Sunday, July 12, 2020

Bitcoin Halving: Explaining this Powerful Phenomenon

Bitcoin halving

Understanding the Bitcoin halving, the latest shift in the murky world of cryptocurrency

 

By Monika Ghosh

 

Table of Contents

  1. Introduction
  2. A brief history of halving
  3. Real-world adoption grows
  4. Impact on Bitcoin price
  5. Impact on Bitcoin transaction fees
  6. Impact on the Bitcoin mining community
  7. Diminishing Chinese dominance in Bitcoin mining
  8. Clarity on crypto gains taxation: a positive shift

 

 

Introduction

 

The Bitcoin halving that took place on May 11, the third halving in the cryptocurrency’s history, was easily the most awaited event in the crypto world, with some even celebrating its arrival through virtual parties amid COVID-19 lockdown.

 

Bitcoin halving refers to the phenomenon of reduction in the supply of Bitcoins that are rewarded to miners. To understand what Bitcoin is, why miners are rewarded with it, and how it works, read our explainer here.

 

In essence, what sets Bitcoin apart from other assets is that its supply is finite. Satoshi Nakamoto, Bitcoin’s pseudonymous creator, designed the software to release only 21 million Bitcoins over the years, and no more.

 

As of May 20, there are 18.38 million Bitcoins in circulation, leaving a little over 2.6 million Bitcoins to be mined, and all Bitcoins will be mined by the year 2140.

 

In order to ensure complete transparency, all Bitcoin transactions are broadcast to the Bitcoin network, and are confirmed within 10-20 minutes through a process called ‘mining,’ which is equivalent to a competitive lottery.

 

In Bitcoin mining, a group of people use powerful computers to run complex calculations in order to guess a random number that solves a complex equation generated by the system. The more powerful the computer, the higher its hash rate or the number of guesses it can make per second, thereby increasing its chances of success.

 

The computer that solves the equation gets the opportunity to update the blockchain by confirming all the Bitcoin transactions in a certain timeframe and arranging them into a block. This enforces a chronological order in the blockchain, protects the neutrality of the network, and allows different computers to agree on the state of the system.

 

Bitcoin miners are rewarded Bitcoins and a part of the transaction fees as a reward for their efforts to update the blockchain. The number of Bitcoins offered to miners is cut in half after every 210,000 blocks mined, or approximately every four years, and is known as Bitcoin halving.

 

 

A brief history of halving

 

In 2009, the mining reward for each block mined was 50 Bitcoins. The first halving took place in November 2012, when the reward was reduced to 25 Bitcoins per block mined, followed by a second halving in July 2016, when the reward per block became 12.5 Bitcoins. The third halving has brought the number down once again, this time to 6.25 Bitcoins per block mined.

 

In order to understand the significance of the event, its impact on investors and miners, and the future of Bitcoin, we spoke to Henri Arslanian, who is the PwC Global Crypto Leader and Partner, the Chairman of the FinTech Association of Hong Kong, and an Adjunct Associate Professor at the University of Hong Kong where he teaches the first FinTech university course in Asia.

 

According to Arslanian, the timing of the Bitcoin halving is “ironic” as Bitcoin’s supply is being cut in half at a time when we are going through “the biggest quantitative easing in financial history,” with Central Banks around the world increasing the supply of money in an attempt to revive their economies from the devastating impact of COVID-19.

 

“I expect this Bitcoin halving to generate more interest, not only for Bitcoin, but also on how money is created, and the purpose of money in society. I also expect that an increasing number of investors will now look at Bitcoin as an asset to hedge themselves from inflation,” says Arslanian.

 

 

Real world adoption grows

 

Last week, Founder and CEO of Tudor Investment Group and investing legend Paul Tudor Jones became one of the first institutional investors to buy Bitcoin, as a hedge against inflation.

 

In his letter to his clients explaining why he authorized the investment on Bitcoins entitled ‘The Great Monetary Inflation,’ he predicts a global inflation with the excess money being pumped into the global market because of money-printing.

 

“The best profit-maximizing strategy is to own the fastest horse,” Jones wrote. “If I am forced to forecast, my best is it will be bitcoin.”

 

He went on to write that Bitcoin reminds him of gold in 1976, when consumer prices were going through the roof.

 

“Gold had just been productized as a futures instrument (like Bitcoin recently) and had enjoyed a heck of a bull market, almost tripling in price. It then corrected almost 50% in nearly two years similar to Bitcoin’s 28-month 80% correction!” he wrote.

 

In the current state of global economic uncertainty, where safe assets are hot commodities, Tudor added that there may be a “growing role for Bitcoin” to hedge against inflation.

 

 

Impact on Bitcoin price

 

There were endless debates in the crypto community on whether the Bitcoin halving would lead to an increase in the price of Bitcoin or not.

 

“Frankly, it’s not as if because the halving was going to happen, that the price was automatically going to jump the next morning. And if that happened, it would mean that the price discovery and the crypto markets were not efficient at all,” says Arslanian.

 

“The beauty of Bitcoin is that this halving has been known for many years – it was predictable, it was very transparent, and it was very open. Everybody knew this was going to happen,” he adds. While difficult to tell at this point whether a market correction in Bitcoin price is complete or not, Arslanian says the halving strengthened Bitcoin proponents’ argument that Bitcoin is a relatively scarce resource.

 

This year’s halving also garnered a lot more attention than the last halving in 2016, because the number of people following the crypto ecosystem is significantly higher than it was four years ago.

 

There have also been many reports of Bitcoin prices reaching or going beyond $10,000. However, according to Arslanian, price as a milestone is just one of the things that experts in the crypto industry look at.

 

“I would say that anybody who’s looking at the crypto ecosystem, who works in it, they’re looking even way beyond $10,000, like the number of institutional investors entering the space, number of new solutions that are using digital assets, and so on,” says Arslanian.

 

“I think the price of bitcoin is great and whether it goes up or down is one thing, but I think that most people who are in the crypto ecosystem, are in it for a very long time, and they really believe it is the future of finance. It’s the future of money. So I think [the $10,000 milestone] is great for media, because it creates more awareness, but practically, it won’t change much,” he added.

 

 

Impact on Bitcoin transaction fees

 

Bitcoin transaction fees have skyrocketed since January, 2020 with an increase of 1,724%. They increased by more than 800% in just one month, with May posting the highest transaction fees since July 2019 so far.

 

Bitcoin fees are related to the number of people who want to transact – the higher the number of people transacting, the higher the transaction fees.

 

According to Arslanian, there has been a lot of activity on the network over the last few weeks due to the Bitcoin halving, but part of it is due to more general interest in cryptocurrencies.

 

 

Impact on the Bitcoin mining community

 

The Bitcoin halving will have the biggest impact on the mining community, because the miners are being compensated with only half the number of Bitcoins for the same work they were doing two weeks ago.

 

Since transaction fees account for a very small part of the rewards that miners gain, despite the recent uptick in the fees, miners depend on the Bitcoin rewards for profitability.

 

Moreover, Bitcoin mining is extremely electricity intensive and requires expensive hardware. Therefore, a reduction in rewards may mean that many Bitcoin miners may find it unprofitable to continue.

 

According to Arslanian, if the cost of mining is higher than the value of the Bitcoins that miners can earn, those who do not have access to cheap electricity or the latest machines will be forced to shut down.

 

Since the Bitcoin halving, around 1.5 million older-generation mining machines have already been taken off from the Bitcoin network.

 

According to miner profitability data tracked by PoolIn and F2Pool, at Bitcoin’s current price and difficulty, old-generation miners – which accounted for 15% to 30% of the Bitcoin network’s total hashrate – won’t be profitable with an electricity rate that’s above $0.05 per kilowatt-hour.

 

With small miners going out of business, there is a risk of mining concentration, where the majority of mining is controlled by a few large mining pools.

 

However, Arslanian believes that Bitcoin has a developed and healthy ecosystem of miners and the risk of mining concentration, although it may be high for some of the smaller cryptocurrencies, is very low for Bitcoin.

 

Bitcoin prices have been steadily increasing, which can keep the mining ecosystem healthy as it increases mining profitability. However, if Bitcoin prices fall, plenty of Bitcoin miners will have to shut down, Arslanian says.

 

To analogize it in more familiar terms, if the value of gold goes up, then it becomes more lucrative for people to mine gold. In the same way, Bitcoin mining will attract more miners when Bitcoin prices keep rising, thereby ensuring that the network remains decentralized.

 

 

Diminishing Chinese dominance in Bitcoin mining

 

China dominates Bitcoin mining, with about 66% of mining happening in the country, which means that Chinese Bitcoin miners control about two-thirds of the crypto network’s processing power.

 

According to Arslanian, there are three main reasons behind this – the relatively low cost of electricity in China, easy access to infrastructure and the latest machines, and the relatively higher awareness of cryptocurrencies in the country.

 

However, many of the Bitcoin miners in China are leveraged, which means that a lot of them have borrowed to buy their machines, or have collateralized their Bitcoin to buy even more machines.

 

This means that if the price of Bitcoin does not increase, many of these miners would be forced to shut down, since they will not be able to cover their debts. Therefore, the percentage of miners in China may decrease in the future.

 

“We may see a diminution of the dominance of miners in China with North America, and Russia being gainers, but again, China will remain the dominant player in Bitcoin mining for the foreseeable future,” says Arslanian.

 

 

Clarity on crypto gains taxation: a positive shift

Cryptocurrencies have undeniably been growing in popularity over the last few years. Tax authorities are also slowly catching on to the crypto industry with the IRS in the U.S. hiring experts to assist in calculation of gains and losses from cryptocurrency transactions.

 

The IRS also hosted a Crypto Summit in March this year and amended its Form 1040 to include questions on cryptocurrencies.

 

Arslanian argues that the crypto industry wants clarification on crypto asset taxation. While regulatory clarity provides comfort to investors, Arslanian thinks that clarity on taxation of gains from crypto assets may help people understand the tax footprint of their investments.

 

“So I would argue that actually having tax clarity will be a positive for the crypto ecosystem,” he says.

 

Paul Tudor Jones predicted that the growing popularity of stablecoins and introduction of Central Bank Digital Currencies (CBDCs), like China’s DCEP, will make the understanding, utility, and ease of ownership of Bitcoin a commonplace option in the future.

 

After all, according to Jones’ letter, “The most compelling argument for owning Bitcoin is the coming digitization of currency everywhere, accelerated by COVID-19.”

 

Header Image courtesy of Henri Arslanian

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