KEY TAKEAWAYS

• In May 2020, the block reward paid to miners will be halved from 12.5 BTC to 6.25 BTC per block.

• The block reward reduction has previously led to price rallies and strongly impacts the profitability of miners.

• Bitcoin’s role as a store of value becomes increasingly important. It shows a low correlation to other asset classes such as equities and gold.

Bitcoin is the oldest successful cryptocurrency and was launched on January 3, 2009. It solved the double-spend problem for a decentralized, trustless electronic cash system, ensuring that each bitcoin can only be spent once. Bitcoin does so by bundling transactions in blocks and chaining these together, which is secured through cryptographic technology and computational resources (proof-of-work). Today, Bitcoin is still the largest cryptocurrency by market capitalization and captures about 66 % of the total market cap of cryptocurrencies. Bitcoin trades at $7.6k at the time of writing.

Looking Back: 2019 in a Wrap

Last year, Bitcoin has made its recovery from the “crypto winter” in 2018. Starting the year at $3.7k, Bitcoin has rallied throughout the first half of 2019 to reach almost $14k in late June, and then corrected to the levels of around $7.6k at the time of writing. With a year-to-date return of 105 %, Bitcoin has been the best-performing asset of 2019. For comparison, the S&P 500 and the tech-focused Nasdaq 100 posted returns of 25 % and 33 % year-to-date, respectively. Market accessibility has been further improved, with physical delivery Bitcoin futures launched in late September.

On the technical side, Bitcoin Core developers have continued to update their node software, currently sitting at version 0.19.0. This brought about several improvements, such as native hardware wallet compatibility. Also, “bech52” addresses – which are less error-prone due to the lack of distinction between upper- and lowercase letters and offer benefits for SegWit – are now the default in the GUI.

Additionally, Electrum – one of the most commonly used Bitcoin wallets – has announced support for Lightning Network payments. The Lightning Network has grown further in 2019 and increased the total capacity among all channels from 525 BTC in January to 825 BTC currently.

More fundamentally, research into the implementation of Schnorr signatures continues as an alternative to the current elliptic curve signature algorithm. Originally proposed as a Bitcoin Improvement Proposal by Bitcoin developer Pieter Wuille, Schnorr signatures would contribute to the scalability of Bitcoin, as well as improving privacy: Multi-signature transactions would be indistinguishable (in terms of signature size) from normal, single-signature transactions on the blockchain. Additionally, the requirement for block space coming from single-signature transactions with multiple unspent transaction outputs (UTXOs) as inputs would be significantly reduced – since only one signature would be required regardless of the number of inputs.

The State of the Bitcoin Network

Illustration 1: The number of transactions per day has been increasing from Q3-Q4 of 2018 through the first half of 2019 and sits now at around 300’000 transactions per day.

Illustration 2: Bitcoin transaction fees paid to miners amounted to around 20 BTC per day in 2019. Upwards spikes in transaction fees typically correlate with increasing market volatility.

Illustration 3: Bitcoin is a truly global network with nodes hosted in almost 100 different countries. The leaders are the United States, Germany, and France, with China on rank 9 by number of nodes.

Illustration 4: The Lightning Network, Bitcoin’s second-layer scaling solution that enables micropayments through payment channels, has seen strong growth of the number of connected nodes in late 2018 / early 2019. Currently, there are around 5’000 nodes present in the network.

Illustration 5: After a slight dip in hashrate (and difficulty) towards the bottom of the bear market in late 2018 / early 2019, Bitcoin’s hashrate – and hence security – continues making all-time highs.

The two last “halvening” events, which cut the block reward handed out to miners in half, occurred in November 2012 and July 2016. Following the 4-yearly rhythm that is deeply embedded in Bitcoin’s protocol code, the next “halvening” is set to take place around May of 2020.

Bitcoin’s “Monetary Policy” Changes in 2020

At block number 630’000, the reward handed out to miners for finding the block will be reduced from the current 12.5 BTC to 6.25 BTC. The predefined schedule for issuing new bitcoin ensures scarcity: There will never be more than 21 million BTC in circulation, and any attempt to change that – e.g. through a hard fork – will most likely encounter massive resistance from the Bitcoin community.

Illustration 6: Bitcoin issuance halves every 4 years. Currently, the rate at which bitcoin is issued to miners sits at about 3.6 % of the total supply per year. In May 2020, this number will be reduced to about 1.8 %.

The maximum supply of 21 million BTC will be reached in 2140. However, since issuance slows down with time due to the halvenings, the majority of bitcoin that will ever be in existence have already been mined today. The current total supply sits at around 18 million BTC, or 85.7 % of the maximum supply. Additionally, it is worth noting that a significant amount of bitcoin has most likely been lost – meaning the original owner has lost access to the private key that controls them. A study estimates that 2.3 to 3.7 million BTC have been lost permanently, which further reduces the effective total supply.

In the past, the block reward halvings have led to extended price rallies following the event.

Illustration 7: Bitcoin price has increased significantly following the previous reward halvings. From the time of the halvening (black line) to the next peak (dashed line), returns on investment of 9’143 % and 2’890 % were achieved, respectively.

The question is now whether the third reward halving will lead to a similar price rally. In principle, the halvening is a predictable event, and all information is publicly available – the supply side increase of the supply and demand equilibrium will be lower. Thus, under the efficient-market hypothesis, the halvening should be “priced in” – however, other factors such as increasing adoption and continued protocol development may also have been contributors to Bitcoin’s previous post-halvening rallies. In a network whose economic incentives for miners are directly correlated with network security due to higher or lower hashrate, price is certainly a non-negligible variable.

Effects of the Halving

After May 2020, the block reward will pay less for network security. This will heavily impact the economics of the mining business. The cost to mine one BTC depends on a variety of factors, such as electricity costs, mining difficulty and hashrate per unit of power. A recent study estimated the cost to mine 1 BTC at an electricity price of $0.05/kWh to be around $5.6k. This cost will increase considerably post-halvening, affecting especially miners using older mining gear and leading to the obsolescence of equipment with lower hashrate-to-power ratios.

In the past, however, halvenings have not led to decreases in hashrate (see Illustration 5 above). After both instances, the subsequent price rallies ensured that miners remained profitable. The time after the first halvening also marked the advent of the ASIC (application-specific integrated circuits) mining area, leading to immense efficiency gains over older methods such as CPU, GPU or FPGA (field-programmable gate arrays) mining – a fact which left its footprint in the hashrate chart.
A block reward halving drastically changes how much the protocol pays out to miners irrespective of network usage (i.e. transaction fees) – next time from 1’800 BTC per day to 900 BTC per day.

Currently, transaction fees only account for about 2 % of the total miner revenue. Since the total miner revenue is tightly correlated with the hashrate and hence the overall network security, there are three possible outcomes. The first is that the Bitcoin price will rally as it did after the first two halvenings – in this case, miners will remain profitable and hashrate will continue to go up. The second scenario in which on-chain transaction volumes and total transaction fees would strongly increase leads to the same outcome. If neither of the two happen, however, then the hashrate could be expected to decrease due to miners with the highest production costs per BTC becoming unprofitable.

The second scenario – an increase of on-chain transaction volume – is also closely related to the heated block size debate that ultimately led to the hard forks that created Bitcoin Cash (forked from Bitcoin) and Bitcoin SV (forked from Bitcoin Cash). Both competitor chains aim to solve Bitcoin’s current scalability limitations by increasing the block size and hence allowing to accommodate more transactions per block. Bitcoin currently has a block size limit of 1 MB, although the use of SegWit – which solves Bitcoin’s transaction malleability and helps with scaling – effectively allows the inclusion of up to 4 MB worth of transactions. Bitcoin Cash’s block size limit is 32 MB; Bitcoin SV lifted the limit to 2 GB in July 2019 with the Quasar protocol upgrade. This highlights the different approaches to scaling between the chains: While Bitcoin plans to achieve scaling off-chain through second layer solutions such as the Lightning Network, Bitcoin Cash and Bitcoin SV proponents argue that scaling should mainly take place directly on-chain.

Another interesting fact to note is that both Bitcoin Cash and Bitcoin SV are projected to undergo their block reward halvings in April 2020 – one month earlier than Bitcoin. Since all three chains also share the same hashing algorithm, much of the hashrate of BCH and BSV will most likely switch over to Bitcoin for a month (until its halvening has also happened).

Bitcoin’s Role as an Investment and a Store of Value

Debt is increasing globally – recently, it was estimated that the global debt would rise to $255 trillion by the end of 2019. Interest rates are already negative in Europe and Switzerland, and the Federal Reserve lowered their target rate to 1.5 % – 1.75 % end of October 2019. Bitcoin was born out of the financial crisis that started in 2007 and offers a hard money system due to its defined issuance schedule. This is especially relevant today in countries with currencies that have issues of trust due to continuous inflation by the government, such as Argentina or Venezuela – where localbitcoins (a peer-to-peer trading platform) volume has reached record highs. In these economies with capital market restrictions, Bitcoin serves as a store of value, similar to gold – with the additional characteristic that it is considerably harder to seize by oppressive governments.

But also in countries where the people still feel safe holding the local currency, Bitcoin makes sense as part of a well-diversified portfolio due to one feature: its low correlation to other markets such as equities or gold.

Illustration 8: Bitcoin has a low correlation to both equities (with the S&P 500 as an example, top) as well as gold (GLD, bottom).

Since mid-2015, Bitcoin has shown a correlation of 0.096 to the S&P 500, and a correlation of 0.020 to gold while providing an overall return on investment of about 3’000 %. Thus, holding Bitcoin in a portfolio improved both diversification as well as risk-adjusted returns. This may also hold true in the coming years, especially if central banks continue their expansion of the monetary base and keep encouraging investments through their policies.

Conclusion

Bitcoin is stronger than ever, with fundamental metrics such as hashrate continuing to make all-time highs. The most anticipated event in 2020 is the block reward halving, which reduces the issuance to miners from 12.5 to 6.25 BTC per block. This has led to significant prices rallies in the past, with beneficial effects to overall network security due to keeping miner profitability high and encouraging longer-term investing into mining equipment.

In order for network security to remain at current levels after the halvening in May 2020, either the price has to increase, or transaction fees need to make up for lost miner revenues. The Bitcoin competitors Bitcoin Cash and Bitcoin SV aim to solve this issue by increasing the block size, which enables more transactions and hence potentially more fees in total which subsidize the network. Bitcoin’s scaling approach is still focused on the development of second-layer solutions such as the Lightning Network; since fewer transactions would then need to be recorded directly on the blockchain, increasing fees would be tolerable.

Bitcoin also remains attractive as an investment – not only due to historical performance, but also due to its low correlation to other markets. Holding Bitcoin is in part also a bet on a future store of value – perhaps a more relevant use case than ever, with growing recession fears across the globe.