As the name suggests, blockchain technology is built upon the concept of stringing together a series of blocks. These blocks are simply data structures where transaction data is permanently recorded. For every successive block to be added to the blockchain network, the transactions in the block have to first be validated. To achieve this end, the enigmatic bitcoin founder, Satoshi Nakamoto, devised an incentive system that one could describe as nothing less than genius. Transaction validators, known as miners, receive new bitcoin in exchange for validating transactions by solving cryptographic puzzles. After validation, the blocks are then added to the bitcoin public ledger/blockchain.
It takes bitcoin miners approximately ten minutes to verify transactions within one block and produce a new block in that blockchain. At the moment the block reward is 6.25 BTC ,that is, a miner receives 6.25 bitcoin for every block they validate.
So what exactly is halving?
Bitcoin halving is an event that happens every 210,000 blocks, which equates to approximately four years. The term halving is used to express the fact that miners will receive 50% less bitcoin for every transaction they verify. Before the last halving in May 2020, miners would receive 12.5 btc for every block they validated. That amount dropped to 6.25 bitcoin post the halving. Arguably, one of bitcoins greatest value propositions is its limited supply. This was not by accident, it was specifically designed to mimic traditional stores of value such as gold whose supply is finite. Halving was intended to specifically limit the inflation of bitcoin by controlling the amount that goes into circulating supply.
As illustrated, the block reward is halved every four years as we get closer and closer to mining the full supply of 21 million bitcoins. Estimates show that the last bitcoin will be mined in 2140.
What does this mean for miner profitability?
To answer this question, it is essential to note that miner profitability is determined by numerous factors. Therefore, to gauge the effects of halving, we need to take into account how it affects some of these factors.
1. Difficulty
Difficulty is a measure of the ‘amount of work’ it takes to mine a block. A higher difficulty simply means that it will require more computing power to mine the same number of blocks and vice versa. It is undeniable that the reduction in block rewards might serve as a disincentive for some miners, especially well established mining pools. The exit of some miners post-halving causes the difficulty target to drop.
A reduction in the difficulty target provides an opportunity for new miners to enter the network. However, this boon for new miners is usually short lived as eventually the difficulty target rises as more miners enter the network. As shown in the graph, bitcoin’s difficulty dropped after it halved in May 2020 but shortly recovered. The crypto mining ban in China seems to have had a greater impact on difficulty than any of the halving.
2. The price of bitcoin
There has been a notable price increase after each of the previous bitcoin halvings. This rise in prices is largely attributable to rising demand for bitcoin fueled by its growing adoption. A 50% cut in the supply of new bitcoin, especially when there is a huge demand surge, develops a shortage. The only way to induce hodlers to sell is a rally in prices.
Bitcoin’s price appreciation has been one of the key motivators for miners. The effects of a reduction in the block rewards due to halving are reduced if the price of bitcoin is high and rising. Miners can therefore offset their operating costs against the rising value of the bitcoin received as block rewards.
The graph shows bitcoin’s price action leading up to and following the last three halvings.
According to research done by pantera capital, on average bitcoin has bottomed 459 days before the halving date. The price then rallies leading up to the halving date, after which it ‘explodes’ to the upside. Post the halving, bitcoin has historically rallied for an average of 446 days until the bull cycle peaks. The eventual rally in bitcoin post halving has served the purpose of negating the hit miner profitability takes due to halving.
How can miners mitigate the risks posed by halving?
As stated earlier, miner profitability is determined by numerous factors. As much as halving reduces block rewards, profitability is ultimately determined by the miner’s ability to keep operating costs low. Miners consistently have to weigh between their operating costs, block rewards and the price to ensure they stay profitable.
Bitcoin halving is a phenomenon every miner has to contend with as it is contained in bitcoin’s immutable source code. Therefore, to maintain their profitability, established miners can implement cost cutting measures. This includes retiring dated mining rigs to cut down on operating costs and prioritize investment in newer, more efficient devices. Electricity costs account for a significant chunk of a miner’s operating costs, it is therefore worth seeking cheaper energy sources. In order to maximize the block rewards, established mining pools can also opt to split up into smaller mining pools if the difficulty drops.
The graph above shows the total value in USD of coinbase block rewards and transaction fees paid to miners, this can serve as a proxy for miner profitability. Despite the clear volatility, it is clear that miner revenues have been in an uptrend. It is worth noting that Bitcoin has undergone three halvings over that time period.
The miner incentive system remains a vital part of any POW blockchain ecosystem. You can be assured that as long as there are transactions to validate and incentives, it will be possible to run a profitable mining venture.
Antony Sure
Research Analyst - Revolution Mining
