May 2020

The Bitcoin Halving

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The third ever Bitcoin Halving takes place on 12 May. This is where the issuance of new bitcoin to miners is cut in half. This is more than just an interesting technical characteristic of the Bitcoin protocol. It is the reason that Bitcoin is becoming recognized as a true alternative form of money.

Bitcoin is slowly establishing itself as the soundest form of digital money. With total supply growth limited to 21 million bitcoin and its supply inflation rate being reduced from 3.72% annually to 1.79% per annum from next Tuesday (at block 630,000) onwards, Bitcoin's features are much to the opposite of the ones of central bank issued fiat currencies like the USD. With Bitcoin's supply inflation rate being reduced 50% every four years for the next 120 years, ending at 0% additional supply from the year 2140 onwards - all governed by code and mathematics as opposed to central bank's discretion - Bitcoin will increasingly become recognized as a true alternative form of money in the coming decades.

The market perspective

Paul Tudor Jones, one of Wall Street's biggest names and most well respected hedge fund investors, with assets under management in access of USD20billion, announced today that his Tudor BVI fund has started to invest in Bitcoin Futures and has accumulated a low single digit percentage of its assets in Bitcoin futures. This comes just weeks after it became public that Jim Simons’ The Medallion Fund of Renaissance has started to invest into Bitcoin Futures.

As Bloomberg reports, “Macro investor Paul Tudor Jones is buying Bitcoin as a hedge against the inflation he sees coming from central bank money-printing, telling clients it reminds him of the role gold played in the 1970s”. With this being said, Jones becomes one of the first big hedge fund managers to publicly embrace Bitcoin as a hedge against inflation. By his calculation, USD3.9 trillion of money, the equivalent of 6.6% of global economic output, has been printed since February. “It has happened globally with such speed that even a market veteran like myself was left speechless,” Jones, 65, wrote. “We are witnessing the Great Monetary Inflation - an unprecedented expansion of every form of money unlike anything the developed world has ever seen.”

“I am not a hard-money nor a crypto nut,” he wrote. “The most compelling argument for owning Bitcoin is the coming digitization of currency everywhere, accelerated by Covid-19.”

Jones started his career in the mid 1970s during a time of stagflation and bear markets in stocks. “Bitcoin reminds me of gold when I first got into the business in 1976,” he wrote.

Read the full Letter to his investors, under the following link: Market Outlook – Macro Perspectives: The Great Monetary Inflation

As the Bitcoin halving event is now only a few days away, the price of Bitcoin is gaining strong momentum again and has hit 10,000 USD/BTC at the time of writing this report. Media attention on the Bitcoin halving is omni present and general FOMO (fear of missing out) seems to be kicking in again. While at CMCC Global we are extremely bullish for the coming 24 months, we also foresee a scenario where the price of Bitcoin takes a dip for a few days or weeks shortly after the halving.

Historically the price appreciation of bitcoin induced by the decrease of additional supply through the Bitcoin halving has taken some time. The first time a halving took place and reduced additional supply per block from 50 BTC down to 25 BTC, bitcoin rallied 79x within 12 months following the halving. The second time when it reduced from 25 to 12.5 BTC/block it appreciated ~30x over 18 months following the event. Each of these times, bitcoin rose to price levels beyond all expectations of investors. There was always a bit of a run up starting around a year ahead of the halving event, and in the same pattern we saw Bitcoin appreciating steadily over the past 12 months from ~5k USD/BTC to ~10k USD/BTC pre the Corona induced 13th March crash.

On 13th March we saw a large sell off, mainly caused by levered long positions being liquidated. Prior to the 13th March crash, the market had seen one of the largest levered long holdings in history, likely in anticipation of the upcoming halving event. When the price fell on 13th March, longs were liquidated in a chain reaction as the global markets were selling off all liquid assets including equities, bonds, gold - and Bitcoin. Ever since, Bitcoin has steadily moved back up. The risk of a second large sell off induced by Corona panic still remains in the short term. In the longer term, we observe that there is a growing desire from investors to hedge portfolios through assets that are not being governed and influenced by central banks and fiat money printing / QE, i.e. gold and its digital brother, Bitcoin.

Bitcoin has already seen a strong recovery with its price hitting 10k USD/BTC (at the time of writing this investor letter) in the run up towards the 12th May, as the media and influential crypto influencers are already pushing the story and crypto investors in the short term tend to be very receptive to PR and news. The halving day itself is very likely not going to see a massive spike, as the specific day tends to be priced in by then. Perhaps there might be a bit of a price dip immediately following the halving day or around that week as some ill-informed retail investors will be disappointed that Bitcoin does not manage 10x on that day.

The real impact on the halving will more likely be a steady appreciation over the 24 months following the halving - in our view very likely surpassing previous all-time highs and perhaps reaching levels of USD50-100k per Bitcoin, as is widely anticipated within the industry. It is important to understand that miners, many of which run professional mining operations that have running operating expenses such as electricity, rent, labour, etc need to cover their costs in fiat currencies. These miners will come under financial pressure if the price of Bitcoin does not appreciate, as their mining reward is about to reduce from currently ~125,000 USD per block (10,000 USD * 12.5 BTC) down to ~62,500 USD per newly minted block (10,000 USD * 6.25 BTC). Therefore, many miners may go out of business if the price does not adjust upwards. Now knowing that Bitcoin markets are not 100% efficient markets, it is not difficult to conclude that miners, which have a big influence on crypto prices, as they are constant sellers in order to cover their OPEX, may refrain from selling Bitcoin for a few months. This adds up over time and reinforces the impact that: a) additional newly minted Bitcoin supply per block has reduced by 50%, and b) those already reduced new Bitcoin will be withheld by miners in the case that the price does not appreciate to a level where they can profitably mine.

The resulting price impact may be further accelerated if this shrinking additional supply meets additional demand from hedge funds, like the one of Paul Tudor Jones, or from ordinary people who wish to diversify their portfolio to include an asset outside our traditional system or simply if bitcoin adoption growth rates continue at their current levels. The impact of this shrinking additional supply through the upcoming halving may be only seen with a time lag of a few weeks or months. In this context it is also relevant to note that miners prepare for upcoming halvings well ahead and many of them will have built a financial cushion by now to be able to withhold from selling bitcoin for a few months and pay their OPEX from their "treasury" or fiat savings.

While the above describes the supply induced drivers for a likely price appreciation, PR or fear of missing out (FOMO) drivers may accelerate the whole process and as we have seen many times in the past, can catapult the price of Bitcoin within weeks to new all-time highs. This is especially true when central banks around the world are publicly announcing unlimited quantitative easing (QE). Companies (stocks) may still be hurt by the real economic impact of Corona (sales, supply chains, etc), bonds represent a claim to fiat, and fiat currencies themselves are publicly announced to be devalued through their central banks. In our view gold, silver and bitcoin will benefit from these unfortunate global realities.

Investors are in search of uncorrelated assets that can hedge their existing portfolio. Bitcoin is often perceived as an emerging digital version of gold. Certainly, bitcoin prices not being correlated to other assets is an advantage for investors based on the belief that the current global financial system is not sustainable or healthy. The last major financial crisis of 2007-08 has been largely fixed through QE. We see the same pattern now again. While this may be the only way central banks can stimulate the economy in the short term, we all know the long term implications for the value of fiat currencies that result from such practices. In fact, looking at an M3 money supply growth curve shows an exponential function that is steeper than the bitcoin price chart. Investors globally are worried about a sustained crisis and they are looking for assets that are uncorrelated with existing assets in their portfolio.

Similar to 2007-08, where gold first depreciated in value, before rising to new all-time highs, we have seen the same pattern now, with gold and bitcoin having taken a slight hit as investors liquidated any asset that they were able to sell. This is normal for any liquid asset in situations in which people need to secure their daily expenses for fear of losing jobs, etc. Considering empirical data from the past 10 years, Bitcoin has been largely uncorrelated with equities, fixed income and oil. The thesis is that Bitcoin is a hedge against a declining global economy. Only time will tell how much Bitcoin will remain uncorrelated in a global financial meltdown, but the nature of it, being a truly decentralised asset, only run by code and mathematics and not governed by any government or central bank, combined with the empirical data of the past 10 years, point towards a credible hedge against a declining global economy.

Further reading:
Interview with CMCC`s Martin Baumann by International Finance: Bitcoin: The new gold in a declining global economy?

The technical perspective

The news dominating the digital asset space is that Bitcoin is about to go through its third ever “halving” (also known as the “halvening”). This is where the supply of new bitcoins issued to bitcoin miners is cut in half. This month we are going to dive into Bitcoin’s mechanics, exploring how bitcoins are created and what the halving is from a technical perspective.

Bitcoin is a protocol, which means that it is a collection of rules. As per the Bitcoin whitepaper, these rules specify how a “purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.” The rules cover how transactions should be signed and proposes a solution to the double-spending problem, through hashing blocks of transactions together. The rules encoded in the protocol also define the supply of new bitcoins and how this supply will change over the next 120 years. It is this set of rules that we are going to focus on.

The bitcoin network is powered by a collection of machines that are run by miners. These miners contribute their computing resources in order to find and propose blocks of transactions. The miners are incentivized to take part in the network in two ways: Firstly, the miner that creates a new block has the right to issue new bitcoin to themselves, much like a capital increase would function in the equity world. Secondly, every transaction that is included in a block has a corresponding transaction fee that goes to the miners. This fee is small, today making up less than 10% of income for miners.

The way that new bitcoin issuance works is through a special transaction that is the first listed in a new block. This transaction is known as a “generation transaction” or “coinbase transaction”. The transaction is constructed by the miner that has won the block and is the reward for this miner’s effort. For example, the coinbase transaction might pay the winning miner a sum of 13.52 BTC. This total amount is made up of the coinbase reward (12.5 new bitcoins) and the sum of the transaction fees from all the transactions included in the block (1.02 bitcoin in this example).

Unlike normal transactions, the coinbase transaction does not require existing bitcoins (also known as unspent transaction outputs or UTXOs) as inputs. Instead, the transaction has a single input called the coinbase. This input can create additional bitcoin as defined in the protocol, with a current maximum of 12.5 Bitcoin pre-halving and 6.25 Bitcoin post-halving. The coinbase transaction has a single output which is payable to the miner’s own bitcoin address.

The Bitcoin whitepaper does not state what the rate of issuance of bitcoin should be, but it does state that Bitcoin should have a deflationary monetary policy. The rate of issuance was formalized in the original bitcoin codebase. This formulation states that for the first 210,000 blocks (roughly equal to 4 years given that blocks are formed at approximately 10 minute intervals) the block reward is 50 bitcoin. At this point, the reward is cut in half to 25 bitcoin. More specifically, block 209,999 yielded 50 bitcoin for the miners, while block 210,000 yielded 25 bitcoin. This halving continues to take place after every 210,000 blocks.

As shown in the above table, Bitcoin’s monetary policy is to decrease the rate of bitcoin issuance until 21,000,000 BTC have been issued. This will happen at the 33rd halving event at around the year 2140. At this point, the block reward will drop to 0 BTC and miners will only be incentivised to provide their server capacity through transaction fees thereafter. The Bitcoin whitepaper makes clear that the goal of the system is to be “inflation free”, stating that:

Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free.

In the Bitcoin genesis block, the first block ever to be mined, a message was posted in the coinbase that read “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”. Satoshi Nakamoto, the creator of Bitcoin, was commenting on the instability of our existing financial system. With unprecedented quantitative easing taking place today, this system continues to look flawed, while Bitcoin is becoming increasingly accepted as an alternative transparent, trustworthy and scarce form of money.