What is the Halving?
The Bitcoin reward halving (known as the “Halving”) is an event scheduled to occur approximately every 4 years. The Halving marks the moment when the block reward (the reward granted to a miner for inputting a new block in the Bitcoin blockchain) is halved, in this case being reduced from 12.5 BTC to 6.25 BTC per block. The block reward comprises the entirety of Bitcoin’s new issued supply, which new issue ultimately acts as downward price pressure either in the form of direct sell pressure in the market or diverted demand - but more on this later. Following the Halving, Bitcoin’s new issue rate will be approximately 1.8% per year, lower even than that of Gold’s. While it’s fairly simple to understand how the Halving impacts the supply side of the Bitcoin market, it’s a bit more difficult to grok the demand-side impact.
An Overview of the Bitcoin Mining Investment Model
To understand this phenomenon, we must understand the fundamentals of the Bitcoin mining investment model. There are two primary input costs to Bitcoin mining, a large upfront expense to purchase mining equipment and ongoing energy consumption expenses to operate the equipment. Historically, mining equipment has a shelf life of 24-36 months before becoming obsolete. Think of it similarly to your computer or iPhone that becomes less capable over time.
The investment behavior surrounding bitcoin mining is tantamount to a futures contract, where the miner is agreeing to purchase [x] amount of bitcoin at [y] price (while making certain assumptions regarding how many people will compete to mine) with periodic physical delivery of the new bitcoin. When mining competition is low (relative to bitcoin price), this “mining futures contract” is a more attractive venue to accumulate bitcoin - which leads to an increase in new mining activity until reaching an equilibrium where cost to mine roughly equals current spot price minus certain margin to compensate for the overhead, headache and longer term risk of taking on the mining position. To use futures terminology, during periods of low competition, the “contract” would be in backwardation.
When mining competition is high, the margin diminishes or evaporates entirely. As such, miners will generally steer capital toward mining when relative value benefits mining behavior or toward purchasing the underlying when relative value benefits direct purchase. Again, using futures terminology, when mining competition is high, the “contract” would be in contango.
Are Miners True Bitcoiners or Just Opportunists?
Miners fit into one of two camps: (1) arbitrageurs, or (2) long term holders.
The arbitrageurs are largely not interested in the long term value of bitcoin or its ecosystem (beyond their ability to mine below prevailing market price during their applicable investment period). Arbitrageurs don’t speculate on price more than necessary to operate the business of mining and generally sell their mined bitcoin for fiat as received. This inherent sell pressure from arbitrage miners will be greatly diminished post-Halving.
Long term miners are speculating on the future maturation and viability of the bitcoin marketplace (and associated price increases that would presumably follow). These miners may otherwise allocate capital to accumulating the underlying through direct purchases but are electing to accumulate by deploying that capital toward mining equipment and energy costs. Following the Halving, the “equilibrium price” of bitcoin will roughly double. As such, it will make far more sense for these miners to allocate new capital toward direct bitcoin purchases as opposed to expanding mining equipment. If these actors remain committed to the network (as I believe they are), this will translate to increased demand in addition to the decreased new supply in the market.
In fact, over the past six months, we have seen miners begin to retain significant amounts of their block rewards. This behavior is nearly identical to miner behavior leading into and following the last Halving.
Market Cycle: Indicators of Mining Cost vs. Underlying Price
As discussed, miners will mine (or add to their mining capacity) to the extent “cost to mine” is below the prevailing underlying bitcoin price. This behavior ensures that cost to mine will generally equal the cost of the underlying. Because mining equipment is limited in supply (it needs to be manufactured and there can be lag time between new demand and available supply of equipment) and because there is a long-term commitment to bitcoin through mining, the average cost to mine lags bitcoin’s spot price. It can be thought of as operating similarly to a moving average of bitcoin’s price.
How do we know whether mining activity produces bitcoin (in aggregate) at a discount to prevailing spot pricing or whether mining capacity has increased to the point of reaching or surpassing equilibrium (i.e. whether the “mining contract” is in backwardation or contango)?
The best metric is observing moments when significant mining power drops off the network following a price correction - indicating that the relevant breakeven price level was breached for a measurable portion of the mining community. These moments are often referred to as “mining capitulations.” Certain investors believe that the “shake out” of weaker miners is what leads to the frequently bullish price action following these “miner capitulations.” I disagree and believe that because mining has reached equilibrium, certain capital that would otherwise be directed toward mining is directed toward underlying spot purchases.
(“Miner Capitulations” are indicated by red periods in the indicator below Bitcoin price in the price chart above.)
The Halving is a little more than two weeks away and there was a significant miner capitulation in March. The data suggests that we may see increased demand (in the form of diverted mining resources) in addition to the reduction in new supply. The confluence of these factors results in an incredibly favorable market structure which I believe should lead to price tailwinds for the remainder of the year.
Thoughts? Comments? Please reach out to me on Twitter @jyashouafar - I’d love to continue this conversation.