Author: Kevin Lu & Coin Metrics Team

“We expect miners to go through a cycle of declining margins, increased selling pressure, capitulation, and the elimination of the least efficient miners. Once this cycle is over, the mining industry should return to a healthier state, supporting future price increases.”

Bitcoin’s next block reward halving is approaching, but the impact of the halving on Bitcoin prices remains controversial.

Two camps have emerged. One camp, citing the efficient market hypothesis, argues that the upcoming halving is already priced in by market participants, while the other camp believes that the halving is not yet fully priced in and expects that the halving will sow the seeds for further price increases as it will bring about an increase in Bitcoin’s scarcity and changes in its supply.

Above: Bitcoin price changes before and after the first two halvings. The first two halvings led to price peaks. Source: Coin Metrics Network Data Pro

We believe that the heated debate between the two camps is partly due to the limited empirical record. Bitcoin has only experienced two halvings in its history, and only a few other PoW coins have experienced the same event. The discussion has been deadlocked due to the lack of shared terminology, small sample sizes, and unavailability of data on key issues.

This article will provide a framework for understanding miner economics to better understand the upcoming Bitcoin block reward halving. The purpose of this article is to present a framework that is reasoned from first principles, rather than relying purely on empirical data. We also apply this framework to examine the upcoming halvings of Bitcoin Cash (BCH) and Bitcoin SV (BSV).

Three Axioms & Three Corollaries

We propose three basic axioms that we believe are largely correct and will serve as a starting point for further reasoning. We consider them “mostly correct” because there will always be some edge cases — they may not apply to certain crypto assets or certain miners. But for the most part, these axioms hold up.

We also propose three basic inferences based on these three axioms. These inferences form the basis of our framework for understanding miner economics.

Axiom #1: Miners operate to maximize profits and have huge economies of scale

Bitcoin mining has become so difficult and resource-intensive that it is essentially uneconomical for individuals or hobbyists to mine. Instead, mining has huge economies of scale. Large miners locate their mines in areas where electricity is cheap. They can negotiate lower electricity prices with power companies, purchase large quantities of the most efficient mining equipment, and rent large facilities to run them.

The ability to mine at scale reduces the cost of mining a coin. Since mining is a competition, miners organize themselves like a profit-maximizing business. Miners do not operate for ideological or altruistic purposes, and they cannot continue to operate for long without making a profit.

Axiom #2: Mining is a competition with a fixed total reward, distributed among all participants at a fixed pace

The issuance of Bitcoin is dictated by the protocol and controlled by mining difficulty adjustments. In current Bitcoin mining, the protocol generates a block reward of 12.5 BTC per block, and regularly adjusts the mining difficulty so that an average of one block is generated every 10 minutes. All miners compete for this block reward and the transaction fees in the block. In a given time period, the total block reward income of all miners is predetermined and cannot be changed.

Axiom #3: Miners’ income is calculated in cryptocurrency, while miners’ costs are calculated in fiat currency

Miners' income consists of block rewards and transaction fees, both of which are denominated in cryptocurrency.

The costs of mining include mining hardware, electricity to run the mining machines, cooling costs, facility rental fees, server maintenance fees, internet connection fees, labor costs, insurance premiums, legal services fees, taxes, etc. These costs are calculated in fiat currency because most traditional companies do not currently accept cryptocurrencies as a form of payment (for example, power companies will not accept Bitcoin as a form of payment). Even if some of these costs are ultimately paid in cryptocurrencies, such as miners using cryptocurrencies to pay for equipment or employee wages, the prices of the relevant goods or services are still quoted in fiat currency.

Corollary #1: Mining is an (almost) perfectly competitive industry

Based on the first two axioms, the first corollary we introduce is that the mining industry operates in a state of almost perfect competition, and the market price faced by each miner is equal to the miner's marginal cost. This is achieved through two mechanisms.

• First, miners seeking to maximize profits enter the industry or invest in more equipment when mining is profitable, and exit the industry or shut down mining machines when mining is not profitable.

• Second, changes in the network’s hash rate (computing power) will trigger adjustments to the mining difficulty, which continually attempts to make the cost of mining a coin equal to its current market price.

Mining is a zero-sum game (in the long run) because every miner is competing with every other miner for the same block reward. This also means that miners operate in an equilibrium state where the economic surplus is zero - that is, in the long run, miners can only earn normal profits and are only compensated based on the opportunity cost of their time and the risk they take. Due to the competitive nature of the miner's economy, it seeks a long-term equilibrium where miners' profit margins are small and close to zero.

However, miner profitability can fluctuate wildly around this equilibrium level because the latency inherent in the system has a significant impact on miner-led selling pressure. We discuss this more in the following two inferences.

In addition, industries upstream of the mining sector, such as mining hardware and semiconductor manufacturers, present an oligopolistic market structure. Based on this supply chain, certain miners (such as Bitmain’s mining pools) can take advantage of information or acquire mining hardware earlier than their competitors, thus reducing the degree of competition in the mining industry.

Corollary #2: Miners have been a significant source of selling pressure

Combined with Axiom #3 (i.e., miners’ income is measured in cryptocurrency, while miners’ costs are measured in fiat), we come up with an important corollary: miners always represent the largest group of sellers. The selling pressure from miners is quite large, because miners must sell the cryptocurrency they mine to cover their costs in fiat. And, since their profit margins tend to zero (in the long run), miners must sell almost all of their cryptocurrency.

Here, we use Bitcoin to illustrate the scale of miner-led selling pressure, which totaled nearly $5.5 billion in 2019. Some researchers have compared this figure to Bitcoin’s annual transaction volume, which is several orders of magnitude larger, and concluded that miner-led selling pressure has a negligible impact on the market.

However, miners’ BTC sales represent a net outflow of capital from the mining sector, and the fiat that miners receive is unlikely to return to the market, while other (non-miner) trading volumes may not. Therefore, miners’ sales have a huge impact on the rest of the market.

In other words, the best estimate is that Coinbase has about 1 million BTC in customer deposits, which at current prices is equivalent to $6.8 billion, equivalent to the annual revenue of miners in 2019. Assuming miners sell most of the BTC they mine, that is, the miner-led selling pressure is almost equivalent to all customers on Coinbase liquidating their BTC in a year's time and permanently exiting the market.

Bitcoin miners’ annual income bar chart, source: Coin Metrics Network Data Pro

Let’s project miner revenue for the full year 2020, assuming prices remain at current levels and factoring in the block reward halving. Under these assumptions, we should only see miner selling pressure equal to half the value of Coinbase user deposits this year — a significant drop.

Corollary #3: Miners have a procyclical impact on asset prices

While the mining industry is constantly seeking a long-term equilibrium in which miners have very small, close to zero profit margins, the reality is that profits can fluctuate wildly within this stable state.

Factors that affect miners’ costs are slow to change and there is a meaningful delay. Decisions to enter or exit the industry, purchase additional equipment, and scale up operations take time. Mining difficulty is adjusted with a delay of about two weeks.

On the other hand, income can change quickly, as a major determinant is the price of cryptocurrencies, which are subject to extreme volatility. Bitcoin’s annualized volatility often exceeds 50%.

Bitcoin price fluctuations (three-month annualized volatility), source: Coin Metrics Reference Rates

Miners’ profit margins are variable due to these factors, which means that the selling pressure miners face to cover their fixed, fiat-denominated costs is also variable. When prices are particularly volatile or trending in one direction over a sustained period of time, miners’ profit margins may be positive or negative for a considerable period of time. When prices fall to the point where they are not enough to cover electricity costs, miners will quickly make the decision to shut down their mining machines.

Miners’ crypto inventory management is not a well-researched topic due to the lack of access to relevant information, but each miner makes their own decisions about how much of their block rewards to sell for fiat and when to sell them.

As mentioned above, since miners’ costs change slowly and their costs in fiat currency are fairly stable, when the BTC price rises, miners will need to sell fewer block rewards to cover their costs. On the other hand, when the price falls, they need to sell more block rewards. According to this theory, miners have a pro-cyclical effect on the market because they further exacerbate price increases.

However, there are limits to this dynamic. Sustained price increases could push miners to sell more of their block rewards to fund additional capital investments in new mining equipment, suggesting that under certain market conditions, prices can be counter-cyclical.

During the “capitulation period” when profit margins are negative for many miners, miner-led selling flow may be high. Miners may try to endure short-term pain, perhaps temporarily losing money, until some less cost-effective miners exit the industry. Miners may also be willing to sell block rewards earned in the previous period that they retain on their balance sheet in order to outlive other miners.

All of this behavior reinforces the direction in which cryptocurrency prices are moving and is a key determinant of why prices often experience bubbles and crashes.

While we believe this framework reflects the pro-cyclical behavior of most miners, the rise of robust cryptocurrency lending markets has the potential to change this dynamic. This allows miners to speculate on the future price of Bitcoin and engage in market timing, using funds borrowed against the Bitcoin on their balance sheet to pay for fiat costs. Miners who engage in this behavior believe that the price of Bitcoin will rise in the future and therefore delay selling their Bitcoin. The rise of derivatives markets that allow miners to hedge against future price volatility could play a similar role.

While the impact on miner-led selling flow depends on how accurate miners are at market timing, we believe that miners tend to borrow fiat in certain market conditions. Assuming that miners inherently prefer Bitcoin, they will tend to borrow fiat when they believe that the Bitcoin price is well below long-term fundamental value and they believe we are firmly in a bull market. This should mitigate the procyclical impact when prices are falling, but it will be exacerbated when prices are rising.

The upcoming Bitcoin halving

Bitcoin will soon undergo its third halving, which will reduce the block reward from 12.5 BTC to 6.25 BTC, equivalent to a reduction in the annual issuance rate from 3.6% to 1.8%. This is expected to occur on May 14, 2020.

Bitcoin's annual inflation rate chart, source: Coin Metrics Network Data Pro

In the past few weeks, BTC prices have fallen sharply, just like risk assets in traditional markets. The procyclical behavior of miners means that miner-led selling pressure will also increase.

The price has almost certainly fallen below the breakeven point for the least efficient and least profitable miners. These miners may have temporarily or permanently shut down their mining machines. This can be seen in the recent Bitcoin mining difficulty adjustment, which dropped by 16%, one of the largest drops in history. See the figure below:

Bitcoin mining difficulty trend, source: Coin Metrics Network Data Pro

Such a large adjustment in mining difficulty suggests that inefficient miners have reached the point of capitulation and are forced to sell the bitcoins they mine to cover costs.

Miner-led selling pressure on Bitcoin is likely to continue to increase as Bitcoin Cash (BCH) and Bitcoin SV (BSV) are set to experience block reward halvings on April 8 and April 9, respectively. All three assets share the same SHA-256 mining algorithm, allowing miners to seamlessly redirect their hashrate to the asset that offers the highest return on investment.

When BCH and BSV experience their block reward halvings, this should force miners to shift more of their hashrate to Bitcoin, since Bitcoin will still have a 12.5 BTC block reward (instead of 6.25) for about a month afterward. As a result, we should expect Bitcoin’s mining difficulty to increase, further squeezing profit margins for all miners.

From top to bottom: Annual inflation rate trends of BTC, BCH, and BSV. Source: Coin Metrics Network Data Pro

The worrying thing is that many miners were already capitulating even before the halving. Once the block reward is halved, miner revenue will be cut in half while costs will remain the same, so we expect more miners to capitulate in the coming months.

Miner capitulation increases selling pressure until inefficient miners are forced to exit the Bitcoin network, but in the long term these events are supportive of prices. Eliminating inefficient miners allows only the most efficient miners with the lowest production costs to remain. Once inefficient miners exit the network, the profit margins of the remaining miners will increase, which will reduce selling pressure, push prices higher, and should repeat a virtuous cycle. Ultimately, if prices bottom out, the procyclical behavior of the remaining miners should support further price increases.

Summarize

Above, through three axioms, we provide a framework derived from these first principles that illustrates how miners are a persistent and significant source of selling pressure that has a procyclical impact on price.

Currently, miner-led selling pressure on Bitcoin, Bitcoin Cash, and Bitcoin SV is high and is likely to increase further in the coming months as all three currencies are set to be halved.

We expect miners to go through a cycle of falling profit margins, increased selling pressure, capitulation, and elimination of the least efficient miners. Once this cycle is over, the mining industry should return to a healthier state, supporting future price increases.

Original link: https://coinmetrics.substack.com/p/coin-metrics-state-of-the-network-e18