Bitcoin Halving — The Mailman

It was the failure of the US financial system in 2007/2008 that set the ground for a revolution in the structure of financial markets. And amid the turbulence, a visionary was working on an invention that would come to question the centrality and the power of financial institutions in these realms. When he, under his pseudonym “Satoshi Nakamoto,” presented his project to the world, he set the foundations for a wave of innovation.

In his whitepaper, Nakamoto labeled Bitcoin as a “peer-to-peer electronic cash system and then broke down the fundamental anatomy of what he called the “blockchain.” A currency based on “blockchain” would allow transactions to be validated by a decentralized network rather than by a centralized third party. Satoshi’s Vision was clear: He wanted to create a currency that would solve the major issues associated with the involvement of a “middleman” at the time (e.g., high cost of transaction) and that would work across the planet.

This article analyses the implications of Bitcoin’s “Halving Cycles” on Bitcoin’s price, as well as on holders’ behaviour. Also, it aims to relate the impacts of said cycles on the rest of the crypto space.

Bitcoin as a deflationary currency

What was truly revolutionary about Bitcoin was its answer to the question of “who keeps track of everything.”Traditional banking systems have a centralized ledger that’s in charge of recording every transfer of value. A ledger always needs to be accurate for people to maintain their trust in that system. If a centralized financial institution has a faulty ledger and thus fails to provide a true representation of all ownership in the system, the whole system could collapse as people lose their trust. For Bitcoin, the ledger is distributed amongst many people and is publicly accessible. Transactions need to be verified independently before new data is added to the ledger. Consensus refers to the process by which all validating entities agree to one single correct version of the transaction history. If 51% or more of all peers agree to one version of the ledger, then that version is held to be true.

Transactions on the blockchain are validated by so-called “Miners.” These miners try to find solutions to cryptographic problems. But to understand exactly what they do, we need to understand the concept of a hash. Imagine a hash as a digitally compiled fingerprint of a set of data. This fingerprint consists of 256 bits and is compiled by the SHA-256 algorithm. By changing even a minor detail in a larger dataset, the hash for that dataset changes completely. By repeatedly changing minor details of a block, miners try to find a hash value of a certain kind (e.g., one that includes a specific combination of characters). Whenever a such a hash is found (or, in other words, whenever a block is mined), a reward and a fee is paid to the individual who found the solution. This reward serves as an incentive for miners to sustain the network with their activity, and the reward is fixed and defined in Bitcoin’s source code. For every 210.000 blocks mined, the reward for successfully mining every next block gets cut in half. That occurs approximately every four years, and the lines in Bitcoin’s code responsible for this can be found below.

The reward for the first block ever mined was 50 Bitcoins, and since Bitcoin’s creation, this reward has been halved four times. Halving will repeat until Bitcoin reaches a circulating supply of 21.000.000. According to estimates, this maximum supply will be reached in the year 2140. After this, miners will stop creating new Bitcoins. Instead, miners’ rewards for successfully mining a block will be limited to the fees paid by people transacting with Bitcoin.

The number of newly created Bitcoins lessens and eventually reaches zero. Thus, as the popularity and demand of Bitcoin rise, there are not enough Bitcoins to satisfy the surge in the market’s demand. Once all Bitcoins have been mined, the supply will be fixed at 21.000.000, and demand will be the only factor affecting price (Meynkhard, 2019).

But Bitcoins can also be lost, for example, when people lose access to their digital wallets. A famous case of this is that of James Howells, who lost 8.000 Bitcoins when he discarded an old hard drive (his story made the news, and he has been searching for the hard drive ever since). The BBC refers to sources that estimate the number of these “Lost Bitcoins” to be as high as 2.400.000 BTC. That is a substantial fraction of the total supply, and these Bitcoins will forever be cut out of circulation. Thus, the total circulating supply will inevitably shrink over time, especially once no more Bitcoins are mined.

All of these aspects make Bitcoin deflationary in its nature, meaning that over time, it will increase in value due to a decrease in supply. Now, what are the implications of this on Bitcoin’s function as a currency or as an investment?

Bitcoins viability as a currency or an investment

We can speculate on potential reasons as to why Nakamoto might have decided to have Bitcoin be deflationary. But the fact remains that the deflationary aspect undermines one of the basic foundational functions of money: its ability to be used as a way to transfer and exchange value. That is for obvious reasons, as there is no incentive for someone to expend an asset that will be worth more tomorrow. There is a loss, in monetary terms, associated with the utilisation of deflationary currencies.

With its deflationary aspect, Bitcoin differs from any other currency. While countries could theoretically create an infinite amount of their fiat currency, Bitcoin’s supply is capped at 21 million. Also, the halving slows down the emission of Bitcoin into circulation over time. The two charts below graph the total supply of Bitcoin and the US dollar over time.

Nowadays, virtually all Bitcoin bought and sold has an investment purpose. A symptom of this was the SEC approval of Bitcoin spot ETFs at the beginning of 2024. This approval was granted to a few of the largest American financial service providers, including BlackRock. This event has funnelled billions worth of liquidity into the crypto space and has also contributed to promoting public awareness of Bitcoin’s aptitude as a financial asset. According to K33 research, 933.000 Bitcoins are owned by regulated investment firms. The most significant players in the Bitcoin Spot ETFs space include Grayscale (450.000 BTC), BlackRock (150.000 BTC), and Fidelity (102.000 BTC) as of May 1. 2024.

Bitcoin has proven to be a lucrative investment for retail/institutional investors and even for countries such as El Salvador. And even though Bitcoin is still mainly used as an investment asset, 15.000 companies in the US and worldwide accept Bitcoin as a method of payment.

Bitcoin halving: Effect on Bitcoin’s price

Professional miners often run costly operations. Not only are miners required to purchase powerful and expensive computational units that depreciate quickly due to intensive use (e.g., CPUs and GPUs), but also to pay for the electricity needed to run the mining rigs. Miners tend to immediately sell newly mined Bitcoins to cover the high costs and scale their operations over time (Meynkhard, 2019).

As mentioned before, every four years, the Bitcoin reward per block mined is halved, reducing supply. Thus, following the halving, the reduced Bitcoin supply is perceived as a supply shock by the market, affecting prices. Much of Bitcoin's price movement can be attributed to these halving cycles, and the Bitcoin price tends to follow a predictable and recurrent pattern. In the following, you can observe the price charts of Bitcoin in the periods between the second and third halving, as well as between the third and the fourth halving.

When comparing the two price charts, one can observe features that are also consistent throughout all of the four halving cycles. Immediately apparent is the initial peak, which usually is reached within 12-18 months of the halving. These periodical peaks tend to set new all-time highs for Bitcoin. Following the Bitcoin peak, a reversal to the downside can be observed in both graphs before the price started to surge again towards the end of the cycle.

One interesting detail can be observed in the most recent halving cycle (2020-2024). For the first time in Bitcoin’s history, Bitcoin reached its all-time high approximately a month before the halving. Causes for this move have likely been positive market sentiment and regulatory changes, including the SEC’s approval of Bitcoin Spot ETFs only months prior.

With crypto being an asset class with a strong reliance on trust, narratives and public perceptions are meaningful drivers of price fluctuation. But besides trust and narrative, many crypto traders base their activity on technical analyses (Meynkhard, 2019). Trends, volatility, and trading volume become important indicators for future price movements. Amidst all the noise, Bitcoin’s periodical halving cycles remain a reliable predictor of price movements (Taskinsoy, 2021).

Bitcoin halving: Impact on Altcoins

As of March 2024, over 13.000 cryptocurrencies have ever been created. Deducting all the inactive coins still leaves almost 9.000 active ones, traded daily. With Bitcoin having the largest market capitalization, the term “Altcoin” refers to any cryptocurrency that is not Bitcoin. These Altcoins are alternatives to the pioneer, usually improving on certain aspects of the original version of the blockchain. The largest of these altcoins is Ether (ETH), the currency used on the Ethereum Network. Altcoins differ greatly in utility and market capitalization, and while much of the price movements that these coins experience are based on individual narratives and trends, Bitcoin’s performance has a great influence on the entire crypto market (Ciaian et al., 2018). Altcoins tend to follow Bitcoin’s price, especially in the short term. A glance at the seven-day price movements of the largest coins makes this very apparent: while there are exceptions, many coins follow Bitcoin’s patterns.

The aforementioned interdependence is likely attributable to Bitcoin's leading position in the crypto space. Bitcoin currently has over a 50% market share of the entire crypto market, measured by the Bitcoin Dominance Indicator.

Let's analyse Bitcoin's influence using the example of Cardano, a high-market capitalisation Altcoin. Cardano was created by Charles Hoskinson, co-founder of Ethereum, in 2017, and today, the currency is ranked 10th in terms of total market capitalization on CoinMarketCap. In contrast to Bitcoin but similarly to Ethereum, Cardano has created a blockchain ecosystem that allows users to create their own tokens or run their own decentralized applications on the network. Also, unlike Bitcoin, Cardano runs on the Proof-of-stake consensus mechanism, which drastically reduces resource insensitivity in comparison to Bitcoin's Proof-of-work.

The following graph compares the market capitalization of Cardano with the market cap of Bitcoin over the span of six years. The observed time frame includes two relevant features, namely, it includes the peaks from the third and the fourth halving cycles (on the 17.12.2017 and the 09.11.2021). What becomes immediately apparent, is that Cardano’s medium-term price fluctuation is clearly affected by Bitcoin’s halving cycles. The two price charts share many similarities in features, peaks and trends.

Not only Cardano is affected by this, but virtually every Altcoin on the market. In other words, this means that a supply shock in Bitcoin ultimately leads to a surge in demand for every other crypto asset. Additionally, Altcoin prices proportionally rise much higher than Bitcoin's price. This is evidenced by the Bitcoin dominance chart. As a reminder, Bitcoin dominance measures how large Bitcoin's market cap is compared to the rest of the market.

The chart below covers the same time frame as the previous one. Marked in red are the months in which Bitcoin reached its halving peaks. The graph shows that as the Bitcoin price rises, its respective share of the entire crypto market diminishes.

To understand why that is, let’s interpret an investor’s situation during a bull market. As the price of Bitcoin rises, investors find themselves with excess liquidity, but because the market perception is still positive they are unwilling to leave the market and take profits. Investors therefore tend to seek higher returns, by exiting Bitcoin in order to acquire more Altcoins. With their lower market cap coins they are often more volatile and have more upwards potential. Thus, a lot of liquidity is funnelled into Altcoins and they end up outperforming Bitcoin.

Conclusion

The Bitcoin halving is a crucial event for the crypto space, as it plays a vital role in shaping price trends and investor behaviour. While Bitcoin, due to its deflationary nature, is not yet ready to be implemented as a functional world currency on a broader scale, its investment properties shouldn’t be overlooked. Given Bitcoin's dominant position in crypto, supply shocks ultimately affect the Altcoin market. In the chaotic and unpredictable realms of digital currencies and assets, periodical Bitcoin halving cycles introduce a certain degree of predictability in the long term, not only for Bitcoin but for the crypto space. In the future, it will be interesting to see what this current halving cycle will bring along, especially considering the effects of increasing institutional adoption.

Bibliography

Meynkhard, A. (2019) ‘Fair market value of bitcoin: Halving effect’, Investment Management and Financial Innovations, 16(4), pp. 72–85. doi:10.21511/imfi.16(4).2019.07.

Ciaian, P., Rajcaniova, M. and Kancs, d’Artis (2018) ‘Virtual relationships: Short- and long-run evidence from Bitcoin and Altcoin markets’, Journal of International Financial Markets, Institutions and Money, 52, pp. 173–195. doi:10.1016/j.intfin.2017.11.001.

Taskinsoy, J. (2021) ‘Bitcoinmania: A ticking time bomb waiting to explode’, SSRN Electronic Journal [Preprint]. doi:10.2139/ssrn.3861836.

Ferdinando Angeloni

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The Mailman