Disclaimer: Your capital is at risk. This is not investment advice.
Bitcoin Halving Series
The Bitcoin Halving is estimated to happen seven days from now, on 12th May around 11:30 am. Contrary to some unpopular beliefs, halving does not refer to the price. Halving means that the number of bitcoins rewarded to miners is cut in half.
At the present time, miners are rewarded 12.5 BTC ($112,500) for each successful block and will become 6.25 BTC ($56,250). The halving process happens every four years, well, every 210,000 blocks.
The exact time of the halving can only ever be estimated since the actual time depends on a combination of the Hashrate, the difficulty and some mathematical probability that goes far beyond my own understanding. As the halving approaches, a number of behavioural changes occur on the network. Through monitoring Bitcoin’s “on-chain” data in real-time we can put together a picture of how the network changes in the run-up, during and after halving.
Let’s start with the difficulty rate.
Difficulty is parameter that adjusts to keep the average time between blocks constant as the network’s Hashrate changes. Miner revenues, or at least a large part of them, come from the new bitcoin earned for adding new transactions to the blockchain – known as the block reward. The rate at which rewards can be earned is driven by the relationship between computing power (Hashrate) and the network difficulty. If miners increase their hashrate, by investing in more equipment and/or electricity, they are able to increase the amount of bitcoin they earn in the short run.
The difficulty level is continually reset by the network every 2,016 blocks in order to limit the rate at which revenue can be earned. It is the dynamic control that keeps new bitcoin being released to the miners as earnings every 10 minutes. If bitcoins are being earned in less than 10 minutes, the problem miners solve becomes more difficult. If it takes more than 10 minutes, the problem miners solve becomes easier.
The difficulty is an important concept to be aware of during halving events. During normal operation on the network, it is the difficulty alone that impacts miner revenues through regulating the distribution. Recall that the 12.5 BTC earned every ten minutes will drop to 6.25 BTC after the halving. The revenues will drop in half while the cost base remains the same. In effect, the marginal cost of mining a bitcoin will double.
How does this affect the network? A significant number of mining operations become immediately unprofitable and turn off their equipment, saving on the variable cost component of mining. When mining equipment is suddenly cut from the network, the rate that new transactions are added to the blockchain falls drastically. The already unimpressive 8 TPS that the network processes can go to an almost unusable 1 TPS. This essentially drives the network to a stand-still in the short term.
The critical number then is how many blocks there are between the halving event and the next difficulty adjustment – which is the period of time that miners must survive with double the marginal cost of production. For this, Bitcoin’s third halving event, there are 1,008 blocks from halving until difficulty adjustment, which should take seven days if the block times remain at 10 minutes per block. In 2012 it took up to 17 minutes per block until difficulty adjusted and was six days before the network returned to its 8 TPS rhythm. In 2016, block times rose up to 22 minutes per block and didn’t return to the baseline for 30 days.
As transaction throughput drops, the next thing to look out for is rising fees.
Fees are paid to miners to facilitate transactions in the Bitcoin Network. The size of the fee is technically voluntary, but transactions that designate a higher fee get prioritised. This is because miners are rational actors looking to maximise their revenues. If they include a transaction in the block, they get to keep the associated fee. The need for prioritising transactions comes down to the transaction throughput of the network. If there are more transactions than the 8 TPS throughput, the fee market hots up. This dynamic means that fees are a good gauge of the level of economic activity within the Bitcoin Network.
Fees have started to increase significantly over the last week and are likely to continue into and after the halving. While this is largely driven by a rise in investor activity, that is not the whole picture.
During times of vulnerability, leading actors of Bitcoin’s main rivals use its reduced transaction throughput to exacerbate the congestion problems. With throughput limited and the fee market rising, nefarious actors spam the network with low-value transactions in an attempt to further reduce the available block space. This dynamic further drives fees up. While higher fees make transactions more expensive for those using the network, they also serve to compensate miners for the drop in revenue from the block reward. Fees as a percentage of total revenue rise sharply during times of network congestions, as competition pushes absolute fees to local highs.
Miner’s Rolling Inventory (MRI)
The final major change to watch out for in the week leading up to halving is the miner’s inventory. Using on-chain data from the ByteTree terminal, we can track the Miner’s Rolling Inventory, or MRI. MRI measures the changing levels of bitcoin that miners hold in their inventory over a six-week period. Miner’s inventory is similar to a traditional supply chain. Inventory expands when production outstrips demand and contracts when the opposite is true. An MRI below 100% means miners are net holders of their inventory, and above 100% means they are net sellers.
Inventory management is a key component of running an effective mining operation. Miners that run tight profit margins or have poor balance sheet management are forced to liquidate inventories quickly. Miners that have secured a relatively lower cost base can afford to build their balance sheet, assuming they are long bitcoin. So what to expect from miners?
Modelling MRI over the last two halving periods, we have found that miners tend to increase inventories prior to halving, which the revenue in BTC terms is highest. Once the block reward halves, there is generally less new selling pressure in the market, driving up the price over the subsequent months. As rational economic actors, miners look to maximise the price they can receive per bitcoin. If a miners balance sheet is strong, they will hold on to the bitcoin and sell into a stronger market.
So there it is, three major movements to watch out for on the Bitcoin Network during the upcoming halving. ByteTree will be LIVE streaming the event with a host of leading Bitcoin thought-leaders to walk us through the action as it unfolds. You can find more information about this, or the metrics that we track, on our website and our academy page.