If Bitcoin doesn’t take off as expected, what will happen to miners after the halving?

The original article is a research report by Kraken on the trends and impacts of Bitcoin's inflation mechanism during its study of Bitcoin halving. The title is: "Trends & Implications of Bitcoin's Inflation Mechanism"

Translator: Xin Nan of Odaily Sunday News. Please indicate the original text and translation source if you need to reprint.

The reason why Bitcoin is hailed as the most sound non-sovereign currency is due to its strictly controlled inflation rate - Bitcoin keeps its total supply constant at 21 million, and the block reward is halved every 210,000 blocks (approximately every four years).

The latest upcoming Bitcoin halving is also the third halving since the network’s inception. This time, Bitcoin will halve at block 630,000, which is expected to occur on May 12, 2020.

After this halving, the Bitcoin block reward will be reduced from 12.5 bits per block to 6.25 bitcoins, and the inflation rate will also be reduced from 3.72% to 1.79%.

This means that Bitcoin's inflation rate will be the first to achieve the 2% inflation target designed by most central banks for their fiat currencies. As of January 31, 2020, the current issuance of Bitcoin has reached 18.19 million, accounting for about 87% of the total supply. In the light of history, halving is often considered to be the trigger point for price surges. But will history really repeat itself?

The report, produced by cryptocurrency exchange Kraken, discusses the timing trends of previous halvings, Bitcoin in the context of other commodities, and the impact of halvings on the mining industry.

Introduction to Bitcoin Halving

The Bitcoin network adds a new block every 10 minutes on average, and each block will issue new Bitcoin rewards to miners who successfully verify the block.

Currently, the reward for each block is 12.5 bitcoins, and the Bitcoin network is adding 1,800 bitcoins per day at an average rate of 144 blocks per day (about 3.9% annual inflation rate).

The code behind the Bitcoin network stipulates that Bitcoin’s inflation rate will trend downward until the total supply approaches 21 million Bitcoins in 2140. However, it is worth noting that by 2032, 99% of all Bitcoins will have been minted.

Every 210,000 Bitcoin blocks, or approximately every four years, the number of Bitcoins rewarded in a block is reduced by 50%.

(Table 1: Bitcoin halving schedule Note: Era1 inflation is a 3-year average because the annualized inflation in 2009 was infinite)

Based on block height 615,350 as of January 31, 2020, the last Bitcoin is expected to be mined in March 2140.

Analysis of historical halving situations

By analyzing the network’s past two periods of history, we can discover a bullish pattern surrounding halvings.

The bull market usually starts 12-18 months before the halving and ends 12-18 months after the halving. We find it useful to analyze the changes in the "relative bottom" and "relative peak" prices during this period.

The first halving

On November 28, 2012, Bitcoin's first halving occurred at block 210,000, reducing the block reward from 50 bitcoins to 25 bitcoins.

Before the halving, the entire network can mine 144 blocks per day. After the halving, the block reward will drop from 7,200 bitcoins to 3,600 bitcoins.

As can be seen from the chart 2 below, the bull run of the year started in November 2011, exactly one year before the halving. Similarly, the bull run ended in December 2013, exactly one year after the halving.

During this period, the price of Bitcoin increased by 50,162% from trough to peak. Later, the upward trend of Bitcoin reversed in late December 2013, entering a multi-year bear market, falling by 80%.

(Table 2: BTC price trend against USD from November 2011 to December 2013)

Second halving

The second halving occurred on July 9, 2016, at block 420,000, reducing the block reward from 25 bitcoins to 12.5 bitcoins.

On a daily basis, the daily output of Bitcoin has dropped from 3,600 to the current 1,800.

It is worth noting that the interval between the first and second halvings was only 1,316 days, nearly 150 days less than the generally expected 1,460 days. Of course, this is because the growth of computing power has exceeded the mining difficulty adjustment of the network since the introduction of ASIC mining machines and the replacement of GPU mining.

Although the mining difficulty is also automatically adjusted, about every 2016 blocks or about every two weeks, to adapt to the growth of the total network computing power and maintain the average block discovery time at about 10 minutes, the algorithm does not take into account the extremely rapid technological progress - from GPU, FPGA and other mining methods to the ASIC mining era.

After ASIC mining, every $1 investment can generate 20-50 times more bitcoins than GPU mining. Of course, this in turn drives huge mining demand among miners.

Unlike the first bull run, which started a year before the halving, the second bull run experienced by Bitcoin started nine months before the halving. It ostensibly crossed the 2017 bull run, when the price of Bitcoin was close to $20,000. In this bull run, Bitcoin rose from a relative bottom price of $213 on September 21, 2015 to a relative price peak of $19,499 on December 16, 2017.

That is, 18 months after Bitcoin’s second decline, the price rose by 9,054%. This parabolic bull run caused Bitcoin to fall 80% later, and it did not bottom out until December 2018.

(Table 3: Bitcoin price trend against the US dollar from October 2015 to December 2017)

Macro perspective

The commonalities between the two halvings suggest that Bitcoin prices will experience a two-year uptrend after the halving, but this will be followed by a 12-18 month downtrend of 80% from peak to trough.

Around the time of the first halving in November 2012, Bitcoin’s relative price peaked at $1,151 in December 2013, almost exactly one year after the halving event.

Two years later, the price of Bitcoin fell 81.5% to $213 in August 2015, before the second halving was initiated and the bull market cycle started.

The second halving pushed the bull run to an end two and a half years later, with the price of Bitcoin reaching a peak of $19,499.

Similar to the first halving, a year later, the price of Bitcoin fell back by 83%, hitting a low of $3,225 per coin at the end of December 2018. As of January 31, 2020, the price of Bitcoin has partially recovered to $9,300, a year-on-year increase of 188%.

(Table 4: Price trend of Bitcoin against the US dollar from January 2009 to January 2020)

The impact and significance of halving

“It is more like a typical precious metal, which does not stabilize its value by changing its supply, but rather predetermines its supply and changes its value. As the number of users grows, the value of each coin also grows. It may form a positive cycle: as the number of users increases, the value also increases, which will attract more users to profit from this growing value system.” - Satoshi Nakamoto

The halving is key to Bitcoin becoming a sound currency.

Halving causes Bitcoin’s supply to follow a disinflationary curve. The upcoming halving will reduce the annual supply inflation rate from 3.7% to 1.8%. This marks the first time that Bitcoin’s inflation rate will fall below the 2% inflation target designed by most central banks for fiat currencies.

Inflation-resistant assets like gold have proven to be a better store of value than inflationary assets like fiat currencies.

For example, the British pound is the oldest legal tender in existence, with a history of 317 years, and has lost more than 99.5% of its value since its inception. (This price drop does not take into account the depreciation of silver, as each pound was originally worth 12 ounces of silver.) In other words, this most successful currency in history may not even lose 0.5% of its value due to inflation.

On the other hand, since the US officially ended the gold standard in 1973, gold has appreciated by 1,760%, while the cumulative inflation rate of the US dollar during the same period was 472.53%. In other words, the purchasing power of $1 in 1973 is equivalent to $5.73 today.

(Table 5: Real purchasing power of different fiat currencies in different years)

Scarcity and Stock-to-flow

“As a thought experiment, imagine that there was once a base metal that was as rare as gold, but had the following properties: it was a boring grey, it was not a good conductor, it was not particularly strong, it was not easily ductile, it could not be used for practical or decorative purposes, but it could be transmitted through communications channels.” — Satoshi Nakamoto

Satoshi’s 2008 white paper proposed a vision for how to prove that scarce data could exist as a form of electronic cash.

Bitcoin is often compared to commodities such as gold or silver. Bitcoin is often called "digital gold", but it currently struggles to compete with widely adopted payment systems due to price volatility, scaling limitations and a complex user experience.

That said, many Bitcoin adopters maintain a firm belief in Bitcoin as a store of value. Existing stores of value, such as gold, have similar limitations to modern payment mechanisms:

• Few merchants accepted gold as payment, the price of gold was subject to fluctuations, albeit more volatile, and the only way to transport or modify the size of a transaction was to melt and cut the gold bars.

• Although gold is not an ideal modern medium of exchange, it has become one of humanity’s oldest and most trusted stores of value.

In fact, gold’s enduring value is due to its scarcity, a property often measured using the SF ratio (Stock-to-Flow ratio, hereinafter referred to as SF). The SF ratio quantifies the scarcity of an asset by dividing the total supply of the asset (stock) by the total annual production (flow).

The stock-to-flow theory holds that the economic utility of consumer goods is realized only when they are used. However, investment assets with high SF rates often rely on their storage and eventual resale.

For reference, an asset with an S2F ratio of 50 would require 50 years of current production rates to produce the same amount of stock as is currently available.

(SF value of metal commodities and SF value of BTC before and after halving)

Assets with high S2F values ​​tend to have relatively low annual inflation rates. Among the currently popular metal commodities, gold currently has the highest S2F value. However, after the fourth halving of Bitcoin in May 2024, the S2F value of Bitcoin is likely to rise immediately, and it is expected to immediately become the leader.

Although Bitcoin is not a metal, this is indeed a meaningful comparison because Bitcoin is often regarded as "digital gold" with properties such as value storage, scarcity, monetary function, and production through "mining".

The S2F value of some commodities (including gold) may be unpredictable if there is a major resource discovery, or if resources become cheaper to extract.

For example, the discovery of a large gold mine, the emergence of new technologies for extracting gold, etc., may bring higher-than-expected capital flows.

Bitcoin uniquely benefits from its mathematical certainty and supply being inferred based on current parameters on the network.

Moreover, Bitcoin’s scarcity is likely being underestimated. A large amount of Bitcoin supply may be unavailable (e.g. lost BTC, BTC locked in wallets that cannot be spent), and it is estimated that this proportion may be between 7% - 29% (1.5 - 6 million Bitcoins).

Impact on Mining

“In the coming decades, when returns are too low, transaction fees will become the main compensation for block producers. I believe that in 20 years, either there will be very large transaction volumes or there will be no transaction volumes.” - Satoshi Nakamoto

The halving does not just affect Bitcoin mining output. Market participants should also note that the mining industry is likely to be affected as well, as their revenue and costs will adjust with the change.

This could be complicated by the fact that miners’ revenue will be reduced by about 50% immediately after the halving. Due to the Bitcoin network’s regular mining difficulty adjustment, miners need to programmatically adjust their programming every two weeks in order to produce valid blocks.

It is worth noting that the Bitcoin network will encounter a mining difficulty adjustment at block 631,008, just over 1,000 blocks after the third halving.

This means that miners will have to spend the same amount of computing power as before the halving to get only half the income until the network mining difficulty is adjusted. (The less competition, the lower the difficulty, and vice versa)

Therefore, validators of blocks must take corresponding actions before the difficulty is adjusted to avoid the associated financial risks.

As the halving approaches, Bitcoin participants should consider the following implications:

• Miners’ block rewards are expected to decrease by 45%-50%;

• The profitability of the mining industry may face great pressure. Since operating expenses such as facilities and electricity are basically fixed, this pressure also depends mainly on the price performance of Bitcoin during the halving cycle;

• Assuming a Bitcoin price of $9,300, total annual mining revenue will drop from $6.1 billion per year to $3.1 billion after the May 2020 halving.

• As network participants begin to digest the depressed network subsidy environment, transaction fees are expected to become a more debatable topic;

• Although the current security of the Bitcoin network is very high and the price is far higher than the marginal production cost of similar products, if miners choose to exit the market, the computing power and security of the Bitcoin network may decrease.

Since transaction fees only make up 4-8% of the total block reward, we have to wonder whether it is possible for broader adoption and transaction volume to make transaction fees high enough to cover the entire block reward.

Furthermore, is the 4-year halving interval long enough for such an exaggerated move to be adopted?

Transaction fees are determined by Bitcoin users, and high fees will incentivize miners to actively process transactions. Transaction fees are more closely related to the growth of demand than the halving of the value of Bitcoin itself.

It may seem that transaction fees did not increase as a result of the halving, but on average, transaction fees have indeed been increasing over time.

(Table 7: Transaction fees and income)

While this may change in the future, in the current state of the network, Bitcoin does not have enough transaction volume or fees to make up for the reduction in the block reward subsidy.

(Table 8: Estimated rewards after block reward adjustment in May 2020 Note: The transaction fee column is based on the 2019 average)

As shown in Figure 8 above, at block 630,000, miners’ total revenue will be reduced by $58,125 (assuming a BTC/USD price of $9,300). In order to fully compensate miners for their lost revenue, transaction fees would need to increase by 19.7 times.

This means that, assuming an average of 330,000 trades per day and total fees of $425,000 (based on the 2019 average), either daily trading volume would have to increase by 1,970% to an average of $6.83 million, or fees per trade would have to increase by 1,869% to $25.40 to make up for the lost revenue (see Figure 9).

(Table 9: Current average transaction fees and daily transaction volume vs. average transaction fees and daily transaction volume required for subsidies after halving)

We expect this topic to receive more attention by the time of the halving in 2020. Moreover, for now, the only metric capable of fully compensating miners for the drop in revenue is a proportional increase in the value of Bitcoin.

Summary and Conclusion

The history of the previous two halvings showed that the price of Bitcoin experienced a two-year upward trend in the 12 to 18 months before the halving, followed by a decline of about 80% from peak to trough.

The most recent bull run lasted nearly two and a half years and ended in December 2017, with prices reaching a peak of $19,499 before gradually falling back 83%.

In late December 2018, Bitcoin fell to a low of $3,225. By January 31, 2020, Bitcoin had partially recovered to $9,300, a year-on-year increase of 188%.

The halving is crucial to helping Bitcoin meet the definition of sound money. Since the production process of Bitcoin is subject to a 50% price reduction, the supply of Bitcoin follows a disinflationary curve. Other assets that follow a disinflationary curve, such as gold, have proven to be a better store of value than inflationary assets (such as fiat currencies).

The third halving is expected to start on May 12, 2020, which will reduce Bitcoin's annual supply inflation rate from 3.7% to 1.8%. This is the first time that Bitcoin's inflation rate has fallen below the 2% inflation target set by most central banks.

Bitcoin’s code provides for a decreasing inflation rate until the total supply approaches 21 million bitcoins in 2140; however, by 2032, 99% of all bitcoins will have been minted.

Assets with higher S2F values ​​(such as gold) have lower annual inflation rates. Although gold still has the highest SF value among mainstream metal commodities, Bitcoin's SF value is expected to lead after the halving in May 2024.

While Bitcoin is not a metal commodity, we believe this is a meaningful comparison as this digital asset is often viewed as “digital gold” due to its similar properties.

Miners’ profitability could come under significant pressure at the time of the halving, depending on Bitcoin’s price performance, as estimated Bitcoin rewards will fall by 45% to 50% and operating costs such as facilities and electricity remain largely unchanged.

Bitcoin currently does not have the transaction volume or fees needed to compensate for a reduction in the overall block reward, although this may change in the distant future.

Transaction fees are likely to become a hot topic as network participants begin to move into a subsidized environment with low block rewards. Currently, the only metric capable of fully compensating miners for the drop in revenue is a proportional increase in the value of Bitcoin.

In summary, due to price volatility, scale limitations and complex user experience, Bitcoin is currently struggling to compete with widely adopted payment systems. Of course, the Bitcoin halving has also strengthened the confidence of many Bitcoin users in Bitcoin becoming "a means of storing value."