The Bitcoin Halving: A Beginner's Guide

April 29, 2020

The Bitcoin Halving: A Beginner's Guide

The much anticipated Bitcoin halving will be taking place this May for the third time in Bitcoin’s 11 year history. But what is the halving, why does it happen and what are the likely effects?

What is the Bitcoin Halving? 

To understand the Bitcoin halving we’ve first got to talk about Bitcoin mining. You can forget about hard hats and digging underground and instead picture a warehouse full of very powerful, very efficient and very expensive computers. 

The supply of Bitcoin increases through ‘block rewards’. Miners receive block rewards by using these powerful machines to verify transactions in the network. In particular, they make sure Bitcoin is not being duplicated or ‘double-spent’.  

A block is mined approximately every ten minutes and miners are rewarded for solving the latest block and adding it to the blockchain. This will occur every ten minutes until Bitcoin reaches the finite supply of 21 million Bitcoin. 

Mining is central to the success of Bitcoin. Mining is used to issue new BTC, confirm transactions and secure the network. 

After every 210,000 blocks have been mined - roughly every four years - the number of BTC entering circulation every 10 minutes is halved. Miners receive 50% fewer BTC for verifying transactions. 

You’ve likely heard the hype around the halving as a lucrative trading opportunity. Like anything - Bitcoin’s value is determined by supply and demand. If the supply of new Bitcoin in circulation halves - and demand stays the same or increases - then in theory the price of BTC will increase. 

But why does the halving happen? 

Little is known about the mysterious inventor of Bitcoin - but we do know that their vision for Bitcoin was the antithesis of central banking. 

“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.”

- Satoshi Nakamoto 

Central banks have the power to print money at any time. They get together every few months to decide whether to adjust the money supply. In recent months we have seen unprecedented levels of quantitative easing in response to the coronavirus crisis. 

The trouble is that creating money out of thin air does not magically eradicate all of our financial woes. In fact, it often creates a whole host of new problems. But when humans, rather than algorithms control the money supply, this is what happens… 

Satoshi Nakamoto wanted the supply of Bitcoin to be predictable, trustworthy and decentralised. And in order for Bitcoin to have any value - it also needed to be scarce.   

For this reason, Bitcoin's monetary policy is written into the code and these set rules are shared across the network. It has a finite supply of 21 million Bitcoin and a predictable supply and inflation schedule.  

Bitcoin’s scarcity is similar to that of gold. And this is exactly how Satoshi intended it.

“As a thought experiment, imagine there was a base metal as scarce as gold but with the following properties: boring grey in colour, not a good conductor of electricity, not particularly strong [...], not useful for any practical or ornamental purpose...and one special, magical property: can be transported over a communications channel.” 

- Satoshi Nakamoto  

It is difficult to significantly increase the supply of gold because there is a long and expensive process for mining it. Similarly, with Bitcoin, there is a limited supply and it takes a lot of effort and electricity to mine it. 

The stock-to-flow ratio helps us understand the value of this scarcity. Stock-to-flow ratios are used to evaluate the stock of a commodity against the flow of new production. Both gold and Bitcoin have a high stock to flow ratio - and this contributes to their value. We highly recommend reading  The Bitcoin Standard by Saifedean Ammous if you want to understand this more. Seriously...it’s awesome. 

What will happen after the Bitcoin halving? 

Most people believe the halving will lead to a significant increase in the price of Bitcoin. Others believe that because of the predictability of the supply schedule - the halving has already been priced in to Bitcoin’s current value. Let’s take a look at what happened at the first two halvings. 

So, take your mind back to 2009. The year Barack Obama became President of the United States, the year of the miracle on the Hudson river and crucially - the year Satoshi mined the genesis block.

At this time, the reward for every block mined was 50 Bitcoin. Hence, 50 Bitcoin entered circulation roughly every 10 minutes. Back in those days 50 BTC was worth less than 50 cents - but at today’s price ($8000) it would be worth approximately $400,000. 

The first halving came 4 years later on November 28th 2012 - when the block reward dropped from 50 BTC to 25 BTC. The price began to increase roughly one year prior and by the time of the halving, Bitcoin was valued at $12.22. Following the halving, the price skyrocketed reaching a height of $1,163 in November 2013 - an increase of over 9000%. 

The second halving happened on July 9th 2016 and saw the block reward fall from 25 BTC to 12.5 BTC. By the time of this halving, Bitcoin was trading at $647.78. After the 2016 halving we saw the bull run of 2017 which hit its peak in December of 2017 at almost $20,000. 

Next month, the block reward will decrease to 6.25 BTC per block. Many expect the same price action we have seen in previous years to follow this halving. According to the laws of supply and demand - a reduction in the supply of BTC - combined with unchanged or increased demand - should result in an increase in the price. 

Others argue that because the halving is highly predictable, that the event has already been calculated into Bitcoin’s price by many investors. 

No one can say with 100% certainty what will happen to the price following the halving. However the most accurate predictor so far has been analyst PlanB’s Bitcoin stock-to-flow model. His most recent calculations are forecasting an average price of  $288,000 between 2020 and 2024.

Mining stability and hashrate 

Price may be the most attention grabbing aspect of the halving, but another important consideration is the stability of the network. As we’ve touched on - miners play a crucial role in Bitcoin’s ecosystem. They mine new blocks, verify transactions and improve the security of the network. 

We use the term ‘hashrate’ as a measure of the processing power of the network. The more miners there are competing for block rewards, the higher the hashrate and the more secure the network becomes.  

Let’s not forget that mining is an expensive and competitive process. So what happens when their reward gets cut in half? 

Immediately after the 2012 halving, mining profitability fell. As a result, some miners paused their operations and the hashrate fell. However, as the price of Bitcoin continued to increase, so too did mining profitability and the hashrate quickly recovered and improved. 

A similar thing happened after the 2016 halving - an initial drop in the hashrate that recovered and improved within 7 months. And over the past couple of years, the hashrate has been consistently hitting all-time highs. 

What happens after the 2020 halving is up for debate. It’s likely mining profitability will initially fall, forcing some of the less efficient miners to drop off the network. But it all depends on what happens to price. 

The block reward will eventually dwindle to nothing once the supply of Bitcoin reaches 21 million. At this point, transaction fees will become the greatest source of remuneration for miners. 

Back in the early days, Satoshi Nakamoto wrote: 

“In a few decades when the reward gets too small, the transaction fee will become the main compensation for nodes. I’m sure that in 20 years there will either be very large transaction volume or no volume.”

One thing is for sure - we have watched the network go from strength to strength over the last 11 years and we can’t wait to see this next halving event unfold.

 


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