mining rigs that are barely covering production costs will be forced to quit the market. There will still be firms willing to mine Bitcoin at the reduced rate, but the market might become less decentralized as a result). Still, new and more efficient ways to mine BTC could emerge, potentially enabling smaller businesses to partake.

Regardless of what happens with bitcoin’s price, the halving will likely wipe out smaller miners whose operations become unprofitable. Larger mining farms, which pool processing power and can achieve economies of scale, are better equipped to stay online.

Summary

The incentive to attack Bitcoin today is significantly larger than it was five years ago. We now have the Presidents of the US and China and other world leaders talking critically about Bitcoin. The more Bitcoin grows, the more these leaders might see it as an existential threat and might feel compelled to react. This question is an interesting one to ponder when thinking about Bitcoin’s future prospects, though it might sound like a far-off matter in 2020.

What we do know that since the last halving the industry has drastically changed since the last halving four years ago.  In that time as cryptocurrencies and Bitcoin, in particular, became part of mainstream news coverage and we can say for sure this halving will be a seminal moment for Bitcoin, given the macroeconomic climate and the amount of QE behind major fiat currencies.

 

 

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