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    Posted by James McQuillan 7 Aug
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    Bitcoin Halving - Here's Why it Matters

    The best kinds of events happen every four years, it seems. We need only look at the sports world to get some testaments to that effect. The World Cup taking place every four years, same with the Olympic Games.

    For the blockchain world behind Bitcoin - its supporters have something to look forward to - which is the halving block rewards for miners. This won't be the first time that this has happened; block rewards depreciated for the first time back in late 2012, having dropped from 50 to 25, and then again to 12.5 Bitcoin in 2016. The third halving event will be taking place on or roughly around May 20th, 2020.

    This event will see the block rewards halved once again from 12.5 to 6.25 BTC.

    It remains to be seen whether it was by pure coincidence, or a pre-meditated design choice, but the last two price cycles have been oriented around the halving of block rewards. So to better understand what we have in store for us, it's important to take a look back at the last two halvings and the kind of impact they both had on the metrics of supply, demand and price of Bitcoin.

    The goal of this is to formulate a more empirical explanation for the kind of price cycles that we've previously seen with price cycles. Inevitably, the aim is to offer some insight for investors curious about what's going to be happening in the foreseeable future.

    First up - the First Halving of 2012 and the Associated Retail Cycle

    So why is it that it gets the nickname 'retail cycle'? It's mainly because at this time, Bitcoin was still on the veritable fringes of the investment market, managing to obtain its first inches of traction through its adoption from technologists and retail investors. It's at the beginning of this cycle that the entire economy behind Bitcoin remained relatively minuscule in the minds of any investor: and hardly one they would consider as an investment opportunity.

    In addition to this, before the beginning of the first halving in this price cycle kicked off, the prior cycle ended with the overall price for Bitcoin slumping by well over 90 percent: plummeting from 31 dollars to hit just 2 - all in the space of 5 months during 2011.

    Fortunately, Bitcoin's price managed to get back on track in November of the same year up to the first halving during November 2012, and continued to rise significantly over 2013 to hit a record high of more than $1,200.

    If we take a look at some of the candlestick metrics from 2012 to November 2013 - we can see a pretty impressive symmetrical pattern to Bitcoin's performance.

    Description: https://miro.medium.com/max/1400/1*1HXBEMtsvbScAtBI_LO3ag.png

    Metrics courtesy of Yahoo Finance

    One of the reasons that we see this otherwise impressive surge in the price happen is thanks to the halving which occurred shortly before - with Bitcoin surging up to 13 dollars just before the halving took place, and started reaching startling highs of $1,200 afterwards.

    To put this into perspective, the kind of appreciation that Bitcoin endured from late 2011 to 2013 was akin to increasing 350 to 400 times, depending on the price and liquidity you look at. Any multiplying of this value came predominantly after the halving as we can see.

    While this made for a pleasant surprise for investors and technologists that newly enfranchised themselves. The rally was followed by a pretty steep recession which lasted for more than 14 months. This saw the underlying price of Bitcoin fall by more than 80 percent, before hitting strong lower supports at 200 dollars. From there Bitcoin's price managed to consolidate around the 200-300 mark through the next 10 months.

    The Venture Cycle - Bitcoin's Second Halving

    This is where Bitcoin becomes a lot more interesting to the world that previously shrugged it off during its last cycle. Hence why we ought to refer to this one as the venture cycle, predominatly because a number of venture capital firms along with hedge fund got a first look at the meteoric first cycle that Bitcoin enjoyed.

    This resulted in them really buying into the concept of digitalized / decentralized money the Bitcoin espoused. Meaning that far more speculative investors started entering the market during this cycle.

    In addition to these individual investors, a good number of crypto-related hedge funds were established and started doing business; and while a good number of these would prosper over this cycle, a large number of them were unable to survive the crash that followed shortly thereafter. Even with the crash, there were more than 150 that continued on to the next cycle at least.

    It's over this cycle that Bitcoin managed to substantially rise from the beginning of November 2015 when the second halving price cycle got started. It's during this span of 8 months that this rally continued well ahead of the July 2016, when the halving would take place.

    This same cycle and surge continued on for a span of 24 months, much akin to the previous cycle, until Bitcoin managed to reach its all time record high of more than $19,000 in December 2017.

    Description: https://miro.medium.com/max/1400/1*FE0gt2oOmEFscLRxVElePg.png

    Price Source: Yahoo Finance

    The lion's share of this appreciation, even with the rally before July 2016, came after the halving event. Ahead of this, Bitcoin only managed to reach $650, before managing to go parabolic to $19,000 and beyond.

    Once again, Bitcoin's valuation increased only threefold before the halving took place, with the majority being after.

    As many of us know by now, this meteoric upward surge was followed swiftly by a year long recession for Bitcoin. This saw its price plummet by more than 80 percent, before hitting a stong lower support of $3,000. Over the next four months, Bitcoin's price consolidated around the $3,000-$4,000 range.

    The Institutional Cycle and The Third Halving Cycle

    Bitcoin's price managed to bravely continue trading upwards, hitting its upper supports of $5,000 back in April 2019, and has since pushed beyond this to reach over $9,000 and peaks of over $10,000 in what can almost be described as the beginning of a brand new halving cycle.

    Description: https://miro.medium.com/max/1400/1*_iRamMDXOFwel4VkEBEeXA.png

    Price Source: Yahoo Finance

    One of the things that makes this (most recent) cycle so unique is the kind of relationship it has with institutional investors compared to previous ones. In prior investment cycles, not a single major name participated in them - until this one. Some of the big examples of this dramatic shift come from businesses like Fidelity, which will be coming out with its own crypto trading solution in the future.

    JP Morgan, and its CEO, Jamie Dimon have also been subjected to a pretty interesting 'about face' on the prospect of involvement with cryptocurrencies. Dimon himself made sure that no-one was unsure of his position regarding Bitcoin in 2017-18, calling it a fraud on a number of occasions. Since then, JP Morgan has begun running tests of its own crypto known as JPM Coin

    The likes of Facebook, Google and Twitter also having imposed bans on the advertisement of cryptocurrencies in 2017/18 have made pivots of their own. None more than Facebook which has been planning (and struggling) its own stablecoin solution - Libra - in conjunction with a substantial amount of globe-trotting institutions.

    While the solutions brought forward by both JPM and Libra don't directly support Bitcoin. They represent a change in the proverbial winds for investment for cryptocurrencies that were previously at the very edge of the investment fringe just years before.

    With this new pool of institutional investors and regulators comes an increasing degree of skepticism when it comes to the wide array of projects, cryptos and businesses out there looking for investment. These same investors are likely taking time to consider whether they should be supporting/investing in a decentralized or distributed currency like Bitcoin, or submit the control of currency to major corporations and financial institutions.

    The Halving Cycles - Their Shape

    Here are some of the major findings that we've managed to see from the previous cycles.

    First Halving (28th November, 2012)

    Price rally - Increased four-fold before halving before increasing in value by 350-400X

    Rally Duration - 12 month rally before halving and increased valuations 12 months after (24 months)

    Post Rally Decline? - Yes, Bitcoin declined by 0.83 times its value before accumulating at around 200-300 dollars for around 10 months afterwards.

    Second Halving (9th July, 2016)

    Price Rally - Bitcoin managed to increase in value three-fold before the halving took place. After this, Bitcoin's value increased by more than 90 times.

    Rally Duration - Appreciation began roughly 9 months before the halving took place. Once the halving happened, price appreciation increased for 16 months after.

    Post Rally Decline? - Yes, Bitcoin slumped over a span of 12 months, shrugging off 0.84 times its value before consolidating at a strong range of around 3 to 4,000 dollars; more than 10 times its previous accumulation/lower support threshold.

    Third Halving (Estimated to take place around 20th May, 2020)

    While a certain amount of this remains theorizing, we are currently seeing an impressive rally over the course of 13 months; managing to push above its previous lower supports of 3-4,000, hitting upper supports of nearly $10,000.

    There are some pretty interesting numbers and recurring patterns from the halving cycles that we've seen so far. But there's one question that remains the most outstanding of them all. And that's why the vast majority of the rally happened after the halving took place as opposed to before?

    These occurances are not spontaneous; they're well known and considered deeply by members of the Bitcoin community. As a result, markets are quick to anticipate the kind of impact that it will have on supply and demand. But with that said, you would think that Bitcoin and its associated markets could then consolidate long before the halving; rendering its impact a lot more muted.

    One of the more obvious answers to the above-mentioned questions would, however, be that with a cut to block rewards, investors would see this as a critical buy time. With Bitcoin being injected into the ecosystem at a reduced pace, this could cause reactionary buying? But it's worth digging into this a little bit more.

    Supply and Miner Revenues

    The price of any asset, regardless of what kind of market they're situated in, will always inevitably balance out supply and demand after a while. As previously, and briefly discussed, one of the primary explanations for why Bitcoin's halving results in a higher over time is the fact that it's supply-side oriented, and hinges on miner activities.

    These miners play a major role, on account of the Proof of Work consensus system that Bitcoin hinges on; confirming transactions within the network. Having successfully confirmed transactions, these miners are then rewarded with new minted Bitcoin for their efforts.

    This effectively makes them marginal suppliers that often hold or sell off the newly minted Bitcoin that they earned, effectively adding it to its total circulating supply. With any halving that takes place, the amount of new Bitcoin that miners contribute to the economy at large diminishes. As a result, users within the community will demand a higher price for it.

    This is the same kind of logic behind trading as a whole; if there's a smaller pool of Bitcoin, buyers will shell out even more money.

    One of the other components that comes into the equation of supply that isn't the subject of much discussion. These same miners actually provide two kinds of revenue - the new bitcoin that they 'mine' along with the fees of any transactions that they confirm.

    The latter is actually more interesting to discuss - especially considering the fact that once all 21 million Bitcoin have been mined and added into circulation, transaction fees will be the only source of revenue for these miners.

    While these transaction fees originate from peer to peer transactions in the existing BTC supply, there's really no difference in the perspective of miners as a source of revenue. Miners are just as likely to sell any Bitcoin that they obtain in order to cover the expenses they accrue over time, such as staffing (if they're big enough), electricity, hardware, etc.

    One of the equations that can help to get to the bottom of the matter of marginal supply is likely the following:

    Marginal Supply = Miner Revenue = Bitcoin Mined + Transaction Fees

    The Daily Amount of Bitcoin Mined

    Before the first halving event, there was a daily mining volume of more than 7,500 Bitcoin being mined on a daily basis and added into the total circulating supply. Once the first halving occurred, this decreased to around 4,000 in the same duration. With the having of 2016, this same daily amount decreased to 1,900-2,000. With the next halving, this will depreciate to roughly 1,000 Bitcoin per day.

    Description: https://miro.medium.com/max/1400/0*aavwXdfDdmKbgOao

    Source: coinmetrics.io

    If we look at the same in terms of US Dollars, and we see a very different kind of pattern and picture. When the first halving took place, the price of Bitcoin was roughly $13, with the daily supply reduced to 4,000 BTC. In Dollars, this equated to a reduction in the supply worth $52,000.

    When the second halving took place, the price of Bitcoin was $650 when it happened. Meaning that the supply fell by more than 2,000 BTC (1.3 million dollars).

    So hypothetically, if Bitcoin's price remains relatively static up to the beginning of the next halving, meaning that it hangs around the $10,000 mark. At that kind of price, the reduction in daily supply hits 1,000 BTC, which amounts to $10 million

    With these kinds of numbers, that's a reduced supply with a price tag of roughly $300 million. And over the span of a year, that's more than 3.6 billion dollars.

    Reduction in Bitcoin Liquidity With Halving

    This overally drop in marginal supply has a knock on effect to the underlying liquidity. But how do you actually go about measure it? The best way is through an inflation rate for Bitcoin, which directly compares the newly included supply with the total circulating supply, but still doesn't offer a meaningful metric.

    This is mainly because a large section of the Bitcoin supply is not technically liquid - they have held in a number if investors wallets for months, even years.

    One of the other kinds of metrics we could use is a comparison of the reduced liquidity due to any of these halvings with the daily exchange trading value. Sadly, the trading volume that is reported by cryptocurrency exchanges tend to fluctuate depending on the exchange you're using as a reference point. Meaning that they're not inherently reliable.

    One of the studies Bitwise provided for the US Securities and Exchange Commission demonstrated that a staggering 95 percent of the trading volume on exchanges should be treaded as suspicious to a certain extent.

    With reference to metrics from CoinMarketCap, more than 2 million Bitcoin-related trades on crypto exchanges take place on a daily basis. With the current block reward rates that miners enjoy, the equates to 2,000 BTC being added to the liquid supply of Bitcoin every day. Taking this to over spans of time - that's 60,000 new Bitcoin entering into liquid supply monthly, and nearly three-quarters of a million every year.

    What this also means is that the market has all the capability to absorb over 2.75 million BTC into its annual liquid supply. With the halving of these block rewards next year, and the reduction of this circulating supply to 1,000 BTC being mined daily, this would lower the supply to 2.365 million. Roughly, this equates to a 13 percent reduction in annual liquid supply.

    Conversely speaking, if we are to regard the reports that 95 percent of reported trading volume is suspicious, then this actual volume would be a lot closer to 100,000. And with the next halving, this would cut down the annual supply from 830,000 to just about 465,000; meaning an annual reduction of 44 percent in the liquid supply.


    A Rounded Up Explanation

    So, let's go ahead and use the kind of evidence that we've accrued so far in order to formulate some kind of explanation for these kinds of price cycles.

    Considering the growing narrative of Bitcoin as some kind of Digital Gold has gained an increasing amount of momentum, the demand for Bitcoin has risen unsurprisingly. This is demonstrable from the increasing number of digital and physical wallets, transactions, searches as well as media coverage on a broader basis.

    According to some of the halvings that we've seen from the Bitcoin community, these cycles have undergone the following phases.

    • Pre-halving - The halving event results in an understandable reduction in the liquid supply of Bitcoin (this is still hard to measure due to the trading data being broadly unreliable). Bitcoin price ends up undergoing a sustained rally in anticipation of the halving event.
    • After Halving - This increase in the price of Bitcoin attracts an increasing demand from investors of all kinds including VCs, institutional buyers, hedge funds, etc. This increased demand exceeds expectations, as the price continues to surge upwards after the halving takes place. This increase in demand comes from a rising price, which was grossly underestimated, in prior cycles.
    • Pricing Bubble - This increase in prices fosters a broader Fear Of Missing Out (FOMO) among buyers and attracts a higher volume of speculation among investors. A bubble forms around the value as they hit record highs. These speculative prices cross the threshold between the stable and unsustainable, with the bubble inevitably bursting.
    • The Crash - This price crash results in a respective reduction in investment demand, much in the same was rising prices lead to a respective increase in demand, with a number of investors leaving the pool.
    • A New Base - Bitcoin manages to find a stable price point, consolidate and find equilibrium at the price of this marginal supply. It then forms a brand new base that is otherwise higher than the previous cycle base.
    • And Back to Stage One

    It remains important to clarify here that this kind of logic hinges on the overt demand that is conjured up by Bitcoin as a kind of Digital Gold in the mind of investors, as well as its already known position as the first crypto asset.

    One of the points of contrast to consider is the function of Litecoin, which is a hard fork derivative of Bitcoin. Its own kind of halving is pretty interesting to keep an eye on as it lacks a generally strong narrative and demand, especially in comparison to Bitcoin. As a result of this, Litecoins cycles have not followed the same kind of pattern.

    Markets are highly febrile, volatile and yet, highly intelligent things - they learn and evolve - with these two cycles, there are subtle differences between the two. The next halving cycle will be interesting to keep an eye on.

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