The halving of the spicy snack is just an appetizer. The third halving of Bitcoin will attract countless people's attention.

Litecoin’s second block reward halving has been successfully completed, and next, we will usher in Bitcoin’s third block reward halving in May 2020.

“History doesn’t repeat itself, but it does rhyme.” — Mark Twain

The World Cup and the Olympics are held every four years, and the Bitcoin mining block reward is also halved every four years. Initially, the Bitcoin block reward was 50 BTC, which was reduced to 25 BTC at the end of 2012 and to 12.5 BTC in 2016. Its third halving will occur around May 20, 2020, when the Bitcoin block reward will be further reduced to 6.25 BTC.

Perhaps by design, or just by chance, the last two Bitcoin price cycles have been closely tied to the block reward halving. By reviewing these two halvings and analyzing their impact on Bitcoin supply, demand, and price, we hope to explain the previous powerful price cycles and help investors prepare for the third cycle.

Source: Yahoo Finance

The first halving and the retail era

I call this period the retail era because Bitcoin was only gaining early adoption among technicians and retail investors at the time. At the beginning of this cycle, the entire Bitcoin economy was too small for institutions to notice it.

Before the first halving price cycle began, Bitcoin experienced a cycle between June and November 2011, when its price fell from $31 to $2, a drop of more than 90%.

The price of Bitcoin began to rise in November 2011, and then in November 2012, Bitcoin had its first halving. After that, its price continued to rise until it hit a record high of $1,200 in November 2013. This cycle shows obvious symmetry, that is, the 12 months before and after the halving generally show an upward trend.

Source: Yahoo Finance

In the first cycle, the price surged after the halving (it rose to $13 before the halving and to $1,200 after the halving). The overall price increase in this cycle was 350-400 times (depending on the price source you see). In fact, Bitcoin only rose 4 times before the halving, and nearly 100 times after the halving.

After reaching a peak of $1,200, a 14-month deep recession followed, with the price of Bitcoin falling by more than 80%, reaching a low of around $200. In the following 10 months, the price of Bitcoin remained between $200 and $300.

The Second Halving and the Venture Capital Era

We call this cycle the VC Era because during this period, several venture capital firms and hedge funds observed the first cycle of Bitcoin and entered the market. Several cryptocurrency hedge funds also emerged during this cycle, many of which did not survive the crash after the VC Era ended, but about 150 of them survived.

The price of Bitcoin began to rise sharply in November 2015, which started the second halving price cycle, which was about 8 months ahead of the official halving in July 2016. After the halving officially occurred, Bitcoin continued to rise, and the entire cycle lasted about 24 months like the previous one, until it reached a record high of $19,000 in December 2017.

Source: Yahoo Finance

In fact, most of the appreciation of Bitcoin in this halving price cycle also occurred after the halving (it rose to $650 before the halving and rose parabolically to $19,000 after the halving). The increase in the entire cycle was about 80-90 times, while it only rose about 3 times before the halving.

After the end of this halving price cycle, Bitcoin experienced a 12-month recession, and its price fell again by more than 80%, reaching a low of around US$3,000. In the following four months, Bitcoin has been hovering between US$3,000 and US$4,000.

The Third Halving and the Institutional Era

The price of Bitcoin pushed above $5,000 in April 2019, and its continued rise since then marked the beginning of the next cycle.

Image source: Yahoo Finance

Large institutions that did not participate in previous cycles seem to be gradually entering this cycle, so we call it the institutional era. For example, Fidelity is launching a cryptocurrency trading business; JP Morgan, whose CEO Jamie Dimon called Bitcoin a fraud in the last Bitcoin cycle, is currently operating its own JPMorgan Coin; Facebook, which banned cryptocurrency ads in the last cycle, is now planning to launch Libra in cooperation with several large institutions.

JPMorgan Coin and Libra obviously will not directly support Bitcoin, but these institutional initiatives have drawn attention to cryptocurrencies and Bitcoin. Institutional investors and regulators are looking at these different projects and asking themselves:

“Should I support (or invest in) decentralized algorithmic currencies like Bitcoin, or should I hand over control of printing money to large corporations?”

Discovery of the halving cycle

Let’s summarize the main findings about the halving cycle so far:

There are some interesting numbers and patterns in the chart above, but one pattern stood out to me the most:

Why do most of Bitcoin's gains occur after the halving, rather than before?

The Bitcoin halving is a well-known event, and the market will wisely predict the impact of the supply reduction on the price. So why is it that the price increase is not very obvious before the halving? We will talk about this question later.

Marginal supply = miner income

The price of an asset at any point in time is what balances supply and demand. The initial explanation for how the halving leads to an increase in the price of Bitcoin is a supply-side story centered on the activities of Bitcoin mining companies. Bitcoin miners play a vital role in confirming transactions on the Bitcoin network. They are rewarded with new Bitcoins for each block they mine. Miners are the marginal suppliers of freshly mined Bitcoins to sell, which also increases the circulating supply of Bitcoin. All else being equal, if miners have fewer Bitcoins to sell (after the halving), they will demand a higher price. Similarly, if the number of available Bitcoins decreases, buyers will pay a higher price.

There is also a supply component that is not discussed enough, which is that Bitcoin miners have two sources of income (new block rewards and transaction fees for confirming transactions). In fact, when Bitcoin's 21 million BTC are nearly all mined, transaction fees will be the only source of income for miners.

That is: marginal supply = miner income = mined bitcoin + transaction fees

Let us analyze the situation of these two components.

Bitcoins mined daily

Before the first halving, Bitcoin had a daily supply of 7,500 to 8,000 BTC. After the first halving, the daily supply dropped to 3,700 to 4,000 BTC. Currently, the daily supply of Bitcoin is about 1,900 to 2,000 BTC. After the next halving, the daily supply will drop to about 1,000 BTC.

Source: coinmetrics.io

From a dollar perspective, the situation is completely different. The price of Bitcoin was $13 on the day of the first halving, when the daily marginal supply decreased by about 4,000 BTC (from 8,000 to 4,000). This is equivalent to a reduction in marginal supply worth $52,000.

$13 * (8,000 – 4,000) = $52,000

The Bitcoin price was around $650 on the day of the second halving, with marginal supply falling by 2,000 BTC or $1.3 million.

$650*(4000–2000) = $1.3 million

Assuming the price of Bitcoin doesn't change much until the next halving and stays around $10,000 (bad assumption, I know, but it makes me happy = =), then at that price, the daily supply will decrease by 1,000 BTC, and the marginal supply will drop by $10 million.

$10,000 * (2,000 – 1,000) = $10,000,000

Over the course of a month, this would reduce marginal supply by $300 million, and over the course of a year, by $3.65 billion.

Halving will significantly reduce the liquid supply

The decline in marginal supply obviously reduces the liquid supply. How much is that reduction, and how do we measure it? Using the Bitcoin inflation rate (comparing new supply to the total Bitcoin supply) is meaningless because most of the supply is not liquid (investors keep it in their wallets for months or even years).

“Marginal supply reductions must be compared to total liquid supply.”

One way to quantify this is to compare the reduced liquidity due to the halving to the daily exchange volume. Unfortunately, the volume reported by cryptocurrency exchanges is not reliable. According to a research report submitted to the U.S. Securities and Exchange Commission (SEC), up to 95% of the volume on the market is questionable. With this in mind, I have used a lot of rounded numbers in this section, so they are not very reliable and are used only to illustrate the logic.

According to CoinMarketCap, there are about 2 million BTC traded in the market every day. At the current block reward rate, the liquid supply will add 2,000 BTC per day, 60,000 BTC per month, and 730,000 BTC per year. This means that the market has the ability to absorb 2.73 million annual liquid supply. When the block reward is halved and only 1,000 BTC is mined per day, the annual supply will be reduced to 2.365 million, which is about a 13% reduction in the annual liquid supply.

On the other hand, if we consider that 95% of reported volume is suspicious, then the actual volume is closer to 100,000 BTC. The next halving will reduce the annual supply from 830,000 (100,000 + 730,000) to 465,000. This is a 44% reduction in the annual liquid supply.

Transaction fees increase marginal supply

Now let’s discuss the second component of miner revenue. The Bitcoin network has been processing over 100,000 transactions per day since 2015. In December 2017, Bitcoin transaction volume hit an all-time high of around 500,000 transactions, and after reaching that high, transaction volume began to drop significantly before continuing to rise in 2018 and 2019.

Source: germany.com

Aside from the 12-month period of 2017-18 when transaction fees skyrocketed, the chart below shows that daily Bitcoin transaction fees have generally remained below 200 BTC. In 2019, daily transaction fees on the Bitcoin network averaged around 70 BTC. Clearly, transaction fees also show a strong correlation with Bitcoin prices (fees fluctuate in a positive correlation with the price of the coin).

Source: coinmetrics.io

Next, we put block rewards and transaction fees together and then get a comprehensive view of miner revenue, as well as the daily marginal supply they may introduce. Newly mined Bitcoin has historically been the main source of mining revenue. Even today, transaction fees, averaging 70 BTC per day, are still small compared to the new supply of 2,000 BTC per day. However, with transaction volume rising and the block reward halving still continuing, it will only be a few years before transaction fees become the main source of revenue .

Source: coinmetrics.io

Price is a reflection of the balance between supply and demand

We’ve spent a lot of time talking about supply, but now we’re going to turn our attention to demand.

Bitcoin is the first and most popular network to implement direct monetization. Unlike other social networks that rely on indirect revenue sources (such as advertising), the Bitcoin network directly rewards miners for their efforts.

The number of Bitcoin blockchain wallet users is growing at an alarming rate, currently exceeding 40 million, with an increase of 8 million in 2019 alone. It can be seen that the Bitcoin network is experiencing explosive growth. According to Metcalfe's law, the value of a network is proportional to the square of its nodes, and given the limited supply of Bitcoin, the price of Bitcoin will obviously rise with the growth of the network.

Source: blockchain.info

In my previous article, I discussed how the value of scarce assets is reflected in limited supply. Bitcoin is the first popular implementation of digital scarcity and has led the cryptocurrency revolution. Since its inception, thousands of crypto assets have emerged on the market, but Bitcoin still maintains its leading position. Assets with stable prices are obviously suitable as a medium of exchange, and as a scarce asset, the rise in Bitcoin's price increases its appeal as a store of value and increases people's demand for it.

“The rise in prices will increase people’s demand for Bitcoin.”

The chart below shows the change in people's interest in Bitcoin as shown by Google Trends. The highest search volume for Bitcoin was in December 2017, when the price of Bitcoin hit an all-time high. The peak of search interest in December 2013 also coincided with the previous all-time high. Recently, as the price of Bitcoin continues to rise, its search interest has begun to rise again.

Source: Google Trends

There is also a lot of evidence that demand price is correlated with blockchain activity. Transaction activity on the Bitcoin blockchain increases as the price of the coin increases, and vice versa. Note that we focus on the number of transactions, not the dollar value of the transactions.

Source: coinmetrics.io

inference

We use the above to try to explain the price cycle of Bitcoin:

The digital gold story has brought a lot of attention to Bitcoin, and demand for Bitcoin continues to rise, as evidenced by the growing number of wallets, exchanges, searches, media coverage, etc.

The past two Bitcoin halvings have shown the following price cycle characteristics:

1. Pre-Halving : Bitcoin price starts to rise on the expectation that the upcoming halving event will be positive.

2. Post-halving : As Bitcoin gains acceptance among venture capitalists, hedge funds, and institutional investors, rising prices attract new demand from increasingly wealthy investors and speculators. New demand exceeds expectations, and prices continue to rise after the halving. In past cycles, the demand growth caused by price increases was severely underestimated.

3. Bubble : Rising prices lead to FOMO and attract more speculation. A bubble forms and prices reach all-time highs. At this stage, speculative prices far outstrip sustainable demand and the bubble eventually bursts.

4. Crash : Collapsing prices lead to a decrease in demand, just as rising prices lead to an increase in demand. Many people will leave the party.

5. Building a New Base : Bitcoin eventually finds price and demand equilibrium at the current marginal supply rate and forms a new base that is significantly higher than the previous cycle's base.

6. Return to step 1 from the higher base.

It should be clarified here that the above logic depends on the demand generated by Bitcoin's unique digital gold "story" and Bitcoin's status as the number one cryptocurrency. In contrast, Litecoin's halving may be interesting, but Litecoin lacks a strong story and demand.

Therefore, Litecoin’s price cycles do not conform to the conditions listed above.

The market is intelligent, it learns and adapts, so no two cycles are the same. Let's see how Bitcoin's third halving plays out. History doesn't repeat itself, but it always repeats itself.

Note: The original author, Vishal Karir, CFA, is a former BlackRock and Mastercard executive and current co-founder and chief investment officer of Huddl.