I am still working on my piece about what the true impact of a "halving" event in terms of the inflation of a cryptocurrency like Bitcoin is. That will come at some point in the future and will be furnishing with a model, rigorous analysis, and plots and things. In the meantime I have some thoughts that I would like to share in what should be about a 15 minute read. I will first present some general background, then a Bearish and Bullish perspective for the halving event. Finally I will share my own opinion about the impact of the halving.
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Background:
Suppose that Bitcoin as a network has some fundamental fair value. The question about whether the current market respects Bitcoin's fair value is irrelevant, we are just concerned that a fair value for the network is coherent and exists. This discussion will largely focus on how the halving impacts fundamentals despite the opinion that the market might not always respect them.
The current supply is 18M coins, but in practice, is probably closer to about 13M coins given the coins that are believed to be lost / orphaned. In the next twelve years or so, another 3 million coins will be generated which will increase the actual realized supply by about 20%.
The Bitcoin network enjoys security from mining. We can quantify the price of forking Bitcoin and re-writing the ledger as the cost of obtaining a near-majority share of the network's hash power. If we assume that the mining ecosystem today is basically honest or at least interested in the long term success of Bitcoin, then the cost of an adversary (such as some nation-state) to come in and obtain a majority hash power in the network is proportional to how much Bitcoin pay's its miners.
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Bearish Perspective:
From the point of view of miners, an average block is earning about 0.08 BTC from transaction fees these days with a coinbase reward of 12.5 BTC. This means that miners obtain roughly 99.4% of their income from the coinbase reward that inflates the currency, and 0.6% of their income is from transaction fees. That means that the security of the network is being paid for by users who hold the currency via inflation, and not by people who use the currency for transacting.
When the block reward is reduced from 12.5BTC to 6.25BTC, a few things could happen for miners. Let us consider the different possible outcomes:
(1) The transaction fees stay roughly the same and so the total income of miners is approximately cut in half (in BTC terms). If the fiat price of Bitcoin remains constant, then this outcome implies that the security (in terms of USD) of the Bitcoin network would also roughly be cut in half.
(2) The total income of miners stays the same in terms of BTC. This implies that the transaction fees will increase by about a factor of 50x as the burden of funding the network's security shifts from those who hold the currency to those who use the currency. The long term vision of the protocol is to eventually fund the network entirely using transaction fees.
(3) The total income of miners in terms of BTC drops, but the transaction fees also increase in a combination of (1) and (2).
What gives Bitcoin fundamental value is up to debate, but it stands to reason that the network's value is positively correlated with both its application for payments as well as its security (with respect to censorship) and consistency. Outcome (1) for miners implies that the security of the network will decrease dramatically as a result of the halving event. Outcome (2) suggests that Bitcoin may become extremely expensive to interact with it as transaction fees will grow immensely in terms of BTC which should also negative impact fundamentals.
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Bullish Perspective:
(4) Perhaps the most obvious bullish argument for the halving is that inflation applies an economic pressure that decreases the value of each unit of currency and so decreasing inflation reduces this pressure. A lot of users choose to think of this pressure as coming from miners selling or "dumping" their coins on the market, but really this is just a matter of supply and demand. If the market capitalization of Bitcoin remains constant, i.e. the market has settled on some fair value for the network, then with each passing day a coin represents a smaller fractional ownership of the network and is therefore worth less.
(5) A bullish counter-point to outcome (1) raised above is that the fundamental value the network derives from mining and security may not be linear. For example, if we double the amount of money that the network spends on mining through new coin production and transaction fees, the network might not be twice as good. At some point, the security of the network is good enough and we have hit diminishing returns on increased spending on mining. If we are currently in that state, where Bitcoin is over-spending on mining, then decreasing that spending to reduce inflation should be a bullish thing.
(6) While not specifically related to the halving event, changes in fundamentals and deflation from lost currency compete with pressure from the inflation rate. Every day as users interact with Bitcoin, coins are lost due to death, faulty hardware, negligence and more. This puts a deflationary pressure on the currency as the effective supply is in constant decline. Additionally, aspects related to the adoption of Bitcoin, its normalization in our society, the regulatory structure surrounding it in major countries and more all contribute to the fundamentals and eventually price. It is possible that the price of Bitcoin is at a delicate tipping point where modest but constant improvements in fundamentals as well as deflation from lost currency is currently very carefully balanced by inflation, and a reduction in inflation will tip the markets into a bull-cycle.
(7) It is entirely possible that the price of Bitcoin is largely inconsiderate of fundamentals. The idea of a currency with a guaranteed fixed supply is both an easy narrative to understand and also emotionally compelling. Cryptocurrency market bull cycles are largely characterized by extreme cases of FOMO and so news about adjustments to inflation seem like a perfect catalyst.
(7.1) Another bullish argument is to recognize that (1) and (2) are both very real concerns that should negatively impact the fundamental value of Bitcoin, but that a bull cycle fueled by the narrative of decreased inflation would cause an increase in the USD price of Bitcoin, and so although miners may be compensated less in terms of BTC, their income in terms of USD may hold constant or even increase, leading to an increase in fundamental network value. This would be a "fake it till you make it" outcome for the halving.
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Neutral Perspective:
(8) In terms of who pays miners for the security that the Bitcoin network enjoys, there is a balance between holders, people who own the currency, and spenders, people who generate transactions on the network that pay fees. At the inception of Bitcoin, holders paid nearly all of the money responsible for funding mining with early transactions being accepted with no fee at all. Eventually, Bitcoin is programmed to operate with mining funded entirely by transaction fees with no inflation imposed upon holders. Somewhere in this spectrum of trade-offs there is an optimal configuration which maximizes the fundamental value of the network.
(9) It is possible that the network is in its most valuable configuration at the limit where transaction fees are entirely responsible for funding security. With each shift towards decreasing the contribution from holders we are inching closer and closer towards a more valuable network. These events will each correspond with an increase in market capitalization.
(10) It is also possible that the final configuration which funds mining exclusively by transaction fees is unstable. The seasonality of Bitcoin transactions along with the increased friction of payments may lead to a network with poor security properties which causes fundamentals and therefore market capitalization to decline. Miners already operate with an unprecedented amount of volatility and perhaps they really depend on their BTC income to be stable in order for their operating risks to make sense. Under these concerns it stands to reason that the most valuable configuration of Bitcoin has some fraction of miner income coming from inflation via new currency generation. Under this assumption, the value of Bitcoin should increase as we approach this configuration and decrease as we move further away, so then the open question is, "Is this optimal configuration in our past, present, or future?"
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My Perspective:
I am partial to (1) playing out, which is that the total revenue in terms of BTC paid to miners for each block after the halving will be only slightly more than half of what they are being paid currently. I believe that this negatively impacts fundamentals and I disagree with (5) in so far I do not believe that Bitcoin has hit significant diminishing returns in network security. I am not confident now that Bitcoin could withstand large scale attacks by nation states and I especially don't believe this in a future where executing such an attack is decreased by a factor of 2.
I am also partial to 6 and 7. I believe that generally speaking, the fundamentals of Bitcoin have been monotone increasing, meaning that things have really only gotten better for Bitcoin in the last few years. This does not need to be the case going forward, for example large government regulations could take away from fundamentals as well as attacks against the consistency of the network, but so far these things have not occurred. I also believe that the market for cryptocurrency is largely inconsiderate of fundamentals and so a narrative such as the halving which may not impact them could still be a catalyst for increases of 3x in spot markets. I believe that if this sort of scenario plays out, the effect on price is only temporary and will not be meaningful on longer time-frames (1-2 years). Trading cryptocurrency in the past few years has taught me to never be surprised that the market is not respecting fundamentals for months at a time and I have no idea what the time-frame of this event would look like.
I find (10) to also be intriguing. I actually believe that Bitcoin is currently pretty close to an ideal configuration in terms of where miner revenue comes from. I have done some light napkin math on the economics of different inflation configurations, and right now I am not in a position to say if this upcoming halving makes things better or worse, but I am confident that 4 halvings from now in 2032, the network configuration will be less favorable then it is now so we are not too far off.
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TLDR: The upcoming halving of Bitcoin may have a number of impacts on the Bitcoin network and therefore spot markets that are both bullish and bearish. My personal opinion is that fundamentals will decline while temporarily the markets improve via trading the halving narrative, but eventually will converge to the decreased fundamentals. I have no idea what the time-frame of this temporary event would look like.
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I would love to hear everyone's opinions about what aspects of the bearish and bullish scenario they see playing out as well as other arguments or points of view I neglected to mention.
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