Article: Wednesday, 17 April 2024
For the past few months there have been rumours that the recent bitcoin price run-up, at least in part, is caused by the upcoming bitcoin halving. In an efficient market, this is not something we would expect. To understand why this is a puzzle, we need a bit of background on cryptocurrencies, blockchain, and price formation in efficient markets.
In this blogpost, Prof. Dion Bongaerts explores the reasons for so much excitement surrounding the imminent bitcoin halving event, expected on 19 April 2024.
In a modern economy, ownership of value, be it cash balances, securities, or other assets such as real-estate are administered using database and IT systems. For example, properly designed and audited IT systems ensure that no one can spend a euro or sell a single share twice (without buying it back of course). Until 2009, such administrative systems were all run centrally by ‘trusted third parties’ such as banks, brokers, notaries, and central banks. We use their administrations because we believe in their integrity and the security measures they implement. To date, we still make use of the services of trusted third parties at a very large scale.
The global financial crisis, however, shook the faith of many citizens in these trusted third parties and their systems because they were directly or indirectly at the root of a crisis that almost wiped out the economic system as we know it. As an anti-reaction, a person or group of persons called Satoshi Nakamoto (a pseudonym) designed a decentralized administration system called blockchain with an associated use case, namely a cryptocurrency called bitcoin.
A blockchain is an administrative system that uses a combination of cryptography and decentralization to create a database that is immutable (i.e., each record cannot be changed after being added). Moreover, a blockchain employs massive duplicity, and because of this it is very resilient to parties that try to corrupt or hinder the administration – and this includes regulators!
Because records cannot be changed after being added, there is no longer a requirement for a trusted third party for the purpose of database integrity. And because of the massive duplicity, interruptions of individual administrators leave the availability of the administration unaffected. Hence, a blockchain, in combination with secure methods to enter data into a blockchain (which were also provided), allow trusted third parties to be substituted by a network of untrusted parties together with some fully transparent blockchain programming code. It is therefore no surprise that the first and so far one of the most successful use cases is a digital currency.
Satoshi Nakomoto, however, built in another feature to set bitcoin apart from the traditional financial system, and traditional currencies in particular. Traditional currencies are managed by central banks through monetary policy. The idea is that a central bank can stabilize the amount of economic activity and therefore prices by actively managing the supply of money in an economy. This is done by tinkering with interest rates, which provide banks with incentives to put more money into circulation or take money out of circulation.
In contrast, bitcoin does not have an active trusted third party in charge of monetary policy. Monetary policy for bitcoin is deterministic: there is a gradual growth in the supply of bitcoins over time. Parties that contribute to managing the administration – called ‘bitcoin miners’ – are more or less randomly compensated by newly generated bitcoins.
However, this growth declines exponentially at almost perfectly predictable and non-discretionary events called halvings when the rate at which bitcoins are generated as compensation for the administrators is halved. The next one is expected on 19 April.
The implications of the deterministic monetary policy of bitcoin are profound and give rise to the highly volatile nature of bitcoin prices. Since no one has discretionary power to change the supply of bitcoin in response to demand fluctuations, prices adjust to make sure that demand and supply are balanced.
In well-functioning and efficient securities markets, the price of a security is equal to the sum of expected future cash flows resulting from it with a correction factor – a discount rate – applied that depends on the riskiness of cashflows. As a result, securities prices in an efficient market should only change if there are changes in expectations of future cash flows or the discount rate. As an example, the price of a stock in an efficient market would increase if expected dividends – these are the cash flows for stocks – increase, or if the discount rate decreases.
Legally, bitcoin is not a security, but in practice for many people, it is. And although bitcoin does not pay any cash flows, neither dividends nor interest, many people expect to be able to buy real or virtual goods or services with it at some point, which will provide them with something equivalent to a cashflow, just as you would save cash to purchase goods or services.
So, given the pre-programmed nature of bitcoin halvings is it likely that the prospect of bitcoin halvings in an efficient market cause the price of bitcoin to run up as the halving gets closer?
Most likely not, because halvings are fully predictable so there is no new information coming to the market. Therefore, expected cash flows (or expected cash flow savings) are unaffected. The effect of the halvings on expected cash flows should already be in the price.
It is also difficult to think of reasons why the halvings would reduce risk in bitcoin returns and therefore justify a smaller discount rate.
So, having excluded rational explanations, what could be behind these bitcoin rumours then?
They could just be rumours without any substance. Alternatively, it could be that the bitcoin market is inefficient after all. This would imply that people in this market are irrational, and particularly so around halvings. It would also imply that this irrationality manifests itself in a coordinated fashion (as otherwise the effect would average out). Finally, it implies that there is insufficient capital available to trade against this irrationality to correct the mispricing. If so, bitcoin was either undervalued before, or its price will, in the longer term, drop again as the irrationality around the halving slowly reverts. Let’s see what happens.
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