April 2024

The Bitcoin Halving

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On April 19, Bitcoin will go through its fourth halving event. This is where the supply of new bitcoins issued to bitcoin miners is cut in half.

This month we are going to provide a refresh of what the Bitcoin halving is, why it matters and how it impacts markets for digital assets as a whole. We will dive into Bitcoin’s mechanics, explore how bitcoins are created and discuss what the halving is from a technical perspective. We will evaluate how the reduction in the rate of inflation may impact the price of bitcoin and how this contrasts with the inflation of fiat currencies like the USD.

The Bitcoin network is powered by a collection of servers that are run by miners. These miners contribute their computing resources to find and propose blocks of transactions. They have two fundamental tasks: a) provide server capacity to the network, and b) act as auditors to the network by verifying and processing 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 6.82 BTC. This total amount is made up of the coinbase reward (6.25 new bitcoins) and the sum of the transaction fees from all the transactions included in the block (0.57 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 6.25 bitcoin pre-halving and from April 19 onwards, 3.125 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.

The halving is a technical event, predefined in the Bitcoin protocol. However, the impact that it has is not technical, but economic. Every halving to date has been followed by a run up in the price of bitcoin. The first time a halving took place, reducing additional supply per block from 50 BTC down to 25 BTC, bitcoin rallied 79x within 12 months following the halving. The second time a halving took place, reducing additional supply from 25 to 12.5 BTC per block, bitcoin appreciated 30x over 18 months following the event. The most recent halving was in 2020 where the block reward was reduced from 12.5 BTC per block to 6.25 BTC per block. This resulted in bitcoin appreciating around 7x over the following 18 months. Price appreciation seems pre-programmed into the bitcoin halving schedule, but why is this?

There are both supply side and demand side dynamics at play surrounding bitcoin halving events. On the supply side, Bitcoin miners are net sellers of bitcoin. Their business model is simple; earn revenue in the form of newly mined bitcoin, sell a portion of it into fiat currencies and use these currencies to pay their operating expenses. Post-halving events, miners’ revenues are instantly cut in half as the block reward is halved. As a result, miners now have fewer bitcoin to sell into the market. Should demand remain steady, there will be a supply shock over time with fewer new bitcoin being sold into the market.

But miners are no fools: they are well aware that their revenues are about to be cut in half and they know that if the price of bitcoin does not rise then they may go out of business. While Bitcoin markets are becoming far more efficient, they are not 100% efficient markets. It is realistic to assume that miners, which historically have had a big influence on crypto prices, may refrain from selling their 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 continue to mine profitably.

This reduced supply of bitcoin hitting the market has historically also been met by increased demand for bitcoin. The halving is a unique and noteworthy event. It results in increased media attention as to what Bitcoin is, its importance and its exceptional price performance. This drives renewed interest in the asset at the same time as a significant supply shock is taking place. Global macro events are of course different at every halving but have often lined up in Bitcoin’s favour. In 2020, the halving took place soon after Covid had become rampant. In response, the Fed was reducing interest rates and increasing quantitative easing to unprecedented levels. Governments globally were aggressively spending to hold up world economies. Against this backdrop, the Bitcoin narrative was strong as a protection against unlimited quantitative easing.

Today, the Bitcoin narrative continues to remain highly relevant. Government quantitative easing has led to global fiat inflation levels pushing up to 9%. The fiat money that you hold in your bank account is losing value faster than at any time since the early 1980s. At the same time, the inflation rate of Bitcoin is reducing after the halving to 0.9%. Bitcoin is a much harder form of money than the USD and as more people in the world learn about this the greater the demand for bitcoin becomes. In conjunction with this, the January launch of spot bitcoin ETFs in the US has made bitcoin easier than ever for investors to purchase. Demand for bitcoin is stronger than ever.

Despite writing about it extensively, bitcoin is rarely a core holding for our digital asset funds and today we hold no BTC. In late 2023 we held a significant bitcoin position in our funds in anticipation of the bitcoin ETF being approved. This was an event driven investment decision. Once the ETF approval took place, we divested from our BTC position to reallocate into alternative digital assets (“altcoins”) that are high beta and should outperform bitcoin in the upcoming bull market. To be clear, we have very strong conviction in BTC performing excellently in the coming 12-18 months. However, the digital asset market is highly correlated and we are confident that other assets in our portfolio will outperform BTC in a bull market and so we are allocated elsewhere at this point in time.

Bitcoin is the bellwether for the market as a whole; when it is performing well it is very likely that the rest of the market is also performing well and vice versa. In addition, the inflation dynamics and philosophy of Bitcoin have also been replicated in varying ways across other digital assets. As we discussed in September 2023, Ethereum went through the “merge” event and as a result, ETH the asset is now deflationary. Since the merge took place, the total supply of ETH has marginally reduced (-0.4%) because of ETH being burned in transaction fees. The philosophy of bitcoin as “hard money” is spilling over into the rest of the ecosystem resulting in strong economic designs and mechanisms for digital assets.

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 high inflation rates around the world, this commentary is as relevant today as it was back in 2009. We look forward to seeing Bitcoin complete its fourth halving event this week, making it a harder asset than the fiat currency that global governments continue to manipulate and inflate away.