Understanding the Bitcoin Halving

Introducing the Halving

Approximately every four years, something extraordinary happens within the Bitcoin network known as the “halving.” The “halving” describes the recurring event where Bitcoin’s issuance per block is cut in half. Every 210,000 blocks, or roughly four years, the miners’ production of bitcoin is halved, while their production cost stays the same. In addition to the effects on bitcoin mining businesses, the halving also has unique impacts to Bitcoin’s supply and demand dynamics. With the next halving currently set to occur sometime around April 2024, it is increasingly important to understand what this historically significant catalyst could mean for bitcoin investors. In this article, we explain what the halving event entails, how it impacts miners and the network’s security subsidy, the effects of programmatic supply changes, and how halvings have impacted bitcoin’s price in the past.

A Technological Overview – The Halving from a High-Level

For every block ever mined within Bitcoin, miners received compensation directly from the network for energy expended. This compensation is commonly referred to as the “block subsidy.” The block subsidy consists of both a payment from the network and an aggregate payment from users whose transactions were included in the block. The network incentivizes and pays for the continuation of miner participation with this subsidy, so there are incentives for miners to secure the network as long as bitcoin is valued.

Every 210,000 blocks, the Bitcoin code halves the total compensation awarded to miners for successfully mining a valid block. Thanks to a mechanism called the “difficulty adjustment,” new blocks are found roughly every 10 minutes. This means that the 210,000th block commonly arrives around the four-year mark. Another way of saying this is we can expect the issuance rate of bitcoin to halve roughly every four years. This monetary policy is set in code and unlikely to ever change. Simply put, Bitcoin’s monetary policy is not dependent on or impacted by politics or external economic factors.

Looking back at the beginning of the network, Bitcoin experienced an extremely volatile issuance rate as new participants came online and the network had to make multiple adjustments to find the average difficulty required for an average block time of 10 minutes. As time passed, the network found an average, only deviating during black swan events, such as a small issuance dip in June 2021, which coincided with China banning bitcoin mining.

During Bitcoin’s first four years of existence, the mining reward was 50 bitcoin per block. After each subsequent halving, the block issuance was reduced to 25, 12.5, and now to today’s current rate of 6.25 bitcoin per block. That gives the network an average inflation rate of approximately 1.8% today.¹

Looking forward to the next halving, the block issuance is expected to be cut in half again, resulting in a 0.8% inflation rate. The Bitcoin network is pre-programmed with 32 halving events, ending in the year 2140. To date, we have only lived through three halving events.

Is the Halving a Threat to Bitcoin’s Security?

What effects could reducing the issuance rate by half have on bitcoin? Let us start with miners who have a continuous energy cost. It is important to note that the difficulty of finding a block is constantly adjusting with the number of participants attempting to find a valid block solution. This causes the mining industry to face ever rising production costs and shrinking gross margins. Therefore, we can assume that miners must sell a majority of their bitcoin to continue operating. With an average block time of 10 minutes, Bitcoin pays out an average of 900 newly issued bitcoin per day.

A common concern with the halving is that miner revenue is fundamentally halved overnight. This comes without any inherent reduction in production costs. While the full subsidy from a block includes the reward payout and any additional fees collected from user transactions, there still are not enough user transactions to hold any weight against the loss of $12.6 million per day (this assumes a $28,000 bitcoin price multiplied by the reduction of 450 coins per day).

Since the 2020 halving, transaction fees have made up an average of around 5% of the block subsidy. However, the introduction of ordinals even surpassed the block reward of 6.25 bitcoin.²  While the halving is entirely predictable, allowing miners to plan accordingly, the bitcoin mining industry itself is extremely competitive. One incorrect business decision and the top mining farms may not exist tomorrow. We can see this play out historically by comparing today’s mining pools to the entire history of pools.

While the halving continuously lowers the amount of compensation in native bitcoin token terms, we haven’t seen the same thing in USD-denominated terms. Over time, miners have been compensated for their continued work as the price adjusts to the lack of new supply. Because bitcoin’s price is largely dependent on supply and demand, when the issuance is halved and provided demand remains the same, the price may be pressured to rise, all else equal. Here, bitcoin issuance appears to be declining, while USD-denominated revenue grows. Put simply, while miners may mine fewer bitcoin over time, their USD-denominated reward needed to pay for maintenance and electricity has continued to grow. On this chart, one can see the halving events and the miner’s revenues sharp decline. As time goes on, the supply shock sets in, and the price has historically rapidly risen to a new all-time-high. As the media craze and demand subside, an equilibrium is found and price levels out. However, each halving continues to reward the miners.

Bitcoin’s Fixed Supply Curve

In April 2024, Bitcoin’s issuance rate will be halved. In this cycle’s 210,000th block, the bitcoin reward will be 6.25 bitcoin and, roughly 10 minutes later, the reward will be 3.125 bitcoin. This change happens programmatically and without any input from external forces. 

A basic economic principle is the relationship between supply, demand, and price. Over time, as demand for a good increase, so too does price. If the price remains high and demand continues, new actors are incentivized to produce said good in search of these profits. As all of these factors react to each other, an equilibrium is eventually found between the supply, demand, and market price. With normal goods, there is a constant feedback loop between supply, demand, and price because the market is a process.

Bitcoin, however, only has two adjustable factors: demand and price. Bitcoin’s issuance is programmatically controlled by a simple mechanism called the difficulty adjustment. As mentioned earlier, the difficulty adjustment attempts to maintain an average block time of 10 minutes. A “block time” refers to the amount of time between each valid block being found by miners. This means that Bitcoin’s issuance is, on average, the same if 1,000 machines were trying to mine bitcoin, or 1 trillion machines were trying to mine bitcoin. In other words, even as demand grows for bitcoin, the market and networks cannot respond by increasing production of bitcoin in the same way that other goods can.

The inability to increase bitcoin production creates an inelastic supply matched by only a few other assets, such as physical land or dated collectables. Although, traveling back in time to produce more of a specific vintage of wine hasn’t yet been possible to our knowledge, humans have been able to create “artificial islands,” so this comparison may not hold forever.³

This is arguably a major feature that is commonly underappreciated when first studying Bitcoin. Drawing from an example given in a previous Research Round-Up by Jack Neureuter and Chris Kuiper, oil is a great example of why this supply feature is unique. While world demand for oil has steadily increased, oil’s long-term price has been decreasing. They conclude with, “the inflation adjusted price of a barrel of WTI crude oil has actually declined nearly 9% over the past 15 years, while demand is up approximately 14% (using prices as of the end of 2021 according to Bloomberg data).”⁴

This indicates that, over time, if the price of a product remains high, it incentivizes formerly less-economically viable means of production. With oil, the higher price inspired new drilling techniques, such as fracking. An increase in production (issuance increase) helped bring prices down over time despite continued rising demand. In contrast, Bitcoin cannot bring about new means of production and increase the supply more than what is already programmed. While technological advancements may bring about more efficient and quicker hash attempts, as the hash rate grows, the difficulty adjustment will continue to keep the block time at an average of 10 minutes.

Effects of Halving Issuance

In a previous research article, we compared Bitcoin adoption to that of cell phones and the Internet, showing that Bitcoin adoption was on a similar adoption curve. It is clear that adoption is rising, but consider a scenario in which adoption was stagnant.

In this example, we will give a simplified overview of how issuance can impact demand. Using today’s bitcoin price of roughly $28,000, and to keep the numbers simple, we are assuming all newly mined bitcoin enters the free market. The newly mined bitcoin is entering the market at the current issuance rate of 900 bitcoin per-day (6.25??? ∗ ( 60/10) ∗ 24ℎ????). Demand can be denoted as the USD amount required to offset newly mined bitcoin being sold at market price, ($28,000 ∗ 900) worth approximately $25 million. Without any change to price or demand, the halving reduces the issuance from 900 to 450, ultimately halving the sell-side pressure. Now, there are only 450 new bitcoin issued per-day (3.125??? ∗ ( 60/10) ∗ 24ℎ????). To maintain a stable price of $28,000 with half of the new issuance($28,000 ∗ 450) there only needs to be $12.6 million of demand. If demand remains unchanged ($25 million of buying), the price must soon correct to match the demand.

Furthermore, by using the adoption curve laid out by Jack Neureuter, we can see that not only is demand not stagnant like in the example above, but it is growing at an increasing rate. The programmatic issuance rate, with a simultaneous growth in the demand curve, could lead to an upward correction in price.

Can the Halving be Priced in?

If the halving reduces supply and demand remains constant, price must increase all else equal. But if the halving is a known event, can’t the forward-looking market already account for it in today’s price? While there is considerable debate on this topic, we believe there is at least one compelling reason why it cannot be priced in, and in the next section, we explore historically if it has been “priced in” in terms of past market performance.

One reason the market is unable to price in the halving event lies in Bitcoin’s infrastructure and incentives, particularly the fact that there is a cost of production for bitcoin and multiple industries related to bitcoin production. These serve as alternative uses of capital and ways to obtain exposure to bitcoin without buying or selling spot bitcoin and, as such, they produce an arbitrage opportunity between spot bitcoin and bitcoin’s cost of production.

One explanation of this is the “Energy Gravity Model” by Blockware Solutions where they describe a concept in which bitcoin mining participants will always be willing to expend energy for a profit.⁵ Because of the difficulty adjustment and proof-of-work mining, the cost of bitcoin production automatically gravitates toward the market price. Any outbreak of price to the upside expands this gap, making alternative investments in bitcoin mining and related infrastructure relatively more attractive.

In other words, if bitcoin’s price were to skyrocket today in anticipation of a supply shock, current miners would see an increase in revenue and margins. It would become relatively cheaper to produce bitcoin than to buy it at the spot price. Investors would be incentivized to shift their capital into mining or mining-related investments and either sell spot bitcoin or stop bidding up the bitcoin price, closing the gap between spot bitcoin and block subsidy rewards. High bitcoin prices would also incentivize new capital to flow into the mining industry over buying spot bitcoin, eventually lowering the margins between electricity costs (cost of production) and the block subsidy. However, the process of acquiring new mining machines can take some time. Therefore, price has historically preceded hash rate.

Bitcoin’s incentives structure essentially demands an equilibrium between miners selling their bitcoin and inflows from old and new buyers.

Today, bitcoin trades around $28,000. For the bitcoin price to reflect the halving today, the mining industry would have to grow as well. Imagine the price was now trading at $56,000 because users are anticipating the next halving. In this example, miners would not need to sell as much bitcoin to pay for the energy costs and their margins would have nearly doubled.

With newly expanded profit margins, miners can sell the additional bitcoin at an extreme profit. The amount of new money required to absorb the newly minted bitcoin at the $56,000 price changes from the previous $26 million (900??? ∗ $28,000) to $50.4 million (900??? ∗ $56,000). This means that, for the halving to be “priced in,” the demand for spot bitcoin would have to double. While this scenario isn’t impossible and price volatility is not out of the question, the bitcoin mining industry’s incentive structure will increasingly curtail demand away from spot BTC as price and hash rate decouple, making it more difficult for the halving to be priced in.

Has the Halving Been a Positive Catalyst for Bitcoin?

Here, we take a closer look at the year leading up to the past three halving events. Comparing the historical price to the price on the day of the halving, price remains volatile, but as time progresses, the trading range is not as large. This could be because of the growing mining industry and maturation of financial markets allowing for new vehicles that offer exposure to spot bitcoin and mining. In turn, this could be the reason for less volatility leading up to each halving event. As mentioned previously, a higher price that increases revenue for miners reduces demand for spot BTC and, instead, turns capital towards the mining industry or other more relatively attractive alternatives.

However, when zooming out to post-halving, we see higher returns compared to pre-halving. Before Bitcoin had reached a market cap of over $150 million, the first halving took place. Roughly a year later, bitcoin’s price had rallied approximately 9,100% and its market cap peaked at just over $13.7 billion. These astronomical returns were most likely a one-time event. The combination of a small asset market cap and a flurry of hype around price growth led to an abnormal and unsustainable price surge. This eventually led to the first substantial “crash” of -75% and caused multiple obituaries to be written for Bitcoin throughout 2014 and 2015.⁶ 

In this chart, the first halving’s expansive increase was removed to more clearly discern the most recent outcomes from the next two halving events. The second halving led to a price peak of 2,913% roughly a year and a half later. The market cap on the day of the second halving was roughly $10 billion and peaked around $329 billion. The third halving’s price peak growth was 686%, also around a year and a half later. Bitcoin’s market cap on the day of said peak reached just shy of $1.3 trillion.

Below is a summary of bitcoin’s market cap appreciation. Each row of data starts with the day the halving takes place, the starting market cap, and then goes through the approximately four years until the next halving date. The “Peak Market Cap” and “Peak % Change” shows the market cap high after the halving, what percentage it appreciated, and how many days it took to reach that high. The “Halving to Halving % Change” details how much the market cap appreciated over the approximately four years from the start of the halving until the next one. For example, the second halving occurred on July 9, 2016 when bitcoin’s market cap was approximately $10.2 billion. From then, it rallied to reach a peak market cap of $328.9 billion, a 3,103% increase, on December 16, 2017, 525 days after July 9, 2016. The market cap ultimately settled back down to $157.9 billion when the third halving occurred on May 11, 2020.

It should be noted that the ‘Halving to Halving % Change’ in the ‘First’ row uses the data from 11/28/2012 to 7/9/2016.

A Convenient Expansion in Global Balance Sheets

Another viewpoint worth noting is the convenient alignment between Bitcoin’s creation and subsequent halving events with global liquidity cycles. Bitcoin was born amid the fallout of the 2008-2009 financial crisis and so, its halving schedule has largely coincided with global liquidity cycles.⁷ This may mean the halving event alone has less significance than historically believed. Here, we can see that many of the global Central Bank’s balance sheet growth and contraction periods line up quite neatly with the four-year cycle of the halving, as well as the ups and downs in BTC prices.

However, it is crucial to consider if the world economies’ liquidity cycles will continue operating within this ostensible four-year cycle. If the Fed were to loosen monetary policy again by the end of 2023 or early 2024, this would once again coincidentally align with the halving. With the last two years being a difficult period of pullbacks, it would not be an unforeseen outcome.

A Programmatic Event Worth Understanding

The fourth bitcoin halving is ~79% of the way here at the time of writing. Bitcoin’s total supply is predetermined, issuance is programmatically inelastic, and adoption is growing at a rate similar to that of prior revolutionary technologies, such as the Internet and mobile phones. It may take some time for a supply shock, but historically, extreme volatility has typically followed halvings. While history may not repeat itself, it can rhyme, which is why so many pay close attention to the upcoming bitcoin halving event.

We will be keeping an eye on Bitcoin and the halving as it approaches, and Fidelity Digital Assets will provide timely updates as the halving block of approximately April 2024 nears. 

In this updated report on the Bitcoin halving, we dive deeper into the economics of the halving from a miner’s perspective, investigating historical trends in hash rate, miner efficiency, and the difficulty adjustment, which all play crucial roles in Bitcoin’s incentive structure.