Why we think the technicalities of Bitcoin mining explain much of Bitcoin’s extraordinary volatility profile.

Expansions (booms) and contractions (busts) in traditional economic cycles are heavily influenced by monetary policy. In the U.S., since 1857, the National Bureau of Economic Research (NBER) has identified 34 business cycles, averaging 17 months peak-to-trough (busts) and 41 months trough-to-peak (recoveries and booms), for an average total length of 58 months per business cycle. In the modern era (1945 - 2020), with a more active U.S. Federal Reserve, the peak-to-trough average is shorter (10 months) while the trough-to-peak average is longer (64 months).

The foundational structure of the Bitcoin protocol is an immutable limit on the number of Bitcoins that can be mined: 21 million. The protocol reduces the reward for mining new blocks (coins) by half each time 210,000 blocks have been added to the Bitcoin blockchain—an event known as “halving.” Given the relatively stable production rate of bitcoins, halvings have occurred fairly regularly around every four years, with the most recent halving event occurring on May 11, 2020.

Halving Date Block Height Block Reward (BTC)
0 1/3/2009 0 50
1 11/28/2012 210,000 25
2 7/9/2016 420,000 12.5
3 5/11/2020 630,000 6.25
4 2024 (estimated) 840,000 3.125
5 2028 (estimated) 1,050,000 1.5625

Source: Bitcoin Visuals, Binance Academy. Data as at August 24, 2022.

Just as traditional business cycles are influenced by monetary policy, Bitcoin cycles are influenced by these halving events.

Like any commodity that has a falling production price, the price of Bitcoin is likely to fall due to a halving event, all else equal. Increasing mining equipment efficiency is likely to have the same affect, all else equal.

On the other hand, as the computing capacity (or “hash rate”) of the Bitcoin network increases, Bitcoin’s protocol proportionately increases the difficulty of mining—this is what leads to the relative stability of Bitcoin production and the relative predictability of halving events. All else equal, this decreases miners’ revenues while their costs remain constant, incentivizing them to buy existing Bitcoins with their profits rather than investing them in new mining equipment, which can lead to significant increases in the price of Bitcoin.

In short, Bitcoin’s protocol is continually seeking an equilibrium price that balances its network efficiency (the cost of mining) with the cost to purchase Bitcoin. In central banking terms, this is a true “open market” price discovery process that creates a meaningful amount of short-term volatility, and we believe this volatility can then be amplified as the Bitcoin protocol requires miners to navigate periodic structural “policy” shifts, in the form of halving events.

The past two, and arguably the past three, halving cycles of Bitcoin, shown in figure 1, have followed a pattern that we often see in cyclical commodities. While (roughly) the first third of the 210,000 blocks in the cycle are being added, the Bitcoin price typically rallies; the second third has been characterized by a large drawdown; and during the last third, Bitcoin has generally traded sideways, as the rewards for mining and the cost of new equipment equilibrate.

Figure 1. Bitcoin Price and the Halving Cycle

The Unsurprisingly Volatile Business of Bitcoin Mining 

Source: Bloomberg. Data as at August 17, 2022. The chart shows the log growth of the U.S. dollar price of Bitcoin rebased to 1 on July 19, 2010. The current halving cycle is shown hypothetically projected to last until May 11, 2024, which would be exactly four years from the last halving event. Historical trends do not imply, forecast or guarantee future results.

The volatility created by this narrowly understood, multiyear cycle around Bitcoin’s mining process can seem irrational, and as a result it scares away many short-term investors. But building an innovative, open source financial network in ‘broad daylight’ was always going to be messy, and for the handful of investors looking to take a multiyear view, we believe a fuller understanding of the Bitcoin mining process can remove some of the mystery around Bitcoin’s volatility and potentially help to identify long-term investment opportunities.