The halving effect has just begun? Looking at the future trend of the cryptocurrency market from the perspective of miner economics

Original source: coinmetrics

Compiled by: Masaka

The next Bitcoin halving is coming, and there has been controversy over how the halving will affect the price.

There are currently two camps. One supports the efficient market hypothesis, believing that the impact of halving has been reflected in market prices by participants. The other believes that the current price is far from reflecting the impact of halving. Since changes in the supply side will increase the sense of scarcity, halving will lay the groundwork for future price increases.

The heated debate between the two sides is limited by experience. After all, Bitcoin has only experienced two halvings, and only a few POW coins have experienced the same event. Due to the small sample size and the inability to obtain key data, the debate has reached a stalemate.

Below we will develop a framework based on first principles rather than empirical evidence that will allow us to more clearly see the economics of miners and how we should respond to the upcoming halving. At the end of the article, we will also apply this framework to the upcoming halvings of BTC, BCH, and BSV.

First, we propose three basic principles, which are tenable most of the time (except in extreme cases). Second, we bring three inferences based on these principles to better understand the miner economy.

Principle 1: Miners are a group that pursues profit maximization and has huge economies of scale.

(Note: Economies of scale refer to the phenomenon that economic benefits increase as the scale of production is expanded, and it is the characteristic that long-term average total cost decreases as output increases)

As mining becomes increasingly difficult, amateur enthusiasts are no longer suitable to participate in it. Today's mining industry has huge economies of scale. Large mining farms are located in areas with cheap electricity. Mine owners can negotiate lower electricity prices with power companies, purchase a large number of efficient mining equipment, and rent large sites to deploy the equipment.

Large-scale mining can reduce the cost of mining a BTC. Since mining is competitive, the miners' organization is like a company that pursues profit maximization. The fundamental purpose of operating a mine is not out of faith or altruism. If it is not profitable, the mine cannot operate in the long run.

Principle 2: Mining is a competition that distributes fixed rewards to participants at regular intervals.

The issuance of Bitcoin is based on the protocol and is regulated by the difficulty of mining. Currently, the reward for each block is 12.5 BTC, and a block is generated every 10 minutes. All miners are competing for this bonus and transaction fees. In a given time period, the total block reward income of all miners is predetermined.

Principle 3: Miners’ income is calculated in digital currency, and miners’ costs are calculated in legal currency.

Miners' income consists of block rewards and transaction fees, both of which are digital currencies.

Mining costs include hardware, electricity, cooling fees, equipment rental, server maintenance, Internet connection, wages, insurance, legal services, taxes, etc. These costs are in fiat currency because most traditional companies do not accept digital currency payments. Even if some expenses can be paid in digital currency, such as purchasing equipment or paying wages, the prices of these goods and services are still priced in fiat currency.

Corollary 1: Mining is a perfectly competitive market

(Note: Perfect competition refers to a market structure that is free from any obstacles and interference, and refers to markets where there are no companies or consumers that can influence prices.)

Based on the first two principles, we can infer that mining operates in an almost perfectly competitive equilibrium state, and the market price faced by each miner is equal to the marginal cost of mining, which is achieved through two mechanisms.

First, when mining is profitable, more people will enter the industry or existing miners will invest in more equipment. When mining is not profitable, a large number of miners will withdraw or shut down. Secondly, changes in computing power will trigger difficulty adjustments, which will constantly strive to make the cost of mining a BTC equal to the current market price.

Mining is a zero-sum game (in the long run), where each miner is competing with other miners for the same block reward. This also means that mining is operated in an equilibrium state with zero economic surplus - that is, in the long run, miners can only earn the minimum profit to maintain operations.

Due to the competitive nature of the mining industry, it ultimately seeks a long-term equilibrium with very small profit margins close to zero.

However, due to the inherent delay of the Bitcoin system, the profit margin of miners will fluctuate greatly around this equilibrium, which will also affect the selling pressure of miners. We will discuss this in the following two inferences.

In addition, companies upstream of the mining industry, such as mining hardware and semiconductor manufacturers, have already shown an oligopoly. Based on this supply chain, some miners (such as Bitmain's mining pools) can take advantage of information or mining machine advantages earlier than their competitors, reducing the degree of perfect competition in the mining industry.

Inference 2: Miners have always been an important source of selling pressure

Combined with the third principle, we have an important corollary: miners are naturally the largest sellers. Their selling pressure is high because miners must sell digital currency to pay for fiat-denominated costs. As mining profit margins continue to approach zero, they will eventually have to sell almost all of the digital currency they mine.

Next, let’s look at the scale of the sell-off caused by Bitcoin miners.

In 2019, miners earned nearly $5.5 billion. Some researchers compared this figure with Bitcoin's annual transaction volume, which is several orders of magnitude higher, and concluded that the impact of miners' selling on the market is negligible.

However, miners' selling often means a net outflow of market capital, and most of the fiat currency obtained by miners will not flow back into the trading market. Therefore, miners' selling will have a huge impact on the market.

To put it in another perspective, there are about 1 million bitcoins in Coinbase's customer deposits, which is $6.8 billion at $6,800 per bitcoin, equivalent to the annual income of miners in 2019. Assuming that miners sell most of the coins, the pressure from the sellers is equivalent to clearing out all the bitcoin deposits accumulated by Coinbase in the past year and permanently exiting the market.

Assuming the price of Bitcoin remains at current levels, we can extrapolate the total revenue miners will receive in 2020 (including the impact of the block reward halving). Under this assumption, we see that this year’s sell-off is only half of what it was in the past – a significant reduction in selling pressure.

Inference 3: Miners have a procyclical effect on asset prices

(Note: The so-called "procyclical effect" refers to the fact that when the market is booming, the inducement of high transaction prices leads to an overestimation of the value of related products; when the market is depressed, the inducement of low transaction prices leads to an underestimation of the value of related products)

Although the mining industry has been seeking a long-term equilibrium in which the mining profit margin is small enough to be close to zero, the reality is that as mentioned above, the profit margin will inevitably fluctuate greatly.

Factors that affect costs are always slow and lagging. Decisions to enter or exit an industry, purchase equipment, scale up operations, etc. all take time, and there is also a delay of about two weeks in adjusting the mining difficulty.

On the other hand, since the price of the currency is constantly fluctuating, the income of miners changes very quickly, especially in extreme market conditions. Moreover, the annualized volatility of Bitcoin often exceeds 50%.

The differences in profit margins caused by these factors mean that different miners face different levels of selling pressure when faced with fixed, fiat-denominated costs.

When the price of a currency continues to fluctuate in a certain direction over a period of time, the profit margin of miners may be positive or negative during this period. These deviations often occur when prices rise, because the delay in deciding to enter the mining industry is much higher than the delay in exiting. After all, if the price of the currency continues to fall and falls below the mining cost, miners can quickly make the decision to shut down.

Due to information gaps, we cannot accurately calculate the inventory management of miners, but each miner will have his own plan to decide when to sell and how much to sell. Generally speaking, the cost of mining is relatively stable, and miners are more likely to choose to sell fewer coins during the rise in coin prices to pay for the expenses.

When the price of coins falls, miners need to sell more coins to maintain operations. Therefore, miners have a pro-cyclical effect on the market, and they will further exacerbate price increases or decreases.

However, this state also has its limits. Continued price increases may cause miners to sell more coins to buy new mining equipment, which also reflects that market prices will be affected counter-cyclically at certain times.

During the "capitulation period", most miners have negative profit margins and miner-led selling pressure will be high. Some miners will endure the pain of short-term losses and sell the mining rewards they have reserved before, squeezing out miners with no money from the industry to secure their own position.

All of these actions reinforce the direction of price movement, which is one of the reasons why currency prices frequently fluctuate sharply.

Although we know that most miners have pro-cyclical behavior, this situation may change due to the rise of the lending market. Lending allows miners to speculate on the future price of Bitcoin. If they believe that the price of the currency will rise in the future, they can borrow money to pay the fees and postpone the time of selling Bitcoin.

Although the amount of selling by miners depends on how accurate they are in timing the market, at some point they are more inclined to borrow fiat currency than to sell. If miners are essentially long-term in Bitcoin, then when miners believe that Bitcoin's current price is far below its long-term fundamental value and that the current bull market is in sight, they will tend to borrow fiat currency. When the price of the currency falls, the procyclical effect is mitigated, and when the price of the currency rises, the procyclical effect is exacerbated.

Bitcoin will soon undergo its third halving, with the block reward reduced from 12.5 BTC to 6.25, equivalent to a reduction in annualized supply from 3.6% to 1.8%, and is expected to occur on May 14, 2020.

Over the past few weeks, the price of the cryptocurrency has fallen sharply along with traditional markets. Due to the procyclical behavior of miners, their selling pressure will also increase. It is almost certain that the price has fallen below the break-even point for the least efficient and least profitable miners, and these miners have temporarily or permanently shut down.

This can be seen from the recent mining difficulty adjustment - the mining difficulty dropped by 16%, which is one of the largest drops in history.

Such a large adjustment suggests that inefficient miners are on the verge of capitulation and are forced to sell their Bitcoin to cover costs.

With the BCH and BSV halvings set to occur on April 8 and April 9, respectively, miner-led selling pressure on Bitcoin is likely to continue to increase. All three assets share the same SHA-256 algorithm, allowing miners to seamlessly switch hashrate to the asset with the highest return on investment.

When the BCH and BSV block rewards halve, this should force miners to shift more hashing power to BTC, as Bitcoin will still have a 12.5 block reward for more than a month to come.

Therefore, we can assume that the difficulty of Bitcoin mining will increase further in the future, and the profit margins of miners will be further squeezed.

Many miners were already in a state of capitulation long before the halving. Once the block reward is halved, miners’ income will be halved, while the mining cost will remain the same. It is foreseeable that more miners will capitulate in the coming months.

In the short term, miners’ capitulation will increase selling pressure until inefficient miners are forced to exit, but in the long run, this change will support the price of the currency.

Inefficient miners will be eliminated, and miners with the lowest production costs and the highest efficiency will remain, which will increase the profit margin of miners, thereby reducing the selling pressure in the market, helping the price of the currency to rebound, and allowing the market to enter a virtuous cycle. Ultimately, if the price of the currency bottoms out and rebounds, miners with pro-cyclical behavior will also cause the price of the currency to rise further.

The framework derived from first principles allows us to understand that miners are a constant and important source of selling pressure, and they have a procyclical effect on the price of the currency.

Currently, the selling pressure on BTC, BCH and BSV, which is dominated by miners, is still very high. Due to the impact of halving, this selling pressure may further intensify in the coming months.

We expect that in the future, miners will experience a process of "declining profit margins, increased sales, shutdowns, and elimination of the least efficient miners". After this process is over, the mining industry will return to a healthier state, thereby driving up the price of coins.

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