NOVEMBER 12, 2018
A Study of Mining Block Rewards and Cryptocurrency Inflation Rates
Bitcoin represents a new technology that represents a significant improvement on existing forms of money and stores of value. For the first time in the history of the world, it is possible to transfer value on a global scale without the need of a trusted intermediary, like a bank or government. One of the key inventions that makes bitcoin have these properties is mining. Mining serves two purposes: it is the incentive mechanism for nodes to support the network and it provides a way to create new coins and distribute them into circulation.
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Miners consist of a decentralized network of nodes that validate new transactions, record transactions on the global ledger, and produce a network-wide consensus without the need of a central authority. Miners are incentivized to do this by the block reward in which new coins are created and given to the first miner to solve a computationally-difficult proof-of-work problem.
This process is called mining because it is analogous to mining for gold or other precious metals. Gold miners expend resources and continuously add gold to the global stock of gold. Similarly, bitcoin miners expend computation resources and electricity to add bitcoin to the global supply of bitcoin. The block reward for bitcoin and most other proof-of-work coins decreases exponentially over time. Eventually, the block reward will decrease to zero and no new bitcoin will be added into circulation. This design decision is significant because this marks the first time in the history of the world that we have a provably-scarce digital asset and a non-inflationary store of value.
Understanding Miner Economics: Miners Are a Continuous Source of Selling Pressure
One of the main reasons why bitcoin is special is because the network is supported by a network of nodes that enables value transfer without a trusted intermediary. This is only possible if the network is sufficiently decentralized, but the degree that bitcoin is decentralized lies on a spectrum between full-decentralization on one end and full-centralization on the other. Full-decentralization would be a world in which each individual that uses the network also runs a mining node. Full-decentralization would be a world in which there is only a single miner that would serve in a role similar to a central bank.
The reality is that bitcoin is closer to the middle of this spectrum than either end. At the time of this writing, the bitcoin network consists of 10,047 nodes. A subset of these nodes are mining nodes. Some mining nodes represent large mining pools in which individual miners come together to combine their hash power and share the block reward based on how much hash power each individual has contributed.
Mining is zero-sum in that each miner is in competition with other miners over the same block reward. Mining has gotten so difficult and resource-intensive that it is largely uneconomical for an individual or hobbyist to participate. Instead, there are large economies-of-scale to mining. Large miners locate themselves in areas of the world where electricity is cheap and the climate is favorable, are able to negotiate lower rates with electricity utility companies, can purchase large quantities of the most efficient mining equipment, and rent large facilities to operate the equipment. The ability to mine at scale lowers the cost of mining a single bitcoin. And since mining is a competition, most miners must operate as businesses in order to mine at scale.
One of the most common misconceptions that I have heard is that miners represent individuals are the biggest believers in crypto and thus are more likely to start saving coins they mine when prices decline below their breakeven cost or some fair value. Hobbyists may use this investment strategy, but miners that operate as businesses cannot because mining businesses incur expenses just like any other business. Mining expenses include the cost of mining equipment, electricity to operate the miners and cooling, facility rent, server maintenance, internet connectivity, salaries, insurance, legal services, taxes, and so on. These expenses are denominated in fiat (electricity utility companies will not take bitcoin as payment) and fixed, regardless of how crypto prices move. Thus, miners are compelled to regularly sell a portion of the coins that they mine to cover their fixed fiat-denominated expenses.
Compelled and continuous selling pressure from miners are also a big reason why prices in crypto prices regularly follow a bubble-and-crash cycle. Miners face a crypto-fiat mismatch in that their revenue comes in the form of the coins that they mine, but their expenses are fixed and denominated in fiat. When prices are low, as they are now, miners must sell more of the coins that they earn to cover their fixed fiat expenses. If prices trend even lower, this increases the selling pressure from miners. When prices are high, miners can afford to sell less of their coins. Both of these behaviors reinforce the direction in which crypto prices are moving.
Miners represent a significant and continuous source of selling pressure for any coin that is secured by miners that compete to solve a proof-of-work problem for a block reward. Understanding the block reward and miner economics is important to understanding why prices behave.
Bitcoin Has the Lowest Inflation of the Major Proof-Of-Work Coins
The bitcoin protocol governs its money supply. The block reward initially started at 50 bitcoin per block in January 2009, halved to 25 bitcoin per block in November 2012, and halved to 12.5 bitcoin per block in July 2016. The protocol is designed to reduce the block reward by half every 210,000 blocks or approximately every four years, assuming that each block is created on average every 10 minutes. Based on this formula, the block reward is expected to be reduced to 6.25 bitcoin in May 2020. Bitcoin has experienced two block halvings in its history. Following both of these block halvings, bitcoin price has rapidly increased and formed a local peak within 1.5 years of the halving. Block reward halvings are significant because it causes a halving of aggregate miner revenue. Since miners are a continuous source of selling pressure, the halving of their revenue reduces the maximum amount that miners can sell to cover their fixed fiat expenses. The reduction in selling pressure causes prices to rise, which causes miner profitability to improve, which allows miners to save more coins. This feedback loop leads to a virtuous cycle which culminates in a bubble.
Halvings also force unprofitable miners to leave the network. Unprofitable miners are less efficient miners and have higher breakeven costs. As unprofitable and inefficient miners leave the network, this raises the aggregate efficiency of the remaining miners. More efficient miners have lower breakeven costs and therefore need to sell less bitcoin to cover their fixed fiat expenses. The increase in efficiency also causes prices to rise.
The current block reward of 12.5 bitcoin translates into the global supply of bitcoin increasing by an annualized inflation rate of 3.8 percent per year. Inflation will slowly decline to approximately 3.6 percent by May 2020 and then subsequently decline to 1.8 percent. For most of bitcoin’s history, it has been in a high-inflation environment, but in the near future, bitcoin’s inflation will decline below the 2 percent threshold that many central banks around the world use as their inflation target and will be approaching gold’s inflation rate which is approximately 1 percent. Bitcoin already has the lowest inflation of the major proof-of-work coins.
The halving in May 2020 will be the third halving for bitcoin and should be an impactful event for prices. Each subsequent halving, however, is less impactful compared to previous halvings because the absolute reduction in the block reward and the absolute reduction in the inflation rate is lower. The halving in July 2016 reduced the block reward by 12.5 bitcoins, for example, and reduced inflation by around 4 percent. The next halving will only reduce the block reward by 6.25 bitcoin and reduce the inflation by 1.8 percent. Therefore, while the next halving should be impactful, it will likely be less impactful than the two previous halvings, and we should expect subsequent halvings to have even less of an impact over time.
Litecoin Will Test the Block Reward Reduction Theory in 2019
The litecoin issuance model is identical to bitcoin’s except that blocks are produced every 2.5 minutes and the total amount of litecoin is capped at 84 million. The block reward initially started at 50 litecoin per block in October 2011, and halved to 25 litecoin per block in August 2015. The block reward is anticipated to be halved to 12.5 litecoin in August 2019.
Litecoin has only experienced one block halving in its history. The price reaction to the halving is different than what happened to bitcoin because of some litecoin-specific events that occurred around the time. One, speculators widely anticipated the impact that the halving would have on prices and began bid up prices in summer of 2015, several months before the halving. Two, a litecoin ponzi scheme was enormously successful in attracting large amounts of litecoin during the same period. At its height, the ponzi scheme had attracted 22 percent of all litecoin in existence. Litecoin price sold off immediately before the halving as the ponzi scheme unraveled and as speculators sold in advance of the halving event. But significantly, the halving successfully stemmed the decline in prices during this period. Current litecoin annualized inflation is approximately 9.3 percent per year. The halving in August 2019 will reduce the inflation to approximately 4.5 percent per year. Since this will be only the second halving for litecoin, it will force a significant reduction in the block reward and inflation rate. The halving should be an impactful event for the price, and we should expect speculators to begin accumulating litecoin as the halving date approaches.
Ethereum Will Experience a 33 Percent Block Reward Reduction in January 2019
Ethereum also uses proof-of-work for its consensus protocol. Unlike bitcoin, however, ethereum does not have a predetermined issuance model and there is currently no cap on the total amount of ether that will be produced. Ethereum rewards consist of block rewards given According to the development roadmap for ethereum, it will eventually move to a proof-of-stake model and the inflation rate will depend on how much ethereum is being staked. Although no consensus has been reached on the exact issuance model under proof-of-stake, Vitalik Buterin expects the inflation rate to decline to a 0.5 to 2 percent range.
In order to smoothly transition from proof-of-work to proof-of-stake, a difficulty adjustment scheme was introduced on September 2015 in which the difficulty for mining a block would begin to increase exponentially. This would eventually force mining to become unprofitable and force a hard fork to use the proof-of-stake protocol. This is also referred to as the “difficulty time bomb” which would cause an ethereum “ice age”. This increase was programmed such that the effects would begin to have a meaningful effect on mining roughly 12 months after it was introduced and the network would become virtually unusable after 16 months.
This difficulty adjustment scheme was implemented at a time early in ethereum’s development when the developers believed that the ethereum core developers would be able to hit deadlines on their roadmap and introduce proof-of-stake before the network reached the ice age. Due to delays in the development process, the ice age was beginning to have a significant effect starting in 2017 which caused block times to slowly increase from the target block time of 15 seconds to 30 seconds near the end of 2017. The increase in block times caused ethereum’s inflation to fall from a rate of around 14 percent at the beginning of 2017 to 6.5 percent in late 2017. The sharp reduction in inflation also coincided with a sharp increase in the price over this time period as miners could sell less of their coins on the market. In order to address the impending ice age, the core developers adjusted the issuance model to delay the difficulty bomb by one year and reduced the block reward from 5 to 3. This was accomplished with the Byzantine hard fork which occurred in October 2017. This change in the issuance model actually slightly increased the inflation in Ethereum due to the reversal in effects of the ice age.
The transition to a proof-of-stake protocol continues to experience delays. In the upcoming Constantinople hard fork, core developers are again delaying the difficulty bomb by 12 months and reducing the block reward issuance from 3 to 2. The target date for this issuance reduction is in January 2019. This 33 percent reduction in the block reward will reduce inflation from its current level of 7.5 percent to 5 percent. This reduction in issuance results in a meaningful reduction in inflation and should be impactful on the price of ethereum, although to a much lesser extent compared to the first reduction in issuance.
When Ethereum transitions to proof-of-stake, inflation should fall to 2 percent or below, depending on how much ethereum is staked. Since the difficulty bomb is only going to be delayed for one year, another hard fork will be necessary on or around January 2020. Ethereum will be experiencing a significant decline in its inflation rate as the roadmap advances.
Thanks for reading everyone. Questions or comments, just let us know.
Portfolio Management Team
Thejas Nalval | Kevin Lu
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