The Bitcoin Halving: Gauging the impact from this month's block reward cut

Research
• Apr 10, 2024
The Bitcoin Halving: Gauging the impact from this month's block reward cut

One of the most important aspects of Bitcoin’s design that Satoshi Nakamoto incorporated in the original code base is that the total supply of Bitcoin is capped at 21 million. The objective of setting a cap was to differentiate Bitcoin from centralized fiat money whose supply is flexibly adjusted by governments opening it up to potential (certain?) manipulation. As such, Satoshi ensured that Bitcoin behaved more in line with commodity-backed money, most obviously gold, whose supply is not politically determined but instead is influenced by technological progress and geographic exploration1.

Halving Ensures Finite Supply

Contrary to popular belief, the 21 million cap is not immutable. Because Bitcoin is nothing more than code and code can always be rewritten, anyone able to code in C++ can change Bitcoin’s 21 million cap. However, this change would only be successful if the majority of Bitcoiners decided that they desired the cap to be raised and collectively chose to switch to a hard fork of the original code base incorporating a higher supply limit. Depending upon how the fee market on Bitcoin evolves, such a change may be necessary at some point in the future2, but given how memetic 21 million has become envisaging such a change is impossible at the current juncture.

Another popular misconception is that the 21 million cap is hard coded into the Bitcoin protocol. It is not. Neither is the cap mentioned at all in Satoshi’s famous white paper. Instead the supply cap relies on the fact that Bitcoin issuance was originally set at 50 BTC and this amount is halved every time 210,000 blocks of transactions are created by miners and validated by the nodes. This mathematical relationship ensures that Bitcoin’s supply decreases monotonically until it reaches 20999999.9769 BTC (or 21 million effectively) – see chart.

Bitcoin Issuance Schedule

Source: Coindesk

The above chart is actually an approximation – albeit an extremely close approximation – because unlike other blockchains, such as Ethereum post-Merge, Bitcoin’s block times are not fixed.

In order to be able to create a valid block of transactions all miners need to do is find a nonce that generates a hash value that meets the target difficulty. This means valid blocks of transactions could be compiled seconds after the previous block is compiled or it could be several hours later. While the timing of each individual block is unknown a priori, the distribution of block times approximates to a Poisson distribution (mathematically it follows a negative binomial distribution due to nonce guessing being a discrete, or binary process, but the Poisson distribution is a pretty close approximation) and by introducing a difficulty target that is determined by the amount of hash power deployed by miners3Satoshi was able to adjust the mean of this distribution to target a 10 minute block time.

The consequence of this ingenious design is that approximately every four years the block subsidy paid to Bitcoin miners for solving the SHA-256 hash function is cut in half and the next halving is slated to occur on or around April 20 this year, depending upon when the 840,000 Bitcoin block is mined.

What does Bitcoin Halving imply in 2024?

For anyone unfamiliar with halving events, they may seem like uninteresting affairs that only exist because it is the mechanism Satoshi chose to ensure the total supply of Bitcoin maxed out at 21 million. However, in the Bitcoin world these events are considered extremely important, and for good reason.

History indicates that “halving events” have quite a marked impact on Bitcoin prices. To illustrate this point, take a look at the following chart which shows the price performance of Bitcoin around the three halving events Bitcoin has previously witnessed. To aid comparison, Bitcoin’s price is indexed to 1 on the day of the halving and the scale is converted into logs.

Bitcoin Halvings – Price Performance

The Bitcoin Halving: Gauging the impact from this month's block reward cut

Source: Author calculations

No obvious price trends jump out in the 200 days approaching the halving, but afterwards is a very different story. In all three instances Bitcoin’s price rallied substantially. The weakest performance occurred after the last halving when Bitcoin’s price “only” went up 5X!

In light of such an impressive track record crypto players, not surprisingly, attach considerable significance to this quadrennial event. However, explaining quite why Bitcoin’s price gets such a substantial and seemingly consistent boost in the months following halving events is not as straightforward as is often presented.

Plan B’s S2F Model

The standard explanation for this phenomenon is encapsulated in the much-talked about stock-to-flow (S2F)4 model put forward by the anonymous Plan B back in 20195. The rationale given is that a reduced block subsidy means there is a fall in the number of new Bitcoin’s coming on to the market (flow) relative to the outstanding supply (stock) of Bitcoin and this increased “scarcity” puts upward pressure on the price of Bitcoin.

As an economist I am not overly keen on this model. My first problem arises from the fact that Bitcoin halvings are, to all-intents-and-purposes, fully deterministic. We know from the Bitcoin code at what block height the halvings will occur, and we know by how much the block subsidy will be cut. The only small degree of uncertainty is when the 210,000th block will be mined as block times are not fixed as mentioned above.

Given the future supply is known so far in advance – we can be confident on halving events all the way out to the final one set to take place in 2140 – one would naturally expect rational, forward-looking profit-maximising investors to pre-emptively buy Bitcoin ahead of halving events in anticipation of higher future prices. In doing so, this would pull forward the positive return and smooth out the subsequent price rally. Yet, for some reason this appears not to be the case.

Some may counter that assuming investors behave so rationally is flawed because we also witness predictable patterns in tradfi asset prices. However, these “seasonals” as they are labelled are mainly the influence of external factors, such as widely observed holiday periods (summer/December) or due to the periodic nature of tax payments/receipts. None of these are applicable to an event like Bitcoin halvings that occur at a four year frequency.

A more substantive objection to the S2F model, one Plan B readily acknowledges, is that it only deals with the supply side of Bitcoin and as every student of economics knows, price is determined by the interaction of supply AND demand. Just because something is scarce does not automatically convey it with an ability to serve as a store-of-value (one of the three key prerequisite functions of money). This means the mechanistic pricing of the S2F model is flawed, but it does not mean it is totally misleading. As long as there is consistent demand for Bitcoin, increased scarcity should translate into higher prices.

And what is the likely source of this consistent demand? As I wrote in March 20236...

...[M]y judgement is that cryptocurrencies will not only survive but thrive because the fiscal challenges facing pretty much all of the major economies in the world are of such a magnitude that it is highly improbable governments will be able to avoid deploying the printing press, resulting in the further erosion of fiat money’s purchasing power.”

Over the past year nothing has changed to alter this perspective. Indeed, if anything, the failure of governments to rein in budget deficits via curbs to public spending since I wrote the above serves only to strengthen further this argument.

So, while some of the surge in the demand for Bitcoin arising from the recently introduced spot Bitcoin ETFs in the US may be attributable to investors front-running this year’s halving event - implying less positive post-halving event returns than has previously occurred - it is extremely unlikely that it is sufficient to completely negative the next halvings impact. And, as such, Bitcoin’s ascent to new all-time-highs seems pretty assured.

Roll on April 20 (or thereabouts).


1 Actually Bitcoin is an even harder currency than one based on gold because the gold supply is not fixed, but increases gradually over time as more extraction occurs.

2 This future may not be that far off in the distance for reasons I alluded to in a previous research note – see: https://trakx.io/resources/research/privacy-and-security/

3 There are many graphs showing Bitcoin’s hash rate but it is not a descriptive statistic of the network but is instead an estimate derived from the time differences between blocks being produced.

4 See: https://www.lookintobitcoin.com/charts/stock-to-flow-model/

5 See: https://medium.com/@100trillionUSD/modeling-bitcoins-value-with-scarcity-91fa0fc03e25

6 See: https://trakx.io/crypto-wager/

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