This article provides an overview what Bitcoin halving is, and what are its implications. We look back at the previous halvings that occurred in 2012 and 2016, and discuss what we can expect from the 2020 event.
What is the Bitcoin halving?
One of the key components which highlights the ingenuity of the Bitcoin protocol is the incentive structure underlying it. This structure has been designed to reward miners, who contribute computing power to the network and successfully validate a block of transactions, with a ‘block reward’ in the form of Bitcoin.
The reward is distributed every time a new block is successfully added to the network, typically every ten minutes. The value of this Bitcoin depends on the amount rewarded and its market price. Usage and demand are in turn premised upon a functioning system, therein presenting the incentive for a miner to continue to validate the Bitcoin network.
To ensure that Bitcoin does not become inflationary, this reward is halved after every 210,000 blocks are mined (or approximately every 4 years) – referred to as halving. The supply of Bitcoin is capped at 21 million, after which block rewards will cease.
The disinflationary nature of Bitcoin stands in sharp contrast to the inflationary nature of the traditional monetary system. After the 2020 halving, the annual rate of increase in Bitcoin will be less than 2 percent, while the US M1 money supply increased by ~9 percent in the month of March 2020 alone, due to asset purchases by the government to bolster the economy during the COVID-19 pandemic.
These reward and supply mechanisms are part of the overall architecture of Bitcoin and are programmed into the protocol, which no single individual can unilaterally alter. There have been two halvings since the creation of Bitcoin, with the next estimated to occur on Monday, 11 May 2020, bringing the block reward to 6.25 Bitcoin.
Implications for miners
The block reward is the revenue that miners receive for validating transactions by contributing their computing power to the network. The most direct impact of this event is that revenue of miners will be halved if Bitcoin prices remain the same, squeezing profitability and affecting their ability to operate.
As mining is competitive and miners have varying levels of efficiency depending on their skills, equipment and computing power, it is expected that the halving will result in less efficient and profitable miners leaving the system, reducing competition, mining difficulty and costs for the remaining miners. Eventually, the market will re-establish an equilibrium between price, difficulty, and capacity.
Mining difficulty determines how much computing power is required to successfully validate a block. The higher the cumulated Bitcoin hash rate is (i.e. the sum of the computing power allocated to mining), the more difficult it becomes to validate a block. The adjustment to the difficulty level of the total hash rate occurs roughly every 2016 blocks (or every two weeks), ensuring block times remain around 10 minutes.
The last difficulty adjustment took place on May 6 and the next one is expected to take place on May 19, about a week after the halving. If the mining capacity drops post-halving, a transaction backlog could develop during that week because less miners are validating transactions. Fees may also rise as miners prioritise transactions earning higher fees.
First halving, November 2012
The first halving occurred in November 2012, when Bitcoin was still in its infancy and trading at ~USD 12. The currency was starting to garner more attention and popularity with early enthusiasts, but had trouble with its image, partly contributed by the major hack on Mt. Gox, the main Bitcoin exchange.
The price of Bitcoin remained stable immediately after the 2012 halving. Then in early 2013, Cyprus introduced a tax on bank deposits as a condition of their bailout from Germany, coinciding with a spectacular rally in the price of Bitcoin which reached ~USD 260. Later in the year it would go on to pass the USD 1,000 mark. Many speculate that this increase was due to a flight of capital into Bitcoin, inspired by concerns over the Cypriot/ Greek financial crisis which was ongoing during that period.
Second halving, July 2016
The second halving took place in July 2016. Corporates were starting to pay more attention to the potential of Distributed Ledger Technology (DLT), but there was much ambivalence towards Bitcoin itself. Some users were hacked through poor management of their private keys, and regulators were starting to clamp down on criminal activity linked to the currency. Bitcoin was trading at ~USD 660, and it now attracted speculative retail investors lured by the possibility of high returns.
Similar to the prior halving, there was no significant spike in the price of Bitcoin directly after the event. However, prices started to increase in late 2016, reaching a high of close to USD 20,000 in December 2017. This epic rally has been variously attributed to the global rise in popularity of ICO’s, increased interest from China, the troubles with the Venezuelan economy, and market manipulation.
Third halving, May 2020 – what can we expect?
There has been much debate over the impact that this round of halving will have on the price of Bitcoin. In the previous two halvings, the price saw significant gains for a period after the event, although important economic and political forces were also at play.
Today, the legitimacy of Bitcoin is growing, and the infrastructure around digital assets has developed and become more secure. Most governments and corporates acknowledge the potential of DLT and digital assets to transform the current financial system.
Additionally, the trading landscape for Bitcoin is growing in sophistication – miners have access to derivative products which allow them to hedge against mining difficulty, leverage is widely used, and there is significant institutional capital in the space – which alters the dynamics of the market.
Given that halving is now a well understood and expected event that all parties can plan for, it is reasonable to believe that some gains are already priced-in. What is potentially a greater force is the impact of the COVID-19 pandemic which continues to play out, with the uncertainty likely to lead to an increase in volatility.
The fragility of the financial system remains a concern which could see the market respond in various ways. Institutional capital will also behave differently, and in risk-on/ risk-off situations the performance of Bitcoin may become more closely linked to traditional assets than usual.
What does this mean for the long term?
This year’s halving occurs against the backdrop of a global crisis which highlights some of the issues with the current financial system. Governments are trapped between a rock and a hard place as they try to balance inflationary pressure and the need for stimulus to support their struggling economies. Bitcoin was partly designed to complement fiat currency in precisely these situations, and halving is a key characteristic of this design.
It remains to be seen what the long-term role of Bitcoin will be in the financial system, although it seems increasingly clear that it will have a role.
At Sygnum we continue to believe that Bitcoin offers a unique investment diversification opportunity, independent from government intervention. Further, its liquidity and volatility make it ideal for trading, and these challenging times could be a catalyst for Bitcoin to realise its potential as a mainstream investible asset.