With Bitcoin halving approaching, it may be worth taking a look at the excellent analysis by James Bennett, CEO of ByteTree, on what to expect from the big event
Bitcoin halving is estimated to take place in seven days, on May 12, at 11:30 am. Contrary to some unpopular beliefs, halving is not about price. Halving means that the number of ‘rewarded’ bitcoins for miners is halved. Currently, miners are rewarded with 12.5 BTC (US $ 112,500) for each successful block and will become 6.25 BTC (US $ 56,250). The halving process takes place every 210,000 blocks, which takes an average of 4 years.
The exact time of halving can only be estimated, since the real time depends on a combination of the hashrate, the difficulty and some mathematical probability that goes far beyond my own understanding. As halving approaches, several behavioral changes occur on the network. By monitoring Bitcoin’s on-chain data in real time, we can build an image of how the network changes in the run, during and after halving.
Changes in mining difficulty and hashrate
Let’s start with the difficulty rate. Difficulty is a parameter that adjusts to keep the average time between blocks constant as the network hashrate changes. Miners’ revenues, or at least a large part of them, come from the new bitcoin earned by adding new transactions to the blockchain – known as block reward. The rate at which rewards can be obtained is determined by the relationship between computing power (hashrate) and the difficulty of the network. If miners increase their hashrate by investing in more equipment and / or electricity, they can increase the amount of bitcoins they earn in the short term.
The level of difficulty is continually reset by the network every 2,016 blocks, in order to limit the rate at which revenue can be obtained. It is the dynamic control that keeps the new bitcoin being released to miners as earnings every 10 minutes. If bitcoins are acquired in less than 10 minutes, the problem that miners will solve will become more difficult. If it takes more than 10 minutes, the problem that the miners will solve becomes easier.
Difficulty is an important concept to note during halvings. During normal network operation, it is only the difficulty that affects the mining company’s revenues through regulation of distribution. Remember that the 12.5 BTC gained every ten minutes will drop to 6.25 BTC after halving. Revenues will fall by half, while the cost base will remain the same. In effect, the marginal mining cost of a bitcoin will double.
How does this affect the network? A significant number of mining operations immediately become useless and turn off their equipment, saving on the variable cost component of mining. When mining equipment is suddenly cut off from the network, the rate of new transactions added to the blockchain drops dramatically. The 8 TPS, already inexpressive that the network processes, can reach 1 TPS, almost unusable. This essentially brings the network to a halt in the short term.
The critical number then is how many blocks there are between halving and the next difficulty setting – which is the period when miners must survive at twice the marginal cost of production. For this, in the third bitcoin halving, there are 1,008 halving blocks until the difficulty setting, which should take 7 days if the blocking time remains at 10 minutes per block. In 2012, it took 17 minutes per block until the difficulty was adjusted and it was 6 days before the network returned to its 8 TPS pace. In 2016, the blocking time increased to 22 minutes per block and did not return to the baseline for 30 days.
As the return on the transaction decreases, the next thing to watch for is the increase in fees.
Increase in rates before and after Bitcoin halving
Fees are paid to miners to facilitate transactions on the Bitcoin Network. The size of the fee is technically voluntary, but transactions that designate a higher fee are prioritized. This is because miners are rational players looking to maximize their revenues. If they include a transaction in the block, they keep the associated fee. The need to prioritize transactions is reduced to the net transaction income. If there are more transactions than the 8TPS throughput, the fee market increases. This dynamic means that rates are a good indicator of the level of economic activity on the Bitcoin Network.
Rates began to rise significantly in the last week and are likely to continue after halving. While this is largely driven by an increase in investor activity, it is not the general picture.
Keeping an eye on the miners’ inventory
During periods of vulnerability, the main players of bitcoin’s main rivals use their reduced throughput to exacerbate congestion problems. With the limited transfer rate and the fee market going up, nefarious actors send spam to the network with low value transactions, in an attempt to further reduce the available space in the block. This dynamic further increases rates. Although higher fees make transactions more expensive for those using the network, they also serve to compensate miners for falling revenue from the bloc’s reward. Fees as a percentage of total revenue increase sharply during periods of network congestion, as competition pushes absolute rates to local highs.
The main final change to be observed in the week before halving is the mining company’s inventory. Using chain data from the ByteTree terminal, we can track the miner’s rotating inventory, or MRI. Magnetic resonance imaging measures the varying levels of bitcoin that miners maintain in their inventory over a six-week period. The miner’s inventory is similar to a traditional supply chain. The stock expands when production exceeds demand and contracts when the opposite is true. An MRI above 100% means that miners are net sellers of their stocks and above 100% means that they are net holders.
Inventory management is an essential component to running an effective mining operation. Miners who maintain tight profit margins or have insufficient balance sheet management are forced to liquidate inventories quickly. Miners who have obtained a relatively lower cost base can afford to build their balance sheet, taking over long positions in bitcoin. So, what to expect from the miners?
Modeling RM in the last two halving periods, we found that miners tend to increase stocks before halving, whose revenue in terms of BTC is higher. When the block’s reward drops by half, there is generally less selling pressure on the market, raising the price in subsequent months. As rational economic actors, miners seek to maximize the price they can receive for bitcoin. If a miner’s balance sheet is strong, it will stick to bitcoin and sell in a stronger market.