Why does a decrease in Bitcoin mining difficulty cause a sharp drop in the price of the currency?

The difficulty of mining Bitcoin (BTC) will decrease on March 25. The last time a downward adjustment took place, the price of Bitcoin plunged by more than 50%.

Bitcoin Difficulty

Bitcoin’s difficulty is designed to adjust every 2016 blocks (approximately every two weeks). This adjustment is based on changes in the network’s hash rate and is done periodically to ensure that the network continues to solve new problems at a rate of 1 every 10 minutes.

If the hash rate has risen over the past two weeks, then the difficulty will also rise, making mining more challenging. If the hash rate drops, the difficulty level will decrease, making blocks easier to solve. The latter is rare and some believe it is an ominous indicator for Bitcoin prices historically. The next time it adjusts, the mining difficulty is expected to decrease by 13.67%.

Recent History

The last downward adjustment occurred on February 25, 2020, when the price of Bitcoin was $9,989.39. Three days later, the price dropped to $8,785.52, and by March 14, it had fallen back to $4830.21. In twenty days, Bitcoin lost 52% of its value.

The previous major downward adjustment occurred on November 7, 2019. The price of Bitcoin closed at $9,310.19 on that day. About twenty days later, on November 26, the price dropped to $6,907.4, a total drop of 25.81%.

Miners give up

While the relationship is fortuitous, there is logic behind the trend. Downward difficulty adjustments complete what is known as a “miner capitulation cycle.”

In short, let's assume we are at a point where mining is highly profitable. This causes more miners to join the network, increasing the hash rate. As a result, the difficulty adjusts upwards, making profits slightly less, but mining is still profitable, which incentivizes more miners to join.

This cycle continues until a significant percentage of miners can no longer keep up. Some are forced to liquidate more and more newly mined Bitcoins, eventually exhausting their inventory. This leads to an increase in the supply of Bitcoins for sale on the market. At some point, they capitulate and stop mining. The hash rate decreases, and finally, the difficulty decreases.

Philip Salter, head of operations at Genesis Mining, recently told Cointelegraph:

“It’s no different than the traditional market, you have to sell everything to keep operating, pay off debts. As a miner, you have bills to pay, you have to pay for electricity, operating expenses; and your expenses are in dollars, so as the price of Bitcoin goes down, it means you have to sell more inventory to keep going.”

This theory will soon be tested again as Bitcoin mining difficulty decreases.

Source: Cointelegraph

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