How do financial models explain Bitcoin's price action after the halving?

Bitcoin is halved every four years. The current reward for miners is 12.5 bitcoins per block, when the block reward miners receive will be halved. The next halving will happen soon in May 2020.

The first halving in November 2012 coincided with a surge in Bitcoin prices. The price of Bitcoin rose from $12 to over $650. After the second halving in July 2016, the price soared to around $20,000 at the end of 2017.

Although it is uncertain whether the next halving will drive prices higher, each previous halving has driven Bitcoin's upward trend. The next halving has naturally caused heated debate.

1. The Stock-to-Flow Model is Bullish on Bitcoin

One popular financial model often mentioned in these debates is the Stock-to-Flow (S2F) model. It models the price of Bitcoin based on the so-called "stock-to-flow ratio," a ratio originally used to value gold and other raw materials. By correlating "stock" (i.e., issuance) with "flow" (i.e., annual issuance), the model predicts a Bitcoin price of $55,000 to $100,000 after the halving (which would equate to a market cap of over $1 trillion).

There is no doubt that the S2F model has attracted a lot of attention since its release in March 2019. Various derivatives of the model have also emerged, which is another boost to the super bullish sentiment of Bitcoin maximalists.

2. Efficient Market Hypothesis

According to the Efficient Market Hypothesis (EMH), prices only incorporate new information. It assumes that markets are sufficiently efficient and are able to react to an equilibrium price that correctly reflects all external or so-called exogenous information. In turn, all market-internal or endogenous processes are already reflected in prices. In this view, only external forces (e.g.: exchange hacks, central bank announcements or political events) can change investors' expectations and prices. Therefore, extreme events such as bubbles or market crashes are the result of external news that has not yet been factored into prices.

For EMH proponents, Bitcoin’s supply schedule (which is encoded into the protocol and known to everyone) constitutes endogenous information and should therefore already be factored into the price, but this does not mean that the halving is also fully factored in.

3. Financial models not only replicate the market, but also adjust the market

There is strong evidence that Bitcoin prices vary too much compared to the price expected by the EMH. Research shows that relevant news releases can only explain a small part of price changes. Price dynamics are mainly driven by endogenous positive feedback mechanisms between investor expectations and prices. This phenomenon was described by George Soros as "market reflexivity."

Whether or not the S2F model works, whether or not you believe in the EMH or anticipate an epic Bitcoin rally, these views underestimate the fundamentally reflexive nature of financial markets.

Markets, and Bitcoin in particular, are reflexive. There is a positive feedback loop between expectations and prices: expectations influence prices, which in turn influence the expectations and behavior of traders or investors. This is a self-reinforcing positive feedback loop and is at the heart of speculative bubbles and market crashes.

Models can shape financial markets due to the phenomenon of reflexivity. Historically, models have repositioned markets in certain situations. For example, the famous Black-Scholes option pricing model led to an increase in the agreement between option price patterns and the model. This was until the 1987 crash broke its validity. Similarly, current short volatility strategies (which use volatility as an input to risk-taking and a source of return) have a transformative effect on equity markets because they systematically suppress volatility.

Financial models are not hard sciences like physics. Financial models not only faithfully replicate the market, but also actively transform the market. They can become what the famous sociologist Robert K. Merton called a "self-fulfilling prophecy," meaning that people always make their own predictions come true without realizing it.

Therefore, the Bitcoin halving or predictions such as the S2F model could themselves become self-fulfilling prophecies that drive price up in feedback loops. While there is no guarantee that it will happen, if enough investors and traders start to believe in these models, then the model predictions do have the potential to become reality.

This article is translated from a column by Tobias A. Huber, a researcher at the Department of Economics, Management and Technology at the Swiss Federal Institute of Technology in Zurich, on Coindesk.

Image source: Pixabay

Author:May

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